CornerCap Investment Counsel Inc.

11/30/2021 | News release | Archived content

Putting Omicron in Context

The potential spread of the omicron strain is roiling markets. Here's our quick take to keep it in perspective.

At its face, the potential rise of a new variant adds to an already uncertain time. (How uncertain? See our companion comment on investing and uncertainty.)

Uncertainty tends to make people uncomfortable. They want to "do something" to feel in control, and those decisions often end up being counter-productive. You won't be surprised to hear us say, keep those emotions-whether greed or fear-in check.

As to the path of omicron, it may take weeks to gain more insight. Key questions are:

  • Will it have a meaningful economic impact? That will depend on how severe it is, how contagious it is, and how effective vaccines are.
  • Will the virus increase current supply chain challenges? And will inflation stay high?
  • Will it force the Federal Reserve to change its approach to interest rates?

We believe the answers will be incremental rather than radical. We don't expect them to change our broader view that:

  • The US consumer remains a strong force to support economic growth and earnings power among companies for 2022.
  • Inflation will likely be lower next year than current levels (6% in October) as supply chain issues gradually subside by next summer…
  • … but inflation should stay higher than what we've been used to, mainly because labor and housing markets remain tight, adding to wage and rent inflation.
  • This backdrop should remain positive for stocks, a hurdle for bonds, and good for real assets.

Importantly, with the latest omicron news, markets are behaving as you would expect. That is reassuring, despite the uncertainty investors may feel. What do we mean?

  • Headlines, not deep fundamentals, are driving market movements in a rather predictable pattern. This has been the case really since the pandemic started.
  • One of the major patterns is tied to the outlook for interest rates. We highlighted this recently here: https://cornercap.com/markets-jolt-big-tech-in-trouble/
    • When investors get defensive, rates tend to fall and the yield curve flattens; during the pandemic, Large US Stocks-heavily skewed to Big Tech-tended to benefit from these moves. With the omicron news, no surprise, investors sought defense, bond prices rose (yields fell), and Big Tech has done well.
    • As rates rise (within reason), the broader cyclical stocks tend to do better. This makes sense, as rising rates tend to mean a healthier economic outlook and improving appetite for risk. On the omicron news, these investments have lagged. If omicron recedes, we expect these groups to do well.
    • Importantly, Big Tech has not historically followed this pattern of trading inversely with rates. We don't expect it to persist indefinitely, but it may work until investor temper their expectations for growth.

We see similar rationality in fixed income. With Chair Powell's announcement today that the Federal Reserve may move more aggressively to taper and ultimately raise rates, bond investors responded accordingly: nearer-term yields rose, longer-term yields fell, and the "yield curve" continued to flatten. Bond markets are (beginning to) digest the Fed's policies, and they are also saying they don't expect inflation long-term to be a major problem[1].

These rational responses don't mean there won't be high volatility though. That's because today's headlines might run counter to yesterday's as we gain insight to the questions outlined above. When markets aren't directly tied to deep fundamentals, this kind of volatility can happen, from our experience.

As a final comment, we'll point out that we ignore the daily headlines. We have actively responded to fundamental and economic indicators along the way and "in advance" to build diversified portfolios designed to navigate uncertainties such as these.

Our bottom line here is that omicron is certainly an unknown that will gain clarity over time. More broadly, it is an example of unexpected events that happen with some frequency, where timing and outcomes are unclear. We strive to navigate uncertainties like omicron through diversified investment strategies designed around your risk profile and wealth plan.

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For details on our current positioning, see https://cornercap.com/the-next-phase-in-the-pandemic-era/.

To summarize:

  • We believe the best opportunity today for long-term growth is in small stocks and quality cyclical stocks, as part of a more broadly diversified set of investments.
  • We have a basic allocation to Large Cap US Growth stocks, which includes Big Tech, as a hedge to periods of falling rates. If those stocks lag for a period, we might increase exposure there.
  • To supplement fixed income, we use alternative strategies in private real estate, middle markets debt, and special situations (as appropriate by client) to help optimize yield and, in some cases, hedge against inflation.

[1] The debate rages as to whether bond markets (and the Fed) are too tame in their view of long-term inflation. We tend to give more weight to messages from bond investors, since they tend to have a longer horizon than the average equity investor. That said, bond markets can get it wrong. Our own view is that embedded inflation may gain enough traction, especially in wages and rents, to render inflation higher than what bond markets expect; but we agree that hyper-inflation (greater than 5%) is not the likely outcome.