Overview
This month’s Scotsman’s note tackles a wide range of topics, beginning with the Omicron variant of SARS-CoV-2, the latest strain of the coronavirus to be designated a “variant of concern” by the World Health Organization (WHO). We then tackle new issues including the re-appointment of Fed Chair Powell and a recap of the COP26 climate change summit. Then finally, we review recent economic and inflation trends, check in with supply chains and the oil market.
Just when you thought it was safe to go back… Omicron B.1.1.529 variant surfaces
Continuing a trend that has been in place for the better part of two months, COVID-19 infections have continued to rise in the developed world. In recent days, more and more countries are reporting cases of the new Omicron variant, which has an unusual combination of mutations that may enable it to spread faster. Scientists are also trying to determine whether the current vaccines are effective in combatting it.
COVID-19 emerging markets vs. developed markets infections
As of 11/21/2021. Calculated as the 7-day moving average of daily infections. Source: WHO, Macrobond, RBC GAM
So far, this virus variant has not been found in many people, so it is impossible to for us to predict if it is anything to be really concerned about because we cannot clearly see how it behaves in the real world. When the Delta variant emerged, we saw very rapid growth within weeks. So far, we have not seen any data anywhere in the world that is clearly demonstrating this behavior in B.1.1.529, yet. Generally, surveillance in sub-Saharan Africa has been poor, so the lack of real-world evidence is simply because we do not have enough eyes on the ground. If the variant has truly been found in multiple countries, then it could represent it is spreading rapidly beneath the surface, and perhaps even outcompeting Delta.
Fed Chair renewal
A key source of uncertainty this autumn (fall for our U.S. readers) was whether U.S. Federal Reserve Chair, Jerome Powell would be nominated for a second term, or instead replaced by the more left-leaning Lael Brainard. That uncertainty has been resolved. President Biden has opted to revert to the long-standing tradition (broken four years ago by President Trump) of nominating the Fed Chair for a second four-year term.
We think the decision on both appointments, yields a slightly more hawkish policy, though it is hardly hawkish in an absolute sense. Nonetheless, at the margin, the decision would appear to be U.S. dollar positive, yield positive and possibly stock market negative (though the stock market may care more about stability and ending high inflation than it fears incrementally tighter monetary policy). Given rising inflation levels and the extent to which the U.S. economy has recovered, it is arguably for the best that the Fed does not pursue a more dovish path. All this being said, Lael Brainard will still be involved in the monetary policy process. She is Vice Chair, and we expect her to supervise the banking sector in that role.
COP26 climate review
The latest edition of the annual global climate change summit – COP26 UN Climate Change Conference, hosted by the UK in partnership with Italy, started on October 31 and ended on November 12, 2021, in the Scottish Event Campus (SEC) Glasgow, UK (my hometown btw). Notably, 151 countries announced incrementally more aggressive climate plans to reduce emissions by 2030. More importantly, specific agreements were reached to:
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- Reduce methane emissions.
- Stop and reverse forest loss.
- Align the financial sector with net zero goals by 2050.
- Phase out internal combustion engines.
- Reduce the use of coal more quickly.
- Provide more support for poor countries pursuing their own climate mandates.
Despite this progress, commitments fell short of levels needed to restrict climate change to a 1.5-degree cumulative increase. That target now seems unlikely to be met, given that global emissions would have to be cut by more than 50% by the end of the decade for it to be achieved.
We expect future meetings to yield additional promises. Laggards such as China, Saudi Arabia and Australia may participate more enthusiastically in the future. Unfortunately, we anticipate many countries will probably fail to reach their targets. In turn, we assume the actual temperature change ends up being close to 2.5 degrees. There are a variety of economic consequences that emerge from this amount of climate change (and from policies designed to limit further warming). These are fairly small at the aggregate level. However, there is a great deal of uncertainty around them and there are massive implications for certain sectors. More to come on this…
Economic trends: Buy U.S.
The U.S. economic trend remains favorable: the mini acceleration we discussed in my last commentary is still seemingly underway. U.S. retail sales data for October was up by a strong 1.7% and industrial production rose by 1.6% over the same month. While not having the finalized data, our models suggest November trends also to be positive.
Conversely, most other developed countries are now underperforming. For example, U.K. GDP rose by 1.3% (un-annualized) in the third quarter. However, this was a tepid showing relative to the prior quarter. It was impeded by a return of COVID-19 infections in the U.K., forcing many people to isolate at home once again. In addition, global supply chain problems have proven particularly acute for export-oriented economies including Germany, Japan, and Korea.
Inflation update
The latest global inflation readings remain high. The U.S. Consumer Price Index (CPI) in October rose 6.2% on a year-over-year (YoY) basis, the highest reading since 1990. Prices roses by a mammoth 0.9% over the past month alone. Core inflation is not so extreme, but has nevertheless now reached +4.6% YoY, with increasing evidence that inflation pressures have broadened out from their original drivers. As we had predicted in an earlier note, this is not transitory. U.K. CPI is now at +4.2% YoY and Eurozone CPI is +4.1% YoY. Japan is the only major developed nation bucking the trend (just +0.1% YoY CPI). To the extent that the developed world buys consumer goods from China, it is concerning to me that China’s Producer Price Index (PPI) rose at its fastest rate in 26 years in October: +13.5% YoY.
Supply chain improvements?!@
Supply chain problems remain an issue. However, patchy improvements are becoming visible. The number of container ships waiting to dock and unload their goods in Los Angeles and Long Beach has fallen (a key metric I follow). However, we hesitate to celebrate too much until my newly purchased furniture arrives…
Container ships at anchor or holding areas in Los Angeles and Long Beach
The cost of shipping goods around the world has also declined – incrementally for containers and quite sharply for dry bulk goods. The actual cost of shipping products is not usually a large part of a product’s price – and therefore is not a big inflation factor. However, insufficient shipping throughput has been a major problem for many industries during this cycle and so lower shipping costs should correlate well with easing supply chain problems.
Shipping costs falling but still elevated
As of 11/22/2021. Shaded area represents recession. Source: Baltic Exchange, Macrobond, RBC GAM
Southern California ports are getting serious about eliminating the backlog of unloaded containers waiting at their ports via the introduction of a new system of fines. However, to the extent there is a severe shortage of truck drivers and rail constraints, it is not clear whether this will significantly resolve the problem. Happily, several large retailers announced in their recent earnings reports that they had plenty of stock for Black Friday and beyond. It is hard to say the extent to which this represents genuine improvement, companies putting a positive spin on the situation, or perhaps even larger retailers outmuscling smaller ones for access to shipping.
Oil outlook
Oil prices have declined but are still high even by the standards of the pre-pandemic period. High oil prices were not expected to be a feature of the pandemic recovery, as demand for oil remains lower than it was pre-pandemic for obvious reasons: fewer people are commuting to office jobs and plane travel remains below prior peaks. But suppliers have proven slow to increase their production, resulting in a shortfall.
We continue to expect oil prices will fall further over the coming six months, for several reasons. First, the International Energy Agency forecasts that oil supply will rise by 1.5 million barrels per day over the remainder of 2021 – a significant sum. The Agency further expects that global oil supply will then moderately exceed demand for most of 2022. Additionally, in keeping with the historical experience after episodes of high energy prices, OPEC now predicts that recent elevated oil prices will hurt energy demand in emerging market countries such as China and India. Finally, financial markets certainly anticipate a further decline in oil prices, as per oil futures that are in an extreme state of backwardation. Backwardation refers to a situation in which the futures market anticipates a lower price in the future relative to the current market price.
With a focus on the U.S., oil production remains well below pre-pandemic levels. This implies significant latent capacity to increase output. Further, there is evidence that this is now beginning to happen, albeit gradually, given a rising rig count (see subsequent chart).
As of the week of 11/12/2021. Source: Baker Hughes, Bloomberg, RBC GAM
To be clear, none of this is a prediction of outright low oil prices. It is more likely that oil prices simply become a bit less high. And we must be particularly cautious in assuming that the supply response will be as eager as in the past given new headwinds. These include a more difficult fundraising environment for oil producers and fears of accumulating reserves that could later be stranded due to climate change mitigation efforts.
Scotsman’s View
The global economy has moderated, but growth remains quite good, and in our view, the economic cycle still has several years of expansion ahead. In this environment, interest rates remain low, but central banks are now contemplating reductions in their bond-buying programs before raising interest rates. We think that bond yields are likely to gravitate higher at a gradual pace. From current levels, even a slight increase in yields would result in negative returns for sovereign bonds.
Overall, recent developments for investors are mixed, perhaps skewing slightly in a negative direction.
Positives include:
- The U.S. economy continues to grow after a lull.
- Supply chain problems have become a bit less bad.
- The Fed Chair will remain unchanged for another four years.
Negatives include:
- New Omicron variant cases rising globally.
- Non-U.S. developed and emerging nations appear to be suffering an economic deceleration.
- Inflation remains high and is no longer transitory.
Given this backdrop, we would remain overweight stocks as they continue to offer better upside potential. We recognize, however, that valuations are demanding and that continued robust growth in profits together with heightened investor confidence will be needed to keep the bull market going. For these reasons, we would suggest keeping a modest cash position to cushion against any volatility and to provide funds for opportunities as they arise.