Divestor

Light yellow line is the 10-year Government of Canada bond yield, orange line is the 2-year bond yield:

Over the past week, Omicron fears have triggered a huge demand for long-dated government debt, while central bank talks of tapering have pushed the front end of the yield up.

Indeed, when looking at the BAX futures, we have the following curve (for those that are unfamiliar, these are 3-month bankers’ acceptance futures, of which you derive the rate by going 100 minus the anticipated yield percentage, so a 98 would be equal to 2.00%):

BAX – Three-Month Canadian Bankers’ Acceptance Futures

The spot price is at 0.54%, while the December 2022 future is at 1.85%, which implies that in the next 12 months we will have a rate increase of about 125bps the way things are going.

The 2-year government bond is yielding 0.95% as of last Friday.  Using expectations theory, this is roughly in-line, but functionally speaking, the inversion of the yield curve is going to signal some ominous signs going forward.

Central banks are engaging in the tightening direction because of fairly obvious circumstances – there are leading indicator signs of inflation everywhere (labour market tightness AND the inability to find quality labour both count; the first is easily quantified, while the second one is not, and is a very relevant factor for many businesses), input costs rising or even being completely unavailable, energy costs spiking, etc.  With governments flooding the economy with deficit-financed stimulus, it is creating an environment where no realistic amount of money thrown at a problem can stimulate productive output.

My guess at present is that tapering and rate increases will go until the economy blows up once again – the evaporation of demand will be mammoth – when these supply chain issues are resolved, the drop-off in demand will commence very quickly.  It will likely happen far sooner than what happened in the 4th quarter of 2018 (the US Federal Reserve started shrinking its balance sheet of treasuries at the end of 2017 and the vomit started occurring around October 2018).  Indeed, you even saw hints of this economic dislocation occur in late 2019 – there was likely going to be an economic recession in 2020 even if Covid-19 did not occur.  Covid instead just masked the underlying conditions, and stimulative monetary policy coupled with shutdowns of global logistics and labour disruptions was the subsequent excuse when fundamentally things were already in awful shape to begin with.

This means that portfolio concentration (other than not being leveraged up the hilt) should be focused on non-discretionary elements of demand.

These are not serious suggestions, but Beer (TAP), Smokes (MO) and Popcorn (AMC…  just kidding!) will probably be the last industries standing among the carnage.  Even McDonalds (MCD) will not be spared as less and less will be able to afford the $10 “extra value” meals as central banks continue to drain the excess, but Dollarama (TSE: DOL) will thrive.

The conventional playbook would suggest that commodities would fare poorly with a precipitous decline in demand, but this is one of those strange interactions between the financial economy and real economy where hard assets will initially lose value in the face of interest rate increases (this has already happened), but the moment the central banks have stretched the rubber band too hard and it snaps, commodities likewise will be receiving a huge tailwind.

2022 is surely to be a worse year for most broad market investors and the public in general.  Returns are going to be very constrained and P/E expansion will be non-existent (other than by reduced earnings expectations!).  Watch out, and hold onto your wallets.  There will be few that will be spared.

Please read my December 21, 2020 post, Mutant SARS-CoV-2 Viruses, Perceived Risk, Actual Risk, which has aged reasonably well since its publication. The only factor I continue to under-estimate at all instances is the notion of “back to normal”, which from the onset of the Diamond Princess I have been consistently wrong with.

I have very consciously been trying to avoid any political discussions of COVID-19 on this site, except when things interfere with the financial markets.

For the most part, the “known unknowns” have been well priced into equities.

However, we might have a game-changer that will require some re-thinking.

Insert today’s scare headline, the B.1.1.529 variant:

The issue here is regarding the psychology of the effectiveness of COVID-19 vaccinations.

Most people believe they work. Indeed, because of this popular support, governments have been able to coerce those that do not into taking them.

The issue is that just like influenza and HIV, you might be able to take something to address the clinical symptoms (which the existing vaccinations have done) versus dealing with the transmission of SARS-CoV-2.

Without preventing the transmission of SARS-CoV-2, vaccinations to mask clinical symptoms of COVID-19 are a delaying tactic at best.

The best analogy I can make here is the advent of computer viruses and anti-virus software. Initially there were programs (McAfee and Norton Anti-virus) that you ran in MS-DOS to search executables for specific code snippets (containing viruses). They worked initially (sometimes producing false positives), and you had to get updates to tell the program the new code snippets of new viruses that were coded and spread around. However, technology advanced (such as auto-modifying code) and conventional anti-virus software is practically useless as a form of computer security (it is beyond the scope of this post to discuss this fascinating matter). Anti-virus software continues to be sold today and all it serves is to slow down the computer system and provide a false sense of protection.

Likewise in the biological world, mutations are rapidly rendering COVID-19 “anti-virus software” (vaccinations) obsolete. You might be able to protect against the “old school” strains, but for the new software versions (variants), you have much less protection.

This is the result of having a population monolithically vaccinated with the same anti-virus software. It doesn’t take much of a code modification to work around it.

What isn’t discussed about the B.1.1.529 variant is whether the severity profile is more or less severe than Delta. This remains to be seen.

Unlike computer viruses, which are engineered to have a specific impact, biological viruses are positively selected for transmissibility, and not for clinical severity. Indeed, too severe clinical symptoms would work against transmissibility, just as it did for SARS-CoV-1.

The changing psychology will be increasing public awareness that the existing COVID-19 vaccinations do a minimal job of protecting against transmission. They were fighting yesterday’s battle. It will be sold to the public as a necessary “first step” to fighting COVID-19, with much more to go, even though it is pretty evident the “vaccinate everybody” strategy that was taken has proven to be incorrect. The correct strategy was to vaccinate those that are at high risk, but now that mostly everybody is vaccinated, there is going to be a new strain that will dominate and this might be B.1.1.529. The question at this point is whether this new variant exhibits increased severity of clinical symptoms.

In the past my ability to predict public reaction to SARS-CoV-2 has been terrible. If B.1.1.529 picks up, from historical reaction over the previous 18 months, the cultural of zero risk will force more sanctions, “to prevent the spread”.

Governments always want to be seen doing something, even if their actions have no effect on the outcome (e.g. outdoor mask mandates).

They will also never admit that their past strategies have been terrible to preserve whatever credibility they have remaining to implement new measures.

My guess at present is that the Covid-sensitive sectors which got hit from March to June of 2020 will probably face another dial-back. Until I see how B.1.1.529 evolves, I’ll reserve judgement on timing.