Having been up almost 2%, the S&P 500 ended 1.2% lower on Wednesday, after the CDC confirmed the first US case of omicron. Investors appear to expect more turbulence. The VIX index of implied US stock volatility, which started November at around 16, below its historical average, now trades at 28.
But we believe investors should avoid snap judgments in favor of a more sober assessment of the potential risks that lie ahead. We see four main scenarios:
1. In our base case, we think the omicron outbreak will merge with the existing delta wave that the global economy is already working through. In this scenario, governments enact partial restrictions to limit the spread of the virus, while stopping short of full lockdowns. This situation could arise because vaccines retain sufficient protection, because symptoms prove no worse than existing variants, or because governments choose to utilize methods like booster programs and mask-wearing to manage risks, rather than lockdowns. Market focus would likely shift back toward a positive outlook for economic growth and earnings. Against this backdrop, we would probably see some equity regions and segments that have been negatively affected in recent days—including the Eurozone, Japan, energy, and financials—outperform. Since this is our base case, we still favor these winners from global growth.
2. However, we see two bear cases: First, omicron proves significantly more harmful than prior variants. In this scenario, omicron evades vaccines and is associated with severe symptoms, meaning governments would likely turn to lockdowns to control the spread. In this case, we would expect equity markets to fall somewhere in the range of 10–15%. We think a repeat of the very negative market moves experienced in March 2020 is unlikely because existing vaccine platforms and new antiviral drugs should mitigate longer-term risks.
3. The second bear case is that government restrictions delay a normalization of supply chains and lead to more monetary tightening. In this scenario, omicron is mild enough that governments only impose partial restrictions on economic activity, but those restrictions impact labor markets and supply chains, leading to concerns about more prolonged inflation and tighter monetary policy. With tighter policy and slower growth, not many asset classes could be expected to deliver positive returns. Investors would have to turn to hedge funds, commodities, volatility-linked products, and more granular asset class strategies to protect their portfolios.
4. The bull case is that the omicron is highly transmissible but those infected show only mild symptoms. This could be indicative of the virus moving to an endemic stage, in which governments start to treat it more like other respiratory illnesses such as the flu and the common cold. In this case, we could see an accelerated return to a new normal and the recovery of supply chains, which would then contribute to a reduction in elevated inflation rates.
So we believe investors will need to keep calm during a period of uncertainty until the scientific data gives a clearer picture of which scenario we face. This, in turn, will help shape the reaction of central bankers. Given this unsettled environment, we advise investors to avoid a hasty retreat from risk assets, which could undermine long-term returns. Instead, we recommend diversification, adding to defensive sectors such as healthcare, and ensuring exposure to alternatives such as hedge funds, many of which typically outperform in volatile or falling markets. In addition, with markets off their peaks and inflation still running at high levels, this is a good time for investors to scrutinize cash balances and think about putting their money to work for the long term. One way to navigate potential volatility is by phasing into equities over the next few weeks.
Main contributors - Mark Haefele, Christopher Swann, Vincent Heaney, Kiran Ganesh, Jon Gordon, Alison Parums
Content is a product of the Chief Investment Office (CIO).
Original report - Risk scenarios investors could face from omicron, 2 December 2021.