Market Update

Over the past month, there have been two major talking points that have and will continue to affect markets across the globe; Omicron and COP26. In this update, we take a look back on these events and what this means for the future.

All eyes on Omicron

After almost two years of turmoil, the world’s best laid plans have been impacted by the discovery of a new variant of the SARS-CoV2 coronavirus. This variant is serious enough to have been designated its own Greek letter: Omicron.

At the time of writing, we are still acquiring knowledge about Omicron, but the revelation of its existence, which coincided with the Thanksgiving Holiday in the United States, briefly created turmoil in financial markets. Global equities, which were hovering close to all-time highs, fell back sharply, while government bonds, which had been under some pressure owing to the prospect of tighter monetary conditions, rallied strongly.

Markets have subsequently moved erratically dependent upon the latest news. One major source of uncertainty is the efficacy of existing vaccines against the new variant, and comments from the vaccine manufacturers themselves have elicited some of the biggest market movements.

The impact of COP26

In the last commentary we promised a discussion around climate change and to review the outcomes of the COP26 summit in Glasgow, and I offer our thoughts now.

While it is not always highlighted, humankind’s influence on the planet could well have had some part to play in the evolution of the original Wuhan strain of COVID, and the destruction of natural habitats, was certainly high on the agenda at COP26.

One of the supposedly key initiatives to be decided upon at COP26 ended up being watered down, and the change of a single word was significant. A pact to “phase out” coal-fired power generation was diluted to “phase down”, with that dilution being driven by a coalition of what one might describe as vested interests: The United States (mainly a producer), India (mainly a consumer) and China (both).

On a more positive note, advanced technological methods have been developed to “sniff out” leaks in the gas supply chain making the task of reducing gas output more realistic, particularly methane.

One of the strong messages from COP26 was that the cost of emitting carbon is going to have to rise to create an incentive to modify behaviour. Finland was the first country to introduce a carbon tax in 1990, but it is its neighbour Sweden that currently imposes the highest tax per metric tonne of carbon equivalent.

However, for all the progress that this promises, the global average cost of carbon is calculated to be around $2.50 per tonne, and that stands against a widely held opinion that the cost is going to have to be as high as $150 (and $100 at a minimum) to start to make any real difference. We saw with the “yellow vest” protests in France that trying to change behaviour through taxation is difficult, to say the least.

Logically, this suggests higher fuel costs for many, with citizens of developed countries perhaps having to carry an extra burden. When it comes to the challenge of climate change and the energy transition, it is important to highlight that nothing will be straightforward.

Inflation, interest rates and equities

One of the consequences of the energy transition, at least currently, has been rising fuel costs. The need to provide electricity when renewable capacity has been under pressure has seen demand for natural gas rise faster than supply. This has had a knock-on effect on oil and coal prices. Natural gas is also a key element in the production of fertiliser, and so costs to farmers have been rising, helping to push crop prices higher when harvests had already been reduced because of unfavourable weather conditions. And with fertiliser production stopped, carbon dioxide, which is used in the process of slaughtering animals has led to shortages of poultry and pork, in particular, and further higher prices.

If we add the consequences of disrupted supply chains, it is not entirely surprising that consumer price indices are hitting multi-year highs in many countries.

The net effect of all of this as we look forward to next year is that we are once again going to be facing a period of probable monetary policy tightening, which will, at the minimum, remove the tailwind that has propelled risk assets higher and possibly turn into a strong headwind.

Conclusion and Outlook

A well-worn stock market aphorism has it that “a bull market climbs a wall of worry”. The one that started in March 2020 from the COVID trough has certainly followed that path, as investors have continued to anticipate recovery, although a healthy dose of liquidity injected by central banks has also been beneficial.

Our view is that a likely tightening of liquidity coupled with high valuations makes us more cautious in 2022. Having said that, good quality equities continue to offer the best prospects for longer-term growth, and they will remain at the core of balanced portfolios.