Could the Delta Variant Derail Economic Growth?

The rapid spread of the coronavirus Delta variant has forced the world, once again, to grapple with heightened pandemic anxiety. In the U.S., the variant’s surge has added to fears that the virus could meaningfully undermine economic growth. 

Financial markets had already been operating with a “growth scare” mindset for some time. Now, virus concerns appear to be driving renewed interest in work-from-home technology stocks, with mega-capitalization secular growth names outpacing cyclical and small-to-mid-cap equities, while U.S. bond prices rally and interest rates dive. For many investors, these market dynamics seem to signal a major economic slowdown ahead.

While we’re concerned about the latest public-health challenges, we don’t believe that the variant will destabilize the economic recovery in a way that justifies current market positioning. From where we stand, the Delta variant’s economic impact is likely to be minimal, given little need and low appetite for business lockdowns, which originally stemmed from overwhelmed hospitals. And that's largely because this problem now appears to have a solution: vaccinations.

At the moment, despite the variant’s higher transmissibility, we know that over 99% of recent COVID-19 hospitalizations and deaths have occurred in unvaccinated people, according to preliminary data from the U.S. Centers for Disease Control and Prevention. But already, vaccination rates in the hard-hit U.S. Southeast are accelerating. In a sense, the Delta variant may actually push us ever closer to herd immunity.

We recognize that the public health crisis is far from over and that it will undoubtedly impact the shape of the economic recovery. But overall, economic fundamentals still look strong. Consider that:

• U.S. service-sector growth is accelerating. Just recently, we saw the July reading for the Institute of Supply Management’s non-manufacturing purchasing managers’ index (PMI) hit an all-time high of 64.1, marking the 14th straight month of growth.

• Bank lending is picking up. We are seeing movement in the once-quiet market for bank lending—a key ingredient to improving the flow of money through the economy.

• International developments are signaling positive tailwinds. For example, the Eurozone Composite PMI reached 60.2 in July, indicating the fastest pace of business-activity expansion in 15 years.
  

It’s notable that today's market risks appear to reside in the richly valued S&P 500 Index and the crowded tech sector. At current levels, after a fresh intraday record notched last week on better-than-expected job readings, the index sits at about 22 times forward earnings, high by historical standards. It’s also dominated by tech: The index’s five largest stocks by market capitalization are well-known tech titans, which comprise 23% of the index. For context, the comparable figure was 18% at the height of the dotcom boom.

All told, general concerns about an economic slowdown, as well as market fears more specifically pegged to the Delta variant, seem largely unwarranted—as does investors’ persistent push into supposedly defensive trades that favor mega-cap tech stocks. Indeed, the cyclical recovery still has more room left to play out in services, bank lending, inventory restocking and global trade. Investors should consider deploying cash into cyclicals, small- and mid-cap stocks, as well as non-U.S. developed-market stocks, as they look ahead to above-average economic growth in 2022. Emerging markets may also make sense for patient, long-term investors.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from August 9, 2021, "Delta Dynamics." Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.