The Independent Market Observer

Is Omicron a Risk for Emerging Markets?

Posted by Anu Gaggar, CFA, FRM

This entry was posted on Dec 17, 2021 1:36:07 PM

and tagged Commentary

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intl-markets-aThe recent resurgence in COVID-19 cases and the emergence of the highly mutated Omicron variant are reminders that the pandemic is still very much a part of our lives. It is unclear how serious the health implications of the Omicron variant will be, let alone how governments, households, and firms will respond to it. While the financial markets have been through a range of emotions in the past few weeks, there is little evidence on how the underlying global economies will react.

From experience, we know that responses to the viral threat will have an economic impact, and some countries are more at risk than others. Indeed, the economic fallout could be greatest for emerging markets. Here, it’s important to remember that Omicron is just one of the many threats facing emerging markets for 2022 and that the recovery for emerging markets will remain bumpy.

3 Possible Scenarios

Emerging markets are certainly vulnerable to economic damage if Omicron proliferates. They are more at risk of renewed restrictions, supply chain disruptions, and deteriorating financial market conditions. Many smaller emerging markets, which have far less medical, fiscal, and monetary flexibility, are likely to be more severely affected than others. There are three potential scenarios that could play out here:

  1. In the absence of reliable scientific evidence, countries and communities could err on the side of caution. This means they may impose greater restrictions on social lives, leading to near-term disruptions in the economies and, hence, in the markets. This is already occurring in several emerging markets as they are still haunted by images of the Delta spread and don’t want to be caught off guard.
  2. Data could emerge that Omicron is spreading faster and is more lethal, causing panic that spreads like wildfire. Many emerging markets have low vaccination rates and scant healthcare systems; thus, a rapid spread could be very damaging and derail their nascent recoveries. Fortunately, preliminary data on Omicron’s effects is not alarming. So, it is likely that this worst-case outcome can be averted.
  3. Omicron could turn out to be less bad or no worse than previous variants, at least in terms of severity and mortality. In this scenario, some restrictions will be imposed but not enough to cause major economic damage. Vaccine uptake and possibly herd immunity would speed up. There would be some bumps on the road and the recovery would be stretched out a bit, but economies could trudge along the post-pandemic path.
3 Factors to Consider

It is likely that the spread of the Omicron variant will widen, possibly even eclipsing the Delta spread. Early reports of less severe outcomes are encouraging. Nevertheless, economic activity in emerging markets could be hurt as administrations try to play it safe. Within emerging markets, some countries will be affected more than others. Here, again, there are three factors to consider:

  1. Government and social appetite for stricter lockdowns. Some countries will be able to impose stricter lockdowns and achieve better compliance than others. While lockdowns could reduce the health damage, the economic damage could be more severe. The vaccination rate will be a key variable as well. Some countries, especially those in Africa, South Asia, and parts of emerging Europe, have lower vaccination rates and, hence, will have no choice but to resort to lockdowns.
  2. Fiscal space. Some countries have more breathing room to provide fiscal support to their economies, while others, including South Africa, need to tighten their purse strings to keep the public debt and sovereign risk in check.
  3. Composition of the economies. For countries dependent on tourism, Omicron could be a severe blow to a fragile recovery as borders are closed again. Others that feed the global supply chain for stay-at-home goods could benefit.
3 Potential Headwinds

Thus, Omicron is a risk to the outlook for emerging markets in 2022. But it’s important to remember that Omicron is just one of the threats facing emerging markets in the year ahead. Even before the emergence of Omicron, there were a few headwinds to the emerging market outlook.

  1. Emerging markets were already staring at the prospects of Fed tightening, leading to tighter global liquidity conditions. Inflation was running hot in several emerging markets, especially those in Latin America and Eastern Europe. As a result, they had already started to tighten monetary policies. If supply chains that were already stretched are disrupted yet again, goods inflation could remain elevated for longer, and the shift to service consumption could get postponed.
  2. China, which has been a major source of growth globally and, more importantly, for emerging markets, is slowing as it shifts its focus from “growth at all costs” to “common prosperity.” This shift will have broader global repercussions, but many emerging markets are clearly in the line of fire.
  3. After a strong year of earnings recovery for many emerging market companies, earnings growth could slow down as the base effects roll over.
Ho, Ho, Ho?

Unless we have a Santa Claus rally, emerging market equities are one of the few major asset classes that could end 2021 in the red or nearly flat. They have underperformed other asset classes since the COVID bottom in 2020, and the emergence of Omicron is certainly not helping with investor sentiment. When the clouds clear, they will have plenty of room to run and could potentially reward long-term investors handsomely. But the waters remain very muddy in the near term, and stormy weather cannot be ruled out. The risks of investing in emerging markets have never been more real, but so is the appeal of investing in economies that have the potential to grow faster than their developed market counterparts but have temporarily fallen out of favor. Selectivity cannot be overemphasized for emerging markets allocation as there are many ways for investors to get blindsided and burned.

Emerging market investments may involve higher risks than investments from developed countries and also involve increased risks due to differences in accounting methods, foreign taxation, political instability, and currency fluctuation.

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