Friday’s stock market sell-off was the worst of the year so far, though it followed seven straight weeks of gains for US stocks, arguably long overdue. In addition, the peak of 50% and more of the Vix volatility indicator gives an idea of ââthe surprise of the market at the announcement of a new COVID variant (Omicron), at a time when the markets were largely focused on the risks of rising inflation.
The massive sell-off, which occurred over the course of a half-day trading, caused an overreaction to Omicron – oil falls sharply, ten-year bond yields fall below 1.5%, and market stress. Risk management may well continue until Monday’s session. From this point, there are probably three scenarios for the stock market through 2022.
Scenario 1: March 2020
The Omicron variant is found to be more resilient and deadly than the other variants, and evidence shows that it has spread across Europe. The UK has already tightened travel conditions and other countries are following suit, causing economic disruption and the risk of a European recession, at a time when the Chinese economy is already suffering. Markets are not prepared for this and central banks are seen as having little room for maneuver. This is obviously bearish and at current valuations it could trigger a deep correction towards 4200 on the SPX, other stocks, commodities and crypto suffering as well.
Scenario 2: 5000
Investors are quickly realizing that South Africa, in particular, has an advanced medical capacity for rare and infectious diseases, and that while the number of COVID cases is rising rapidly, deaths are still almost minimal. The vaccines can be adapted to combat the new variant.
The markets also understand that the short-term effect of the Omicron fear will be to reduce inflation in a few months (i.e. lower oil prices, lower airfares), which contributes to keep bond yields low. While evidence of Omicron’s spread in Europe is scarce, markets are likely to retrace their losses and once in December, the aggressive flow of funds into the markets means investors are starting to think seriously about the 5,000 level on the SPX.
Scenario 3: Noise
There is little immediate evidence of the spread of Omicron, but it is proving to be a red flag and generally health and precautionary measures are being stepped up in Europe and the United States. It is also a warning signal for investors in terms of positioning, and the lack of room for maneuver of central banks. Contrary to this is the growing recovery in the developed world and the possibility that China will act to stimulate its economy. As such, the markets remain stable until the end of the year, but the volatility decreases.
I have a feeling that the second and third scenarios are more likely, which gives some upside by the end of the year, once the volatility goes down.