Even though we’ve all become epidemiology experts over the past several months, Peter Berezin walks the walk.
The Chief Global Strategist at BCA Research earned a Master of Science from the London School of Economics back in the day so his insights into possible COVID-19 vaccines likely hold more weight than the opinions of average, well-meaning folk.
Berezin can see a post-pandemic horizon but here he presents five key risks along that path investors should be aware of.
The following is an edited version of Berezin’s most recent research report:
- Stocks jumped earlier this week on encouraging news on the vaccine front. While we remain positive on equities over a 12-month horizon, we would stress five vaccine-related risks that stock market investors should be cognizant of.
- First, immunizing most of the world’s population could prove logistically challenging, especially in light of widespread skepticism about the safety of the vaccine.
- Second, the virus could mutate in a way that undercuts the efficacy of the vaccine, as recent unsettling news from Denmark demonstrates.
- Third, vaccine optimism could, ironically, lead to weaker economic growth in the near term, even if it does lead to stronger growth in the medium and longer term.
- Fourth, improved prospects for a vaccine could reduce urgency around extending fiscal support.
Fifth, bond yields could rise further in anticipation of an earlier return to full employment. This could pose a headwind for equities – especially growth stocks.
V is For Vaccine
Stocks rallied this week on news that Pfizer’s trial of its Covid-19 vaccine had apparently immunized more than 90% of test participants.
Such a high efficacy rate is on par with that of the childhood measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu (Chart 1).
Pfizer’s vaccine leverages messenger RNA (mRNA) technology developed by its German partner, BioNTech.
The new technology is similar to the one being deployed by US-based Moderna.
It uses synthetic genetic material to coax the body into producing antibodies, thus bypassing the time-consuming process of formulating a vaccine using dead or weakened forms of the actual pathogen.
This week’s vaccine news is certainly encouraging, and it does pave the way for a rapid rebound in economic activity next year.
Thus, we remain bullish on stocks over a 12-month horizon.
Nevertheless, investors should be cognizant of five vaccine-related risks:
Risk #1: Immunizing most of the world’s population is likely to prove logistically challenging, especially in light of widespread public skepticism about the safety of the vaccine.
Pfizer’s version of the vaccine needs to be refrigerated at -70°C, making it difficult to store and transport. It will also need to be administered twice over the course of 21 days (Merck is the only company working on a single-dose vaccine).
All this will require health care providers to keep track of who received which dose of the vaccine and at which time.
There is also considerable uncertainty about how long immunity from the vaccine will last. Pfizer is cautiously optimistic that it will be over a year, but the truth is that no one really knows.
Vaccinating most of the global population repeatedly year in, year out could prove to be challenging.
In addition, the rollout of the vaccine could face widespread public skepticism. Even before the pandemic struck, confidence in the safety of vaccines was waning in the United States.
A Gallup study published on January 14th of this year revealed that the share of Americans who thought it was important to get their children vaccinated fell from 94% in 2001 to 84% in 2019.
Risk #2: The virus could mutate in a way that undercuts the efficacy of the vaccine.
Unlike most RNA-based viruses, coronaviruses carry an error-correction mechanism in their genomes.
While this confers certain advantages to this family of viruses, it also means that they tend to mutate more slowly than notorious shape-shifters like the common flu.
Nevertheless, there is plenty of evidence that SARS-CoV-2, the virus that causes Covid-19, has mutated since it first emerged in China. Viruses tend to become less lethal but more contagious over time.
This is not surprising. A virus that kills its host will also kill itself. The speed at which a virus mutates is partly a function of how much of it is in circulation.
The more copies of the virus there are, the larger the number of adaptive mutations there are likely to be.
The fact that SARS- CoV-2 has spread to virtually every corner of the earth raises the risk that it will readily produce strains that the current batch of vaccines is not equipped to target.
Unfortunately, this may not just be an idle threat. In Denmark, 12 people have already been infected with a novel strain of the virus that first emerged from mink farms.
Although the data is still sketchy, the virus seemingly jumped from humans to minks early on in the pandemic, mutated within the mink population, and then jumped back to humans.
The mutation appears to have altered the virus’s spike proteins. These are the proteins that the virus uses to gain entry into human cells. They are also the proteins that Pfizer’s vaccine is targeting.
It is still not clear if the mutated strain will be vaccine-resistant, but governments are not taking any chances.
The UK barred entry to travelers from Denmark on November 5th. Other countries may follow suit.
Risk #3: Vaccine optimism could lead to weaker economic growth in the near term.
The release of the results of Pfizer’s vaccine trial comes at a time when the number of new confirmed global cases has reached record highs.
The latest wave of the pandemic has hit Europe especially hard. European governments have responded by tightening lock-down measures.
Euro area GDP is likely to contract in the fourth quarter. While the development of a vaccine is good news for the economy in the medium-to-long term, it is not clear if it will help growth in the near term.
On the one hand, vaccine optimism could cause firms to invest more, while curbing household precautionary savings. This would boost aggregate demand.
On the other hand, vaccine optimism could prompt people to make even more effort to avoid getting sick.
Risk #4: Improved prospects for a vaccine could reduce urgency around extending fiscal support.
So far, the pandemic has left only limited scarring on the global economy.
For example, according to the American Bankruptcy Institute, corporate bankruptcies are lower now than they were this time last year (Chart 6).
The same is true for delinquency rates on most consumer loans. Many economies have displayed resilience so far thanks to ample fiscal and monetary support.
In Europe and Japan, the combination of wage subsidies and job retention programs has kept unemployment from rising significantly (Chart 7).
The unemployment rate rose rapidly in the US, Canada, and Australia early on in the pandemic, but has since declined. In the US, there are now fewer than two unemployed workers per job opening (Chart 8).
It took the US over five years to reach that point following the Global Financial Crisis. The risk is that fiscal policy support will be withdrawn before lockdown measures can be lifted.
While such a risk cannot be ignored, two things should help mitigate it.
- First, fiscal hawks are more likely to support a temporary stimulus package that lasts a few months rather than an open-ended support scheme that may be needed indefinitely.
- Second, public opinion still very much favors maintaining stimulus. According to a recent NY Times/Siena College poll, 72% of voters support a hypothetical $2 trillion stimulus package that extends emergency unemployment insurance benefits, distributes direct cash payments to households, and provides nancial support to state and local governments
Such a package is basically what the Democrats are proposing. Strikingly, when this package is described in non-partisan terms, even the majority of Republicans are in favour of it.
Risk #5: Bond yields could rise further in anticipation of an earlier return to full employment.
If a premature tightening of fiscal policy is unlikely to sink the stock market, could higher bond yields do the trick? Central banks will not raise interest rates for the next few years.
However, rate expectations could still rise further along the forward curve if investors believe that a vaccine will allow the output gap to close earlier than previously anticipated.
Investors expect US short-term rates to average only 1.25% in 2027-28.
Upward revisions to where policy rates will be later this decade could lift long-term bond yields.
Higher yields, in turn, could raise the discount rate that stock market investors use to calculate the present value of future cash flows. This might lead to lower equity prices.
The valuation of growth companies, whose earnings may not be realized for many years to come, is especially vulnerable to changes in discount rates.
Despite the threat posed from rising bond yields, we suspect that the actual impact on equity prices will be fairly modest.
There are three reasons for this:
- First, any increase in bond yields will probably occur alongside rising inflation expectations. As such, real yields may not increase that much.
- Second, provided that higher yields are reflective of stronger growth, earnings estimates are likely to drift up. Rising profits will dampen the impact of higher bond yields on equity valuations. Conceptually, it is real yields, rather than nominal yields, that matter for equity valuations.
- Third, central banks have both the tools, and just as importantly, the inclination to keep bond yields from spiking as they did during the 2013 “taper tantrum.” These tools include QE, aggressive forward guidance, and if necessary, yield curve control strategies.
The path to ending the pandemic is likely to be a bumpy one. Nevertheless, the balance between risk and reward still favors over-weighting equities versus bonds over the next 12 months.
- Within the equity portion of a portfolio, investors should reallocate funds from US stocks to overseas markets and from growth stocks to value stocks.
- Growth stocks benefited from the pandemic and from falling bond yields, but will suffer as yields rise modestly from current levels and investors shift exposure to stocks that will benefit from the reopening of economies.
- As a countercyclical currency, the trade-weighted US dollar is likely to weaken further in 2021. Non-US stocks typically outperform their US peers when the dollar depreciates.
- A weaker dollar will provide an additional boost to emerging market equities, given that many EMs have a lot of dollar-denominated debt.
- Assuming Joe Biden becomes president, a de-escalation of the trade war would also help emerging markets, particularly China.
- Lastly, EM equities are still quite cheap based on cyclically-adjusted earnings.
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