The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2021 Fourth-Quarter Outlook:
- U.S. economy: Stimulus wearing off but growth remains solid. More workers needed.
- Global economy: Slowing from its fastest pace in decades even as parts of Asia and the emerging markets are set to reopen.
- Policy watch: Policy is shifting from “extremely accommodative” to merely “quite accommodative.”
- Fixed income: Income generation remains a challenge as rates rise gently from very low levels.
- Equities: Valuations have come down but remain high relative to history; earnings growth will be key to returns.
- Asset allocation: Balance the risk of hotter inflation with that of slower growth.
Quote of the week:
“Art, in itself, is an attempt to bring order out of chaos.”– Stephen Sondheim
Omicron delivers a left jab to markets
As we’ve stated in previous editions, markets abhor uncertainty. The latest example? Omicron, which the World Health Organization announced on Friday, November 26 is a COVID-19 “variant of concern.”
Although scientists are still gauging whether Omicron is more contagious, more deadly and/or more resistant to vaccines than the Delta strain and previous mutations, the possibility that it may be any of those sapped investor sentiment. Since the day after Thanksgiving, the S&P 500 Index has fallen 3.5% from its all-time high set the week before.4 Meanwhile, the 10-year U.S. Treasury, a safe-haven asset, has rallied hard, with its yield slipping 32 basis points from its most recent peak (1.67%) on November 23.5 (Bond yields and prices move in opposite directions.) Against that uncertain backdrop, the VIX, or Wall Street’s “fear gauge,” spiked late last month.6 Stock and bond markets worldwide performed similarly.
On a country-by-country basis, each new wave of COVID-19 has had a smaller economic impact than the one before it. This should continue to be the case in the U.S., where we believe a return to the onerous lockdown measures of early 2020 is socially and politically infeasible now that schools and businesses are open and a large majority of adults have been vaccinated. So even if Omicron ends up becoming a bigger threat to public health than the previous variants, we doubt GDP growth will plunge, as it did in the second quarter of 2020, or even decelerate by nearly as much as it did in the fourth quarter.
Outside the U.S., the economic damage should be closely correlated to the degree of severity in the mitigation strategies employed. We’ll find out for certain soon enough, as a few European countries, including Austria, the Netherlands and Italy, have re-implemented mobility restrictions and/or enacted strict vaccination mandates. It’s important to remember though, that much of the global economy has recently entered another boom period, led by an acceleration of spending and hiring in the U.S.
So what’s the key to determining the impact of COVID-19 variants on the U.S. economy? Consumer activity. And the verdict there is so far, so good. October U.S. personal income and spending data was solid, and wages/salaries are easily outpacing inflation even as fiscal aid from the government has dried up. That said, a severe variant could dent overall consumption if it resulted in more people staying home with fewer spending options. And unlike what we saw during prior COVID waves, the federal government has no plans to provide households with financial stimulus to goose online shopping.
Moreover, we could see a pause or reversal of the rotation away from spending on goods and toward spending on services (e.g., traveling, dining out, attending concerts), a trend that has prevailed as the economy continues to reopen and consumers feel less compelled to spend money on “stuff.” If demand rises for goods, supply chain issues could be further prolonged, fueling an extended period of higher prices for many products.
What’s a central bank to do under such circumstances?
Powell counters with a right hook
In his semiannual testimony before Congress last week, Federal Reserve Chair Jerome Powell speculated how Omicron might hinder the Fed’s ability to fulfill its dual mandate of maximum employment and price stability. Powell specifically mentioned two possible effects from Omicron in addition to the obvious threat to headline economic growth: (1) a further drop in labor supply and (2) longer-lasting inflation affecting the price of goods.
Both of these dynamics occurred during periods of rapid COVID-19 case growth, most notably in March 2020 but also in early 2021. Fewer people look for work when the virus is raging, even if businesses are hiring. But this time is different, for several reasons:
- More people are vaccinated, which has been correlated to an increase in labor supply among the working-age (25-54 years old) population.
- Accumulated savings have been spent, and federal assistance has run dry for most households, making gainful employment especially important.
- A lack of more federal aid could limit or avert another surge in demand for goods (and its inflationary impact).
In our view, the likeliest outcome of the onset of the Omicron variant, paired with the simultaneous increase in Delta cases, is that the end of the fourth quarter of 2021 and beginning of the first quarter of 2022 will be another soft patch of growth for the U.S. and Europe, similar to the economic deceleration experienced in the third quarter.
In terms of monetary policy, Chair Powell conceded that the Fed will have to consider tapering its monthly quantitative easing (QE) asset purchases more rapidly than it had previously anticipated in order to battle inflation. Indeed, he indicated “that it’s probably a good time to retire” the word “transitory” to describe inflation, as the Fed has done for much of 2021. The faster pace of tapering will probably be announced at the Fed’s December meeting.
Doubling the rate of tapering from the current $15 billion to $30 billion per month would wrap up QE by the end of March. As we see it, the Fed’s shifting timetable isn’t related to resurgent COVID fears driven by Omicron headlines. Rather, the Fed doesn’t want to be seen as losing credibility by being “behind the curve” on inflation. Scaling back its bond buying more aggressively will signal that it’s taking inflation seriously. An earlier end to tapering also gives the Fed flexibility to take its next tightening step — raising interest rates — sooner, if needed.
The question now is: Will the Fed use its fast-approaching post-QE window to hasten its rate hikes? Not necessarily.
Although markets are still pricing in more than 2.5 increases in the target federal funds rate next year, and a few more in 2023, we consider this to be on the extremely hawkish end of possible outcomes. We still doubt the Fed will start rate hikes by July 2022, which is what the fed funds futures market has currently priced in.7 If growth and/or inflation have softened considerably by then, the Fed can simply hold steady on rates and deliver a “dovish” surprise to markets, which few investors would mind.
Low job creation bedevils, but the angel’s in the details
How investors feel about November’s U.S. employment report, released on Friday, will depend mostly on their preference for either the household survey, which polls individuals about their employment situations, or the establishment survey, an estimate of payroll and compensation changes based on data from employers.
An average of the two surveys (+1.1 million jobs created according to the household, +210,000 per the establishment) yields a net addition of 650,000 payrolls, more than what the market was expecting.8 That expectation, however, was based on the establishment figure, which clearly fell short, making last month’s job growth a “miss.” A similarly sized gap in the opposite direction occurred in June, so such a disparity isn’t unprecedented. That said, the enormous difference makes interpreting the November data in isolation nearly impossible.
Among the household survey’s high points:
- The unemployment rate fell sharply, from 4.6% to 4.2%. Such a drop often signals a tighter labor market, but in this case it was due to a combination of fewer unemployed people and a labor force that increased by the greatest amount in over a year.9
- The number of workers on temporary layoff or working part time against their wishes has fallen to “normal” (pre-pandemic) levels.
- The labor force participation rate edged up by 0.2%, to 61.8%.10
Some of the neutral-to-less-positive household survey data included:
- November’s average hourly earnings growth (+0.3%) was a tick softer than expected.11
- The average hourly work week rose slightly, a sign that employees are putting in more hours to make up for understaffing.11
Our major takeaways from this jobs report? First, it shows that people are coming back to the workforce, which could be easing upward pressure on wages. Second, the wide disparities in estimates across the various parts of the report show that the effects of COVID-19 are making it difficult to pinpoint exactly what’s happening in the economy.
Equity markets weren’t happy with November’s mixed results. The S&P 500 Index fell 0.84% on Friday, increasing its loss for the week to 1.9%.12 In the U.S. Treasury market, the yield on the 10-year note declined 9 basis points (bps), closing the week 13 bps lower, at 1.35%.13
As for whether or how the latest employment report will influence monetary policy, there’s not much in the data that should tempt the Fed to accelerate the timing of “rate liftoff.” We do, however, anticipate the announcement of a faster pace of tapering at the Fed’s December 15 meeting.