And so, after much trepidation, it was indeed Jay Powell that won the contest to run the Fed. Mr. Powell remains at the helm of the most influential central bank globally as the Biden administration opts in favor of continuity rather than partisanship and legacy.
Ms. Brainard gets the Vice-Chair post, and presumably, she will be groomed for the top spot, should the Dems win the next presidential election. The market first cheered Powell’s re-appointment, as a curtain of uncertainty was being lifted, but then subsided as new anxieties began to surface. Chairman Powell is walking a fine line, and a need to pivot toward more restrictive monetary policy is becoming more and more a necessity rather than a choice.
The new Omicron variant (more on this later) forces the hand of Powell in ways he would have rather avoided. The new variant is a classic temporary negative shock, and monetary policy can only fix one part of the problem. Powell must decide if he wants to stabilize prices or economic activity and employment. Given the inflationary backdrop already present, the Chairman has little wiggle room and will probably reduce demand and stabilize prices.
This course of action has become apparent in the last few days as the Fed has indicated that it may speed up the tapering process and that the definition of inflation as “transient” was no longer valid. Unfortunately, the timing of the pivot is painfully similar to the previous “attempted” pivot in December 2018, which caused the so-called Xmas massacre – a violent correction in most financial assets – and eventually forced Powell to retract his words and policy actions.
How strong will Powell’s resolve be this time? Probably the answer lies in the reaction of the long bonds in the US and Emerging Markets currencies. Should they start unraveling, the Fed may decide to live with higher inflation than imagined before.
There will be blood
On Thanksgiving evening, the now notorious Omicron variant entered most investors’ lives. A media focus on the new variant creating havoc in South Africa became the center of attention in financial markets. In the backdrop of low and decreasing volumes due to the holiday season, markets started to correct.
Delta, Alpha, Omicron… Keeping track of all the Covid related variants should be no problem for options traders who use Greek letters daily to refer to different derivative variables. However, it may be a little more difficult for the rest of the traders and investors who thought that they only needed to pay attention to earnings and moving averages.
But how serious is this Omicron twist? Relevant data is still being collected, but it seems like a more transmissible variant possibly carrying milder symptoms at first sight. How resilient Omicron is to the existing vaccines is still early to call. Still, Moderna already voiced that in the case of vulnerabilities in the current vaccine, they could probably create an Omicron targeted version very quickly. JP Morgan put out an interesting view that if Omicron is confirmed to be more transmissible but less severe, it could help speed up the process of turning Covid into just another flu. By the way, this course of action is indeed what you would expect in the pattern of virus evolution based on historical comparisons.
Governments’ responses to Omicron, on the other hand, could be much less in line with reason or historical patterns. For instance, Austria immediately decided to shut down again completely, and many countries quickly imposed travel restrictions, often in an irrational and conflicting fashion.
While too early to confirm, it would seem that Omicron is not a major negative game-changer, but financial markets are probably responding to the trifecta of uncertainty, high valuations, and poor government responses. The current volatility will probably persist for a while, and it should open up interesting opportunities in trades that are now being shunned. Inflation-sensitive assets and cyclical strategies should shine again soon.
Liquidity, Liquidity, Liquidity
Bank of America and Blomberg recently published astonishing numbers on the number of liquidity investors directing toward equity mutual funds and exchange-traded funds. As of mid-November, equity-related flows exceed $1 trillion. While the number in itself is awe-inspiring, the magnitude becomes historic when one realizes that this much money is superior to all the funds combined that went into equities over the last…. 19 years!
This is probably a function of the higher rate of savings that Covid forced and a reshuffle of the funds distributed by the generous fiscal policy of the last 18 months. It probably also has to do with TINA, or There Is No Alternative to stocks. With yields so low on most bonds and a perception that companies should manage inflationary pressures by passing along to their customers most of their cost increases, many investors have reasonably overallocated to equities.
But the fact is that there are alternatives. For example, commodities might be in the early innings of a supercycle. While not so cheap either in some sectors, commercial real estate is probably built to outperform in the coming economic environment.
And then there is Private Equity. Deals are booming, and big leveraged buyouts are logging a record year. PE firms have done a record $944 billion worth of buyouts just in the United States, which is 2.5 times the volume of last year and more than double the value of the previous peak in 2007. This booming effect is primarily driven by pension funds that apparently believe in TIA or There Is Alternative!
There is a risk that just like it happened at the previous peak in 2007, the returns of deals struck now might be disappointing in the following years. However, the frantic pace and significant flow underscore the rising importance of space in asset allocation. The two most invested sectors, unsurprisingly, are healthcare and technology.
The success of the space also warrants a look a the traded shares of PE firms and alternative managers for long-term exposure to the growing future flow of management and incentive fees.
The accumulation is holding well so far. If we see strength in it in the coming days, I will consider it a buy signal. The Put/Call ratio is why I believe there will be a rally despite Omicron. It reached a moderate-high near 0.84. In other words, long traders buy protection in the event of an extended breakdown in the stock market. Historically, the market bottoms when the Put/Call ratio reaches levels above 0.80.
So if the market finds support above the weekly trend line, we have the chance to see a 4 – 7% rise in SP500. On the other hand, if the price breaks below mentioned level, bears will target 4200. So, all eyes on accumulation this week.
Will There Be A Christmas Rally This Year? by Inna Rosputnia
Wishing you a great week!
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