INSIGHTS

Rather than a film in the Transformers franchise or another instalment of Marvel's Avengers, Omicron is the name of the latest variant of the COVID-19 coronavirus that has troubled the world for almost two years now.

Financial markets were very volatile on Friday as news of its emergence broke. Shares, commodities and other risky assets fell sharply, and investors flocked to the safety of government bonds.

Omicron is unlikely to derail the recovery we have been enjoying, and it will most likely turn out to simply be another setback in the ‘two steps forward, one step back’ reality of living with this virus.

However, nobody really knows how this will play out and like Delta, it might still prove troublesome. We should expect further weakness in the short-term, especially with many markets having performed so well and with major indices close to record highs.

It’s no great surprise that we are seeing new variants like this emerge. The vaccine rollout has been hugely impressive, with more than half the world population having received at least one dose.

This equates to around four billion people, which is quite remarkable considering the first doses of the Pfizer vaccine were only given in December 2020.

However, while vaccination rates are very high in developed countries, some 95 per cent of people in low income countries remain unvaccinated. This provides an opportunity for new strains to emerge.

Having been first detected by scientists in South Africa, Omicron has already been discovered in Hong Kong, Israel, the UK, Europe and Australia. One would think it’s probably in the US by now too.

On Friday the S&P 500 in the US suffered its worst daily drop since February, erasing the gains from November. European shares were hit even harder, while oil prices tumbled and bond yields fell as investors flocked to the safety of US Treasuries.

As is often the case during a period of market weakness, the local market might hold up better than most. It is dominated by healthcare, utilities, property and infrastructure-type businesses. This has been a headwind for much of 2021, as investors have been more interested in companies that will benefit from an economic recovery.

That’s why markets like Australia, the UK and Europe have been very strong in 2021. They are heavily weighted to banks, commodity companies, and other sectors that tend to do well when the going is good.

As long as Omicron is unnerving people, these markets could come under pressure as investors look to reduce risk in portfolios.

The US market is an interesting one. Almost 30 per cent of the S&P 500 is technology, more if you include the likes of Amazon, Google and Facebook which find themselves categorised in different industry sectors for various reasons.

When the prevailing market worry is rising interest rates (like it has been recently) the highly-priced tech sector finds itself out of favour, but while it’s the threat of more other virus variants, the tech sector is very much a haven. If Omicron is indeed more transmissible or resistant to vaccines, remote working, online shopping and anything digital will be in demand.

It could take weeks before scientists get a handle on just how infectious this new strain is, or whether it’s more resistant to vaccines. That makes it very difficult to predict whether there will be any sustained impact on the world economy or financial markets.

Some volatility in the weeks ahead feels likely, although this could be short-lived if it proves a relatively benign strain and the concern blows over quickly. This could mean any weakness is a buying opportunity.

In terms of our recommended investment strategy, we would suggest staying the course, but also exercising caution as the situation develops.

Defensive businesses shone during the worst of last year's pandemic, while the ensuing recovery saw the baton pass to cyclical sectors that are more sensitive to economic activity and higher inflation. We have always made a case for straddling both camps, in the hope of insulating portfolios and mitigating risk.

More recently, we have noted that an unappreciated silver lining of rising interest rates is that reinvestment opportunities have improved dramatically. The higher rates go, the better value bonds look, and the more attractive future returns become.

If this new variant proves more troublesome that hoped, interest rates will undoubtedly retrace some of their recent increases as investors become more cautious about the outlook.

Another important positive is that during periods like this, the currency almost always falls in response. Since the end of October, the NZ dollar has fallen more than five percent against the US dollar.

This is a very important shock absorber for our economy. It makes our export sector immediately more competitive, while offsetting any decline in value for our international share investments.