“Just when I thought I was out, they pull me back in!”
Michael Corleone, The Godfather III
The final installment of The Godfather trilogy focuses on the Corleone family’s efforts to abandon their criminal past and move into legitimate businesses. However, escaping their old life proved more difficult than expected.
Globally, by mid-November more than 7.8 billion doses of COVID-19 vaccines had been administered, travel and social restrictions were easing, and economic recovery was firmly taking hold. Optimism was returning. Then Omicron, a new coronavirus variant of concern, emerged from South Africa and began to dominate headlines over the U.S. Thanksgiving holiday. Hope that we might finally be returning to some semblance of normal was dashed.
Stocks fell on worries that Omicron would disrupt the economic recovery and indications that the U.S. Federal Reserve might pull back on bond purchases sooner than expected. Winding down this support for the economy likely heralds an increase in the benchmark interest rate, which has been resting near zero since early in the pandemic. Equity markets performed very well in early November – before investors panicked. At month’s end, most markets fell sharply and posted a loss. Despite the Fed’s more hawkish stance, bond yields tightened.
Even though the variant’s emergence triggered a sharp decline in crude oil prices, the U.S. will go ahead with its plan to release 50 million barrels of oil from its strategic reserves. Meanwhile in Canada, the government-sponsored cartel that controls Quebec’s maple syrup supply (and 70% of the global supply) decided to tap 22.7 million kilograms from its emergency stockpile. The decision comes after lower-than-expected production last spring and surging international demand for this liquid gold.
Canada – A growing economy
Canada’s economy grew at an annual rate of 5.4% in Q3, helped by household spending and exports that more than offset a contraction in business investing. Supply-chain disruptions continue to hobble manufacturers. In addition to catastrophic destruction, severe flooding in B.C. created extra delays in delivering materials and merchandise. Inflation has been high for an extended period, largely due to cargo congestion. Even so, Bank of Canada (BoC) Governor Tiff Macklem believes that inflation will decrease and hit its target of 2% by the close of 2022. Now that the central bank has shut down its bond-buying program, markets expect rate hikes will come in stages next year.
Our economy added 154,000 jobs in November, well above analysts’ predictions of 35,000 and a clear signal that the economic rebound is gaining strength. The unemployment rate dropped to 6.0%, beating a consensus estimate of 6.6% and pushing unemployment to pre-pandemic lows. Total hours worked also returned to pre-pandemic levels. Gains came after the Canada Emergency Response Benefits program ended in October.
Omicron has already resulted in travel restrictions globally and will potentially lead to a reintroduction of stricter lockdown measures. This cast uncertainty on oil demand, putting downward pressure on prices. West Texas Intermediate (WTI) crude declined from approximately US$84 to US$66 per barrel by the end of November.
While the stock market started strong in November, the new variant clouded the economic recovery outlook and prompted markets to reverse course. The S&P/TSX declined 1.6% in November, with energy a top detractor. After gold reached US$1,860 mid-month, it closed essentially flat at around US$1,775 per ounce. The 10-year government bond yield contracted by 24 basis points to 157 basis points from its high point in November.
United States – Inflation no longer “transitory”
On November 30, newly re-appointed Fed Chair Jerome Powell testified before the Senate Banking Committee that inflation would likely persist well into 2022. He acknowledged the downside risks that Omicron poses to employment, economic activity and inflation uncertainty. Mr. Powell said it’s time to stop calling higher inflation “transitory” and indicated that interest rates could begin to rise as early as the first half of 2022. “The economy is very strong and inflationary pressures are high, and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases…perhaps a few months sooner,” he said.
The Fed now faces a difficult task. It has long maintained that it would not raise interest rates until inflation was running above target and the labour market was showing significant strength. Omicron’s emergence is likely to have inverse effects on these two factors. Increased supply-chain bottlenecks will push prices up and adversely impact the labour market.
Volatility returned to the markets in November as the CBOE Volatility Index (VIX), which is Wall Street’s fear gauge, spiked.
President Biden reacted to the arrival of Omicron by imposing travel bans on eight southern African countries, adding that economic lockdowns are not currently on the table.
Treasury Secretary Janet Yellen urged lawmakers to take quick action on the U.S. debt ceiling. Congress sets a limit on how much money government can borrow to pay expenses. Once this limit has been met, Congress must vote to either lift or suspend the ceiling before the Treasury can raise more debt. After President Biden signed his US$1 trillion infrastructure bill, Secretary Yellen estimated that the U.S. could reach its ceiling by December 15 – giving lawmakers a narrow window to strike a deal and avoid a default.
Equities surged to start the month, but worries about the new variant’s potential damage shook the S&P 500. It gave back most of its early gains and finished down 0.8%.
Europe – Gloomy mood on numbers
Eurozone annual inflation rose to 4.9% in November – the highest level on record – up from 4.1% in October. High gas prices and expensive imports sparked the increase. Core inflation, which does not include energy or unprocessed food prices, also spiked to 2.6% from 2.0%. The European Central Bank wants inflation at 2.0% in the medium term and believes that it will slow in 2022, although less quickly than expected.
German GDP grew 1.7% in Q3, slightly missing estimates of 1.8%. Ongoing manufacturing-supply bottlenecks are holding back growth. Companies also invested less in machinery and construction during Q3. Rising COVID-19 cases in Europe’s largest economy dampened consumer sentiment. The GfK institute’s consumer sentiment index fell to -1.6 points heading into December, its lowest reading since June. Morale is down based on anxiety that current high inflation levels will cause companies to increase wages, thereby creating higher consumer demand and even greater inflationary pressures. Germany’s incoming government intends to hike the minimum wage by about 25% to 12 euros an hour.
In November, the Euro Stoxx 50, FTSE 100 and DAX fell 5.1%, 3.1%, and 4.5%, respectively. Uncertainty about Omicron’s impact made for a gloomy market mood.
China – Property sector delivers more stress
China’s consumer price index rose by 1.5% in October compared to a year ago, while the producer price index went up 13.5%. Consumer prices could rise if producers pass on their higher costs. China’s central bank is not likely to cut rates to kickstart growth, but could instead lower the cash reserve requirements for banks, allowing them to increase their lending. China’s urban unemployment rate held steady in October at 4.9%; however, the jobless rate among those aged 16 to 24 was much higher at 14.2%.
In October, both exports and imports grew at lower-than-expected rates of 27.1% and 20.6%, respectively, on a year-over-year basis. The trade surplus of US$84.54 billion was higher than the US$65.55 billion forecast. Electricity shortages leading to production shutdowns are expected to be resolved since both coal production and imports have increased. Despite a decline in some significant areas like autos and apparel, retail sales grew by 4.9% in October thanks to increased spending during China’s “Golden Week” holiday. The real estate sector, which accounts for about 25% of China’s GDP, has slumped lately. October prices for new homes declined in more than 70% of major Chinese cities.
For November, the Hang Seng posted a 6.1% loss and the Shanghai Composite recorded a slightly positive return of 0.6%.
Japan – A rebound expected
During Q3, the economy shrank by an annualized rate of 3.0%, a greater slump than anticipated. Supply-chain congestion has hobbled growth and exports. On the bright side, improved consumer confidence and increased spending on services point to recovery. Even though at least 76% of the country is fully vaccinated and COVID-19 case numbers are dropping, Japan reinstated a strict travel ban on all foreign visitors after Omicron became headline news.
In Q4, the economy is expected to bounce back with the help of a record US$490 billion economic stimulus package. Japan has been a straggler at recovering from the contagion’s economic impact, which has prompted highly supportive fiscal and monetary policy even as other countries were scaling back. The spending packages to combat the pandemic have left Japan with long-term debt approximately twice the size of its US$5 trillion economy.
The Nikkei fell 6.2% in November.
Our strategy
November reminded us why diversification is vital. Since the coronavirus market crash in March 2020, equity markets have been on a tear. Although we have an overweight allocation to equities, their outperformance has nevertheless been nudging the upper limit of our range. That trend continued for most of the month, but sharply reversed course after Omicron emerged and the Fed took a more aggressive stance. Bonds rallied and provided support where an allocation was appropriate in client portfolios. It is tempting to reduce exposure to an asset class that has been lagging and has limited potential to provide returns. However, bonds have been a good risk mitigator for our portfolios.
We made no changes to our positioning. We continue to favour U.S. equities, based on long-term trends and their return potential relative to bonds.
The last word
While the Corleone family was unable to move into a new, brighter future, we believe here in Canada we are much better positioned to move past COVID-19 and learn to live with it.
At this point scientists don’t have a full understanding of Omicron. It seems to be more transmissible, yet there is some evidence that it causes milder illness. If current vaccines prove less effective against new strains, they can be adjusted and mass produced. In fact, we may never be fully rid of COVID-19, but we could get to a place where its impact is much more limited.
Although equity markets declined in two of the three previous months, so far this year the S&P/TSX and S&P 500 are up more than 21% and 23%, respectively. As supply-chain challenges are resolved, economic recovery should continue to strengthen and inflation should settle down.
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