Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 439

Chairman Powell and Omicron: the Grinches who stole Christmas?

Equity markets were generally chugging along quite nicely until November when news broke that a new Covid-19 variant, Omicron, had started spreading outside South Africa, grabbing global headlines and sparking fears of a new round of economy- and company-damaging restrictions.

Then on the last day of the month, US Federal Reserve Chair Powell threatened to become the ‘Grinch who stole Christmas’. He abruptly changed his tune on inflation. Powell announced he would retire the word ‘transitory’ – the word he’d been using to quash concerns about a possible sustained surge in inflation. Powell’s about-face was a hawkish signal that the monetary punchbowl that has turbocharged markets might be drained faster than expected. As a result, most equity indices fell between 0% to 4% over November.

Non-profit techs fare worst

One section of the market, ‘non-profitable’ tech companies, has been particularly severely affected. These companies entered a veritable bloodbath, slumping -13.4% for the month and taking falls from their November highs to a bear-market sized -25%.

Non-profitable tech bear market

Source: Bloomberg, Goldman Sachs Non-Profitable Tech Index

We explore the impact of Omicron, although by early December, investors were becoming more sanguine about the variant’s impact and reecouping some losses.  

Omicron – different, different, but same?

Late November and December usually have little stock-specific news. The last quarterly or six-monthly results are out of the way and investors are waiting for the next earnings results in late January and February the following year. Late in the calendar year markets are often driven by macro factors like inflation, unemployment, GDP growth and geopolitics.

Omicron is the ‘X-factor’ driving markets late this year, and experts are worried this new strain could send the COVID fight back to square one.

The excellent chart below from Nextstrain.org shows just how different Omicron is to previous variants, including Delta. It details the number of mutations to the spike protein (S1) that different variants have undergone. Omicron is in red and the most recent Delta variant in green. Different indeed!

Source: Nextstrain.org

But the growing consensus is that while Omicron may potentially be more transmissible than Delta, it may not be as severe. Early evidence also suggests that whilst existing vaccines may provide less protection against Omicron, they still guard against severe disease and booster shots may help re-establish previous protection levels.

As you can see in the chart below, the recent rise in cases in South Africa has not been accompanied by a rise in deaths as was seen in previous waves.

It is too early to be definitive, though. Omicron cases in South Africa have been disproportionately in the young and in a population with higher vaccines levels than in the past, which makes historical comparisons tricky.

Markets hate uncertainty and news on this new variant will dominate markets moves until there is greater clarity across three key areas:

  • Its transmissibility
  • Its virulence
  • The effectiveness of current and future vaccines

For equity investors, the impact of the virus on company valuations is often most directly felt through the effect of mobility restrictions on demand for companies’ goods and services. Governments will be loath to reintroduce more restrictions given what countries have already been through. However, if Omicron threatens to overwhelm health care systems investors need to be prepared for fresh measures. Some countries have already slapped restrictions on travel. 

We manage the Ophir funds so that companies in our portfolio are impacted as little as possible by virus outcomes. Examples of these businesses for our Australian equity funds includes:

  • Elders – the rural services business involved in the sale of wool, grain, seed, fertilizer and animal health products.
  • EBOS – the medical consumables and equipment company that supplies goods to hospital and pharmacies.
  • NextDC – Australia’s leading independant data centre operator that benefits as businesses move to the cloud.

Given our lack of PhD’s in virology, we are unlikely to get an ‘edge’ on the market by pricing Omicron outcomes. We remain content to maintain our edge from the bottom-up work we do in meeting with company management and others (customers, suppliers, competitors, etc) in the eco-system in which they operate.

Inflation (and rate rises) – a Scrooge-like shadow

The other main risk garnering attention for equity markets in 2021 is inflation, which is casting a Scrooge-like shadow over Christmas. 

COVID and inflation are linked at the hip, with the former in large part causing the latter. Today’s current multi-decade-high consumer price inflation levels in some major developed economies has been caused by two main influences:

First, huge fiscal stimulus by governments in response to COVID. When combined with mobility restrictions, this pent-up demand has been disproportionately spent on goods, while supply chains simply haven’t had the capacity to keep up with that demand.

Second, labour supply has taken a knock because COVID has forced some workers permanently out of the workforce and others are unwilling to come back to work yet due to virus-related health concerns.

Inflation has persisted longer than most economists predicted, including central bankers whose job it is to tame it, so many now expect the removal of rock-bottom emergency-level interest rates to be brought forward.

Earlier this year, most expected US interest rates to begin increasing only at the start of 2024. Now the consensus is steadily moving towards rates lifting off in 2022. Below we show the US government debt ‘yield curve’, or the rate of interest for lending money to the US Government for different time periods from 1 month up to 10 years. These rates have been consistently moving higher recently, particularly for short periods like the next 2-3 years.

US Government yield curve

Source: Bloomberg

Bear market bloodbath and the ‘expensive small growth’ implosion

This has created headwinds for domestically-orientated small-cap growth businesses in the US, especially ‘non-profitable tech’ companies. These up-and-coming technology-based businesses are not making profits yet or are deliberately suppressing profits to reinvest for future growth.

Some examples of more well-known names to be hit hard include, with their share price falls from their 52 weeks highs in brackets: Draft Kings (-61.2%), Pinterest (-59.9%), Lyft (-43.7%), Robinhood (-76.8%), and Docusign (-55.6%).

 

In the chart below of US small-cap growth (as proxied by the Russell 2000 Growth index in the yellow line), and non-profitable tech businesses (dark blue line), you can see steep falls over the last month or so as bond yields (red line) have continued to move higher.

Source: Bloomberg

Higher interest rates disproportionately negatively impact the valuation of businesses with the most profit growth out further into the future, and this tends to be the smaller and less profitable businesses.

The median valuation of non-profitable tech stocks has almost halved (!) from a peak this cycle of 10x Enterprise Value/Sales in March this year, to 5.6x today.

Some of our most growth-orientated and high valuation companies in our Global Opportunities Fund have had their valuations de-rate substantially – hurting performance – whilst underlying company fundamentals such as revenue growth, in general, continues to be strong and beat consensus.

The key question for us is whether there is much further to go in the valuation pull-back for the ‘growthiest’ parts of the global market, particularly the US small-cap market? The good news is that the underperformance of non-profitable tech versus Big Tech (Nasdaq) has been historically extreme recently, with the biggest gap seen in years (chart below).

Valuations in our global pond still looking ok

The reality is there is no one ‘market’, just a collection of individual companies in which we can invest. That said, the two most ‘expensive’ parts of the markets are the two pools we don’t invest in – US large caps and US Big Tech.

In the chart below, you can see that the long-term average (cyclically adjusted) price-earnings ratios of the S&P500 and the Nasdaq are well above their pre-COVID levels. Global small-mid caps (MSCI World SMID Cap), US small caps (Russell 2000) and the Australian share market (ASX200) valuations don’t look anywhere near as worrisome. 

Difficulty anticipating corrections

The uncertainty of Omicron and more recent heightened volatility can no doubt create some unease for investors. For those perpetually worried about market falls and trying to time them, the wise words of famed investor Peter Lynch often come to our minds:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

 

Andrew Mitchell and Steven Ng are co-founders and Senior Portfolio Managers at Ophir Asset Management, a sponsor of Firstlinks. This article is general information and does not consider the circumstances of any investor.

Read more articles and papers from Ophir here.

 

RELATED ARTICLES

Australia, the Lucky Country again?

Five charts show investors should care about US midterm elections

2022 outlook: buy a raincoat but don't put it on yet

banner

Most viewed in recent weeks

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Welcome to Firstlinks Edition 467

Fund manager reports for last financial year are drifting into client mailboxes, and many of the results are disappointing. With some funds giving back their 2021 gains, why did they not reduce their exposure to hot stocks when faced with rising inflation and rates?

  • 21 July 2022

Welcome to Firstlinks Edition 466 with weekend update

Heard the word, cakeism? As in, 'having your cake and eating it too'. The Reserve Bank wants to simultaneously fight inflation by taking away spending power, while not driving the economy into a recession. If you want to help, stop buying stuff.

  • 14 July 2022

Welcome to Firstlinks Edition 465 with weekend update

Many thanks for the thousands of revealing comments in our survey on retirement experiences. We discuss the full results. And with the ASX200 down 10%, the US S&P500 off 20% and bond prices tanking, each investor faces the new financial year deciding whether to sit, sell or invest more.

  • 7 July 2022

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.