Team No Comments

Please find below a insight into the impact of the Omicron variant on world markets, received from Legal & General yesterday afternoon.

 The COVID-19 situation had not been looking good across Europe anyway, but at least there was the hope that the shift into an endemic scenario was not far away, especially with a re-acceleration in vaccinations, boosters and the availability of antiviral drugs. This may well still be the case, but the emergence of a new variant of concern has added to the tail risk that it won’t be.
 
Déjà vu all over again

We are neither virologists nor epidemiologists. But from a market perspective, there are a few things we can say about the virus without their expertise.

It’s still very early and there is little data about B.1.1.529, now known as ‘Omicron’, but it appears to be spreading faster than the Delta variant did in South Africa. It has many mutations that in other variants have been associated with greater transmissibility and evading immunity.

The variables we will be watching most closely are:
Is it more transmissible?
Is it more likely to lead to hospitalisation and is it more lethal?
Do vaccines and antivirals still work against it, and how well?

We must also consider the response of policymakers. It’s relatively easy for major central banks to do nothing for the time being, should market worries intensify. Rates are already at zero with some tapering underway. It’s a bit trickier for the Bank of England, given expectations of a December hike, but the Federal Reserve (Fed) does not have to speed up tapering in December.

Fiscal support, if needed, should be no different than in previous waves. In Europe, the past few weeks have shown that countries increasing restrictions are just as willing to renew fiscal support measures as previously. In the US, Democrats being in control of both the House and Senate – and with an election coming up next November – should make building consensus to support the economy easier than in 2020.

Restrictions have already been ramping up in Europe in response to the winter wave. New variant concerns could accelerate this dynamic. The US faces a different situation, as a new variant would require a greater shift from the status quo. China’s zero-COVID strategy would be more difficult to maintain with a more transmissible variant.

Mandatory vaccination has already become more likely in several European countries, and a new variant could push more towards this step. This would have little immediate impact on markets, but could potentially be positive for 2022.

Markets will clearly remain sensitive to news on the variables mentioned above. But our initial line of thinking is that, should market weakness around a new variant intensify, similar to geopolitics, it could create an opportunity to increase risk in portfolios.            

M&A: here to stay?  

Until Omicron, the most interesting financial story in late November was merger and acquisition (M&A) activity, sparked by KKR’s* bid for Telecom Italia*.

From an equity perspective, we see M&A as a coincident indicator rather than a leading indicator in the market cycle. It’s more the case that M&A is up because markets are up, rather than markets rallying because of M&A, in our view. Business confidence has typically been the main driver of corporate M&A. Of course, cheap financing also helps, especially for private-equity transactions. Interestingly, M&A activity tends to be highest when share prices are highest. M&A happens not when it’s cheapest to buy, but when management teams feel confident about the future.

We therefore agree with our colleagues’ argument that headline-grabbing M&A can be a late-cycle indicator, but is not necessarily a leading indicator of the end of the cycle. We expect the M&A theme to be with us for the duration of this cycle and bull market, even if financing conditions become less favourable as the cycle matures. One precedent is the Fed rate-hiking cycle from 2004 to 2006, when M&A activity accelerated and kept going until the economic cycle and bull market ended.

Another macro factor that could become less favourable, but seems unlikely to derail overall activity, is US regulation. The Department of Justice and Federal Trade Commission, under new leadership, are trying to enforce antitrust rules more strictly than in the past. This is probably mostly targeted at big tech, but might also put off some other acquisitions that are borderline on antitrust and industry concentration. Aon* and WTW* was one recent example.

For equities, actual deals don’t typically have a positive first-round effect. The shares of the acquirer typically trade down, and the shares of the target trade up, but the target is usually smaller. So, if anything, it’s generally better for small-caps than large-caps. We had a good example in the telecoms sector last week. Telecom Italia was obviously up significantly following the KKR bid. But on the same day, Ericsson’s shares fell 5% on its planned acquisition of Vonage in the US.

Private equity aside, there is another incentive for corporate buyers to consider M&A. For most of this year, companies that have undertaken cash or debt-financed M&A have outperformed companies using cash for buybacks and capex. So, for management whose compensation is linked to the share price, M&A has a definite appeal.    

Earnings 2022  

Of course economic data matter. Of course COVID-19 matters. But for equities, the main reason they matter is because of what they tell us about corporate earnings.

Coming out of a solid third-quarter 2021 earnings season and heading into year-end, it’s a good time to think about what earnings will look like in 2022. The obvious caveat to all of the below is that a dangerous variant would change everything.

Our economics team’s roadmap is consistent with US earnings growth in the high single digits, more specifically around 9% by the end of 2022. That would be a slowdown from the post-recession extremes, but solidly positive and a bit above trend.

The 9% estimate is unusually close to the bottom-up consensus of 8.5%. Bottom-up forecasts were too pessimistic about the post-recession rebound, but our own analysis suggests that the big upward revisions to analyst expectations should soon come to an end. It’s too early to tell for sure, but the top-down numbers from sell-side outlooks also appear to sit in the high single-digit area.

The biggest swing factors to next year’s earnings, COVID-19 aside, are US corporate taxes. Assuming about half of the initial proposals from the Biden administration become law, that would take around 5% off earnings growth estimates. The latest proposals, however, have come in a bit smaller than previously. It’s possible the statutory tax rate could stay unchanged, with reforms focusing instead on foreign income, a minimum tax rate and a buyback tax. So the hit to US profits could end up being smaller than 5%.

Another factor to consider is slower economic growth in China, given that we are at the bearish end of forecasts for the country’s GDP. However, the first-order impact on US profits should be manageable. We estimate that 1% off Chinese GDP growth takes a bit less than 1% off S&P 500 profits. Given the other uncertainties around earnings growth, this should not be a dominant driver of the US earnings debate next year.

*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.    

Please continue to check back for a range of blog content from us and from some of the world’s leading fund management houses.

David Purcell

30th November 2021