Capital Markets Commentary

Overview

This month’s Scotsman’s note tackles a wide range of topics Omicron peaking, another potential variant, lockdowns ebbing, choppy markets, and Russia/Ukraine. More recently, the challenges have outweighed positive developments.

Negatives:

There is mounting evidence of real economic damage from the Omicron wave in both December and January.
A sub-variant of the Omicron variant could be twice as contagious.
Geopolitical risks surrounding Ukraine continue to mount.
Inflation has increased even further.
Central bank tightening appears to be imminent.
Financial markets have recently tumbled.

There are fewer positives, though they are important:

The Omicron wave may be peaking.
Activity restrictions are beginning to ease.
Economic activity should accordingly accelerate from there.
Q4 corporate earnings announcements have been robust.

Omicron peaking

The Omicron wave appears to be peaking in the developed world (see next chart). This is consistent with the experience in countries that encountered the variant first – it has repeatedly proven to be a high but brief wave

Consistent with this, the fraction of countries reporting rising daily COVID-19 cases has plummeted from nearly 90% a month ago to just over 50% today. This is a welcome change, though it also concedes the point that most countries have not yet encountered their peak – especially in emerging-market countries. India’s infection rate is unfortunately spiking again.

Among the countries now mending, the U.K. infection rate is already just half its earlier peak, Canada shows some nice improvement, and the U.S. numbers are down slightly. At a minimum, fewer U.S. states are suffering rising caseloads than before (see next chart).

As of 1/23/2022. Transmission rate calculated as 7-day change of underlying 5-day moving average of new daily cases, smoothed with 7-day moving average. Transmission rate above 1 suggests increasing new daily cases. Includes Washington, D.C. Source: Haver Analytics, Macrobond, RBC GAM

Another potential variant

As I have written about previously, since mid-December there have been reports of an Omicron sub-variant named BA.2. It has now been found in 40 countries, including India and many western European nations.

Sub-variants crop up all the time, but BA.2 is a worrying development because it appears to be significantly outcompeting the original Omicron strain in Denmark (to the point of now representing over 50% of new infections), with a sharply rising trend now being reported in the U.K., Germany, and the Netherlands. Over half of Indian infections may also be of the BA.2 variety.

Estimates from Denmark are that BA.2 possesses a 90% growth advantage versus Omicron. The early estimate in the U.K. is that it has a whopping 120% growth advantage. This means that it can be expected to spread around twice as quickly as Omicron. That’s remarkable and frankly rather distressing given that Omicron was already among the most contagious viruses in history. That said, the data quality is not yet particularly good, in part because standard tests cannot distinguish between BA.2 and the Delta variant.

It is too soon to say whether BA.2 is more contagious or instead better at circumventing vaccines. The distinction does matter to the extent it informs the extent to which vaccinated people should be concerned and whether vaccine-makers need to revise their formulas, but in the short run it is all the same: there would seem to be yet another looming risk of a further wave.

Lockdown’s ebbing

Notwithstanding the possibility of another COVID-19 variant, there is evidence that we are passing peak lockdowns. This is mostly in the form of government announcements that restrictions are being or will soon be eased.

There are two reasons governments are easing their rules. First, the Omicron wave appears to be peaking or even receding in many jurisdictions. Second, attitudes toward COVID-19 continue to evolve. In early 2020, most countries were in a zero-tolerance mode. They then progressed toward a limited-tolerance approach over the past year and a half. Now, as the willingness to abide by restrictions erodes, vaccination campaigns approach saturation and the rate of bad outcomes diminishes, countries are increasingly choosing to view COVID-19 as akin to a flu.

Even as restrictions ease, the global economic hit from the Omicron wave remains significant: according to Goldman Sachs estimates, the current level of restrictions is consistent with economic activity that is around 1.5% lower than before the wave, and around 3.5% lower than it would have been in the absence of the pandemic altogether. Near-term, data (business confidence & retail foot traffic), along with unemployment claims, suggest January employment and retail sales could again be weak … in part due to Omicron. At the same time, other headwinds are building – some Covid-benefited sectors are seeing demand fall, inventories grow, prices weaken, and production cut. The good news is that’s all deflationary. The bad news is that there’s a lot more of that to come, with Peloton, Lululemon, and Netflix just for openers.

Choppy markets… Thanks Omicron, the Fed and Inflation

Stocks have performed quite poorly in recent days and weeks. At the time of writing, the S&P 500 is down around 10% from its peak – thus almost in correction territory.

The stock market decline is not completely indiscriminate. Higher beta stocks are naturally down by more, though that is normal. More interestingly, it is the most expensive and lowest quality stocks that had previously led the market that are now underperforming. The information technology sector has felt the brunt of this.

Why are markets retreating? It arguably has little to do with COVID-19 given that Omicron is beginning to improve. We think the main reason is that the U.S. Federal Reserve is gearing up to begin a tightening cycle. This has created anxiety over the prospect of more restrictive monetary policy in general, as several central banks have pulled forward and ratcheted upwards their planned tightening cycles.

And, of course, beneath central bank tightening lies high inflation. While we don’t believe inflation will be structurally elevated, if one wanted to reprice the stock market for a persistently 4% inflation world rather than a 2% world, you could argue fair value in the stock market should decline by about 10%. We hasten to emphasize again that we do not believe there is a structural change in inflation underway.

Russia/Ukraine

Ukraine and Russia are again in focus as Russia amasses weaponry along the Ukrainian border. The two are not strangers to conflict: Russia invaded and captured the Crimean portion of Ukraine in 2014 and has maintained an outsized influence over parts of eastern Ukraine ever since.

The rate of troop movement and seasonal considerations argue that Russia is likely to act soon if it ultimately opts to invade. Some diplomats and the families of diplomats are now leaving Kiev. Russia has stated it is threatened by NATO as it looks to welcome Ukraine, and in so doing expand right to Russia’s border. Russia demands that former Soviet bloc countries never be allowed to join NATO, that it removes its weaponry from eastern European nations, and that the U.S. remove all nuclear weapons from Europe.

NATO members are unlikely to oblige these requests. The U.S. and others have been vocal in warning Russia not to take further actions and are much better prepared than they were in 2014, including the Ukraine. Some military repositioning has occurred, and the U.S. has threatened a forceful response.

The “Let’s be Sensible” crowd assigns a 75% chance of a Russian invasion resulting in fatalities. Thus, it is not certain, but it is deemed likely. We are inclined to assign a somewhat lower probability, but no lower than 50%. Of course, such an invasion could take any number of forms. A mild invasion scenario would find Russia crystallizing control over the 7% of Ukrainian territory with a significant Russian population that it has already functionally possessed via rebels for the past seven years. A more aggressive invasion would see Russia claiming a substantial portion of the country. An extreme scenario would see the capital claimed and the government forcibly overturned. The worst-case scenario would be the above plus direct military conflict between Russia and NATO nations, as opposed to merely with the Ukrainian military.

That said, there are certainly ways in which a military conflict can be avoided. Russian President Putin historically becomes more popular domestically when he threatens war on others. So long as he can extricate himself without appearing to have lost face, he will enjoy higher popularity. Russia could also “win” if the stress put on Ukraine results in the fall of its government, with the possibility of more Russian influence thereafter (though it is hard to fathom voters inclining in this direction after recent threats). This episode could also decrease Ukraine’s inclination to join NATO and reduce the likelihood of other border states later joining NATO – which would be a win for Russia.

Alternately, military conflict may be avoided – or quickly halted – via aggressive sanctions on Russia. This could include limiting the travel and financial flows of senior government officials or blocking Russia from accessing the global SWIFT financial network (which would be economically catastrophic for Russia in the short run but could backfire against the U.S. eventually if a competing network were developed). It could also mean preventing Russia from accessing key electronic components. The Russian stock market has retreated on these fears.

Of course, Russia has a trump card of its own. It provides for a large fraction of Europe’s energy needs, famously via natural gas pipelines, but also in the form of oil and coal. If Russia were to turn off the spigot, that would be a big problem for Europe. Of course, it would also be a huge problem for Russia from a government revenue perspective. Furthermore, it might trigger the aforementioned sanctions, motivate reluctant countries such as Germany to participate more fully in any military opposition to Russia, and ultimately encourage Europe to turn away from Russian energy via a mix of alternative sources in the medium run and renewable energy in the long run. As such, we think any energy shutoff is unlikely barring a worst-case confrontation.

What to take from all of this? The Ukrainian situation is an undeniable geopolitical risk, and one of particular significance to energy prices. That said, a major military conflict is not a part of my base-case economic forecast. Major geopolitical risks rarely manifest, and even when they do, they rarely have a lasting influence on the economy or global financial markets. The events of seven years ago certainly didn’t.

SCOTSMAN’S BASE CASE ASSUMPTIONS FOR 2022:

COVID peaks and its impact on the economy diminishes.

Inflation peaks and noticeably moderates.

The labor market is not as tight as consensus thinks.

The Fed ultimately does less than consensus is forecasting.

Corporate profits remain resilient as both operating margins and growth positively surprise.

ESG RESEARCH COMMENTARY

The History of Black History Month

Despite being the shortest month of the year, February has long been an important month in our nation’s history. While it is the only month affected by the leap year, shares the tradition of not only Ground Hogs Day but the Hallmark holiday of Valentine’s Day, and has the venerable long weekend honoring all of our country’s Presidents, the annual observance to honor and celebrate the innumerable achievements of African Americans is one of meaningful historical significance and sacrifice.

While there are countless people we could highlight when speaking of all the contributions that Black Americans have made for our country, we’d be remiss if we didn’t recognize the trailblazer and visionary who was instrumental in creating what we now call Black History Month.

Black History Month as we know it, is an extension of what was previously known as “Negro History Week” established nearly a century ago on February 7, 1926, thanks to historian Dr. Carter G Woodson. Woodson purposely chose the timing of the week to coincide with the birthdays of two of the most revered men at the time by the Black community, Abraham Lincoln and Frederick Douglass. Subsequently, 50 years later with the country’s bicentennial and nearly eight years after the Civil Rights Act was enacted, President Gerald Ford expanded it to encompass an entire month asking Americans to “seize the opportunity to honor the too-often neglected accomplishments of Black Americans in every area of endeavor throughout our history.”

But who is Carter Woodson?

Born in New Canton, Virginia in 1875, Carter Woodson was the fourth of nine children born to illiterate parents who were formerly enslaved. Growing up during the Reconstruction era, he had few educational or employment opportunities until his family moved to Huntington, WV. It wasn’t until the age of 20 where had saved up enough money from working in the coalmines to enroll and graduate from one of the few black high schools in the area at the time. He later obtained multiple college degrees from Berea College, the University of Chicago and finally earning his PhD in History from Harvard University, making him only the second black American, following W.E.B. DuBois, to do so. He is also the only person of enslaved parents to earn a PhD in History from any institution in the United States.

While clearly an intellect as education was an important facet of his life, it was the feeling that Black history and African-American contributions and achievements were largely being ignored, misrepresented and entirely absent in American history books that prompted his lifelong dedication to remedy the issue. Woodson’s entire career was spent teaching black history in some form or fashion and authoring more than twenty books. He founded the Association for the Study of Negro Life and History and established black history as an actual field of study, and because of this, was given the moniker the “Father of Black History” and the “Father of Black History Month”.

Not only did Dr. Woodson break barriers and boundaries in an era that was nothing short of impossible for a Black man to do, he worked tirelessly to promote the teachings of black history and is credentialed as being one of the greatest thought leaders of his time. Let his work and passion serve as a reminder that understanding the complete history of Black Americans is a key to understanding the strength and richness of our nation that cannot be confined to merely just a month.

“Those who have no record of what their forebears have accomplished lose the inspiration which comes from the teaching of biography and history.” – Dr. Carter G. Woodson

Country Governance Research Commentary

by Matthew Zimmer, Head of Governance Research

Tensions over Russian troop buildup near Ukraine continue

Over the past several months Russia has built up its forces surrounding Ukraine in a way that military observers have said gives them a range of possibilities including a full-scale invasion. U.S. General Mark Milley, chairman of the Joint Chiefs of Staff, described Russia’s deployment as the largest in scale and scope since the days of the Cold War. While Russia has dismissed the idea that anyone should see their forces as menacing, they have put forward demands for legally binding security guarantees, and Putin has threatened unspecified “military-technical” measures if their concerns aren’t addressed. Some of Russia’s demands, such as ending NATO’s “open door policy”, are seen as so outlandish as to call in to question Russia’s seriousness in pursuing a diplomatic solution, and instead have raised the possibility that Russia will seek to use the failure of diplomacy as a pretext to carry out the attack they have been planning all along. Nonetheless, over the last several weeks a number of countries, including the United States, have had discussions with Russia in multiple formats, most recently at a meeting of the UN Security Council. So far none of these engagements have led to any optimism that a de-escalation is forthcoming. The West has promised swift and consequential sanctions, including discontinuing Nord Stream 2, should Russia move into Ukraine.

Implications: Trying to discern Putin’s intentions towards Ukraine has occupied Western capitals for the past weeks, which is no doubt very much to his liking. Putin himself hasn’t spoken publicly on the situation since late December, but earlier this summer he published a much remarked essay questioning the idea of Ukrainian independence. His window for major ground action likely doesn’t stretch beyond the end of February after which the spring thaw would impede tank movements. That doesn’t preclude there being some combination of a more limited incursion, cyberattacks, or other acts of sabotage and destabilization within Ukraine. Something along those lines could also give him a fig leaf to deny Russia’s culpability and would provide him the best possibility of dividing the Western alliance in hopes of forestalling the most severe of threatened consequences.

Chinese growth slows and reforms have lagged

China announced GDP growth of 8.1% for 2021, its best pace since 2011. Much of the growth, though, was in the first half of the year before slowing sharply in the second half of the year. The economy grew by only 4% in the fourth quarter, which was a further deceleration from the 4.9% growth reported in the third quarter. The IMF in its 2021 Article IV consultation with China noted that the recovery relied heavily on public support while private consumption was lagging. The Chinese government has set a goal of pursuing “high-quality” growth in recognition of limits to their practice of boosting growth through infrastructure and real estate investment. However, structural reforms to increase their growth potential have progressed unevenly. In particular, the IMF highlighted the need for China to reform their state-owned enterprises and to ensure that the private sector is able to compete with them on an even playing field. China should also undertake reforms that would rebalance the economy towards consumption rather than investment. The IMF projected GDP growth of 4.8% in 2022 down from its previous projection of 5.7%. Risks to the economic outlook are tilted to the downside.

Implications: China’s leaders have said economic stability will be their focus ahead of a key once-in-five-years Communist Party congress later this year where President Xi Jinping is expected to claim a third five-year term. Towards this end the government has recently taken a number of steps easing monetary and fiscal conditions. Longer-term reforms, such as improving the social safety net, will be needed to achieve more balanced development.

Italy presidential election maintains status quo for now

Sergio Mattarella was re-elected Italy’s president after eight rounds of voting by a joint session of parliament and regional delegates. The president is head of state and has a largely ceremonial role, but they do have the power to dissolve parliament, appoint prime ministers, and give approval of cabinets. The prime minister, Mario Draghi, was himself asked last year by the president to lead a unity government in order to overcome a political impasse. Mattarella’s term as president ends on February 3, and at 80 years old he had made clear his desire to retire and not seek another seven-year term. Before the election there was an expectation that Draghi would move over from the prime minister’s office and assume the presidency. Proponents of Draghi’s move believed it would position him well to oversee the continued implementation of reforms he initiated as prime minister beyond when his term ends in 2023. After seven rounds of inconclusive voting, though, no candidate was able to muster a majority. Many of the parliamentarians feared electing Draghi could trigger the collapse of the government and send Italy to early elections. With the politicians unable to settle on another consensus candidate, Mattarella was persuaded at the last moment to postpone his retirement, and he won overwhelmingly in the final round of voting.

Implications: Italy is slated to be the largest recipient of EU pandemic recovery funds and northern countries, who for the first time agreed on collective EU debt to finance the expenditures, will be glad to have the former ECB president staying on as prime minister. Draghi’s ability to successfully steward structural reforms tied to the 200 billion euros in recovery funds could finally lift Italy from its decades of stagnation. In Draghi’s first year, Italy notched its best growth in forty years.

Chile finance minister pick reassures markets

President-elect Boric has announced the make-up of his first cabinet. In keeping with his campaign promise to bring about change, the 24 ministers come from diverse political backgrounds including several who are, like Boric, former student protest leaders. The majority of the ministers are women and seven members of the cabinet are under 40 years old. The appointment of current central bank president, Mario Marcel, as finance minister reassured the markets that Boric would keep his commitment to lead a fiscally responsible government. Marcel has been president since 2016 and has been seen as staunch defender of the bank’s independence during his tenure. His selection lends credibility to Boric’s pledge to rein in spending after pandemic stimulus pushed the deficit above 7% of GDP in 2020 and 2021. Boric has said he will target a structural deficit of 3.9% of GDP this year and then start gradual deficit reduction in 2023.

Implications: Markets have reacted favorably to Boric’s early efforts to show that he will be a pragmatic leader and not the radical hard-leftist some had feared. The Chilean peso is the best performing major currency in the world so far this year and the stock market has rallied, recovering from a downturn immediately following his election. There is still uncertainty, however, as to how he will govern in practice once he finally takes office in March.

Capital Markets Commentary – Feb 2022