Happy new year! If you’re experiencing a case of déjà vu, you’re not alone. Canada, and much of the rest of the world, is once again grappling with another wave of rising infections of Covid-19. It feels eerily similar to the beginning of last year, though there are some stark differences that help explain why the markets have not been too bothered to date. Instead, markets have been more preoccupied with a rise in bond yields to start the year, which coincidentally was also the case at the beginning of last year. We discuss these issues more below.
The Omicron variant, discovered just over a month ago, has rapidly become the dominant strain globally. Its high transmissibility has led to an exponential increase in global cases. While it may be much more contagious, it also appears less likely to cause severe illness. This may be a function of the virus itself, and because of the protection offered by vaccines. As a result, while hospitalizations are rising, the rate of change has been more modest compared to the growth in new cases. Yet, health care systems have come under strain in some areas once again given the sheer volume of people getting infected, including hospital staff themselves. As a result, some governments have responded with renewed restrictions in hopes of limiting any further pressure.
There will be an economic cost to this wave and the controls put in place. It will be largely borne by the services side of the economy, just as we’ve seen with prior episodes. Additionally, there may be more disruption, staff shortages, and loss of productivity across various industries in the near-term given the large number of people getting infected and being unable to work. But, each successive wave of the virus to date has resulted in less of a hit to the economy because governments, households, and businesses have learned to cope and function as best as possible. Investors expect these renewed disturbances and the associated impact to the economy to be relatively short-lived. Furthermore, some investors are holding out hope that the Omicron variant could be the catalyst that helps transition this virus from a pandemic to an endemic state, something that epidemiologists have expected to happen at some point in the future. That would mark a meaningful change, where the virus would exist without leading to mass hospitalizations.
Amidst all the attention being paid to the virus, there has been another development of late that may be more important for the broader markets. Government bond yields have been on the rise to start the year, suggesting investors have been selling government bonds, pushing their prices lower and yields higher. Bond yields tend to be driven by expectations of the future. More specifically investors may be anticipating stronger growth, higher inflation, or higher interest rates, particularly in light of the U.S. Federal Reserve which released some notes from its December meeting that revealed the committee may be gearing up to withdraw its supportive policy faster than the consensus view. Rising bond yields are not necessarily a bad thing, but these episodes can create short-term volatility as investors reposition portfolios accordingly.
Most noticeably, we have witnessed some strength of late in sectors like the banks that tend to benefit from higher bond yields as they are a driver of lending margins. Meanwhile, areas like technology and growth stocks in general have seen some weakness given how well they have done and the sensitivities of their valuations to bond yields. This may end up simply being a short-term rotation, similar to what we saw in the year ago period when bond yields witnessed a similar, but limited, ascent. But, it bears monitoring because there’s always the risk of a more meaningful and sustained change in trend.
Should you have any questions, please feel free to reach out.