It says something when a currency loses 20% of its value in a matter of hours and still isn’t the week’s major market event. While Turkey will doubtless continue to struggle with the ramifications of its collapsed lira – and you can read all our coverage on the crisis here – investor attention has suddenly been captured by news of what could be the most virulent COVID-19 strain yet.
I began this year warning that the evolution of the pandemic was the key risk facing the global economy. News of Omicron, followed by swift moves by governments to close borders to limit its spread, and the sharply negative market response to these events, are a reminder of this acute economic vulnerability.
There are still many more questions about Omicron than we have answers. Some variants that were initially feared to be a concern have faded from memory without causing widespread harm. Others, such as Delta, have caused damaging new waves of the pandemic. There have been some positive noises over the weekend – doctors in South Africa, where the strain first emerged, have said that the symptoms so far have been mild and pharmaceutical companies have suggested that vaccines could be adapted quickly if necessary. But we’re unlikely to have the full picture for several weeks. In the meantime, there are three points worth making.
First, the lesson from Delta is that it’s very hard to stop the spread of virulent new variants. Most countries have now heavily restricted travel to and from Southern Africa, where the Omicron strain first emerged. Some have also tightened restrictions on international travel more generally. Israel, Japan and Morocco have closed their borders to foreign visitors altogether.
But this probably won’t prevent it spreading to other countries, particularly if it’s as contagious as currently feared. Cases have already been found in several countries in Europe as well as Hong Kong, Australia, Botswana and South Africa. The genie is already out of the bottle. According to Professor Chris Whitty, the Chief Medical Officer for England, it is “inevitable” that the variant will spread across the world over the coming days.
For countries where vaccine coverage is still low, the key issue is whether the new strain is more transmissible and more likely to result in severe illness or death. In most places, though, the key issue is the extent to which this new strain can escape vaccines. These are questions for scientists rather than economists and, according to the major vaccine developers, we may not know the answer for several weeks.
The second point to make is that it’s the restrictions that are imposed in response to the virus that causes the bulk of the economic damage. So, the key question is how governments will respond as Omicron spreads. This in turn will hinge on the extent to which it escapes the vaccines and, importantly, causes strains in national healthcare systems.
However, approaches to managing the virus may also start to emerge. In the UK and the US, governments have shifted a bit more towards an approach of “learning to live with the virus”. This means the bar for imposing severe restrictions on activity is probably higher than in Europe, where governments are already adopting tough new measures in response to a spike in the Delta variant.
Meanwhile, the arrival of Omicron in China would probably cause Beijing to double-down on its “zero COVID” strategy. That would mean localised lockdowns as outbreaks emerge, tighter restrictions on regional travel and a greater likelihood of port shutdowns. China has proved adept at managing outbreaks, but the long-run economic costs will mount if highly-transmissible strains are endemic globally.
The final point to make is that the global economic backdrop is very different now than in previous waves of the virus. Supply chains are already stretched. A virus-related surge in goods spending, or port closures, would exacerbate existing supply strains and add upward pressure to goods inflation. Likewise, a new, more dangerous, virus wave could cause some workers to temporarily exit the workforce, and deter others from returning, making current labour shortages worse. Compared to previous waves of the virus, which were on balance disinflationary, a major new wave could now be inflationary.
All of this further complicates an already-complex policy challenge. At the margin, the threat of a new, more serious, variant of the virus may be a reason for central banks to postpone plans to raise interest rates until the picture becomes clearer. The key dates are 15th December, when the Fed meets, and the 16th December, when several central banks, including the Bank of England and European Central Bank, meet. But unless a new wave causes widespread and significant damage to economic activity, it may not prevent some central banks from lifting interest rates next year.
The market sell-off on Friday provided a blueprint for how markets are likely to react if the worst fears about Omicron materialise. Stocks sank, government bonds rallied and the sectors and countries most exposed to the pandemic, such as tourism and energy, came under the most pressure.
Equity markets have rebounded this morning following the reassuring noises over the weekend. But the key point is that markets had been priced for perfection – something approaching a goldilocks scenario of continuing economic recovery alongside continued negative real rates. If Omicron proves a false alarm – similar to the Beta strain, which was detected last summer – then risk appetite could quickly be restored. But the sharp reaction in markets to this latest twist in the pandemic underlines the vulnerability of risky asset prices with valuations at such rich levels.