17 Dec 2020
After a tumultuous and volatile year, the dangers of longer-term predictions could never be better illustrated. After a huge hit to economic activity in the first half of the year economies, aided by huge monetary and even more importantly fiscal government support, have started the long road to recovery. With an abundance of global liquidity stock markets, together with corporate credit, have front run the anticipated upturn in economic activity with markets bottoming out in the end March/early April period. Stock markets have always looked forward and in the period post the Financial Crisis, they have done so at a faster rate than before. Investors are now looking out to the end of 2021 and beyond to try and see how far the global economy will be below what it would have been pre-Covid-19 and more importantly, whether the economic cycle can resume.
The fourth quarter of this year has been dominated by November’s vaccine news, which has been highly positive. Both the Pfizer and Moderna vaccines use ground-breaking mRNA technology and have demonstrated over 90% efficacy rates with no evidence of side effects. The Moderna CEO Stephane Bancel has even commented that he believes the Moderna vaccine will end hospitalisations and deaths. The Oxford/AstraZeneca vaccine has also passed the necessary hurdle rates for approval. There was some confusion with the trials as the standard double dose produced an efficacy rate of around 62%, with the accidental process of giving an initial half shot followed by a full shot delivering efficacy rates of over 90%. The latter sample was not particularly robust though as the trial numbers were below 3,000 and only included those below fifty-five. Further studies are now being conducted on the dosage.
The stage 3 trials have dominated news and there has been continued monitoring of those enrolled earlier in the very limited stage 1 and stage 2 trials. To date, results over this longer time frame have been encouraging; there has been no serious side effects from recipients of the vaccine and all three vaccines have seemed to prove effective on the older population. The Moderna stage 3 trial was particularly interesting as it was tilted towards those classified as more vulnerable. In the trial sample there was a higher than average number of ethnic minorities, more elderly participants and an increased number of people with underlying medical conditions. The control (placebo) group reported three times the number of hospitalisations and deaths compared to the Pfizer trial, despite the similarities between the vaccines. This accounts for the optimism of the stock market in Moderna, which is now up around 700% year to date. The strength of the Moderna share price not only reflects its vaccine success, but also a growing belief that the mRNA technology platform which is designed to develop not just general vaccines, but cancer vaccines and therapeutics, will be pivotal in healthcare treatment over the coming years. One positive spinoff from Covid-19 could be the acceleration of the ability to treat specific cancer treatments targeting certain cells rather than the current broad-based approach of chemotherapy.
In November, most risk assets rose and in the immediate days following the vaccine news there was the largest rotation from growth to value in history; a vaccine that prevents large numbers of the population contracting the disease is a huge positive for the global economy. Another less commented on subject is that treatments for coronavirus have improved, demonstrated by Donald Trump, who recovered quickly after receiving Regeneron’s expensive monoclonal antibody treatment. These improved treatments explain the lower mortality rates, even in countries now enduring a second wave. Importantly to date there is no real sign of the coronavirus mutating. Over the coming months, there are likely to be further positive vaccine announcements. Novavax’s vaccine is a strong candidate with governments around the word already pre-ordering the product. Johnson & Johnson also have a highly promising vaccine.
It’s ironic that during the second half of 2019, one of the largest concerns in the market was whether the weak manufacturing sectors in the developed world would hit these now service orientated economies. The pandemic has hit the service sector harder than manufacturing. Companies operating in the service sector that relied on a high level of personal service and human interaction have, unsurprisingly, been hardest hit and as a result have seen significant falls in their share prices, often due to the necessity for re-financing corporate balance sheets. This has been demonstrated once again in the northern hemisphere and in Europe and in the United States, there has been a significant pickup in new infections as temperatures have fallen and schools have returned. During the summer months, consensus economic forecasts had generally been revised upwards, together with earnings estimates compared to the forecast outlook in April, but in the light of further lockdowns and restrictions, the third quarter V-shaped recovery is likely to flatten off before there is a full rebound in economic activity. In the US, post-election political squabbling has so far prevented a further extension of fiscal stimulus measures. While uncertainty persists, there is also likely to be a lower level of business investment and during the fourth quarter of the year manufacturing activity is likely to continue to fare better than the service sector.
The world is clearly highly dependent on a vaccine to see a return not only to more normal levels of economic activity, but also to previous ways of life; a vaccine will end social distancing and restrictions on travel. However, even with a successful vaccine, there are some structural changes in the economy that have been accelerated by the pandemic resulting in permanent change. There has been a massive structural shift in the economy and arguably the largest channel shift in the history of the internet. Many technology-enabled, disruptive businesses able to offer products or services online have seen at least four years of expected growth occur within six months. Arguably, some investors are still underestimating the impact of this. Within the retail sector, many legacy businesses have not had the working capital to re-stock ahead of Christmas and as a result there have been further failures on the high street. Lockdown measures announced for Christmas and beyond will only further benefit these businesses. Even in a Covid-19-free world, the acceleration of existing structural change will result in a global economy that is very different to what was anticipated 12 months ago.
There has been commentary about the narrow market this year with a small group of significant winners that many value investors have talked about over the past five years. Academic research has shown that long-term equity returns are dominated by a relatively small number of stocks. A study of US equity returns by Hendrik Bessembinder, an academic at the University of Arizona, looked at data over 90 years and found that most of the gains were delivered by only around 4% of the stocks. Over the past decade, the world has become more interconnected than ever, with the internet, mobile and social networks. Markets that were once independent have become interconnected with companies benefitting from network effects and/or social effects, both of which create bigger winners. Network effects refer to situations where the value of the product increases with more users. Social influence is different but also magnifies the inequality between winners and losers, although it does not explicitly change the value of the product or service to the user. Therefore, social effects will be present in a broader set of businesses that are not associated with network effects. To show this in practice, the best-selling album in 2000 sold around 10 million copies globally, but the most popular songs today have been streamed more than 2 billion times on Spotify. Social influence can also work in reverse on issues such as climate change or Black Lives Matter.
In a technologically enabled age, it’s easier for people to buy a product without capacity limitations. With more products and services digitalised and delivered through the internet, there are less supply constraints for many products in today’s world. These factors suggest that the world will continue to see bigger and greater outliers in both the winners and losers table.
November saw a rotation away from some of the previous winners of the post-pandemic world and innovative healthcare or biotech stocks have continued to perform strongly. There is now a belief that the post-Covid-19 era will see transformative healthcare treatments become commercialised. Moderna has frequently made news with the development of its mRNA Covid-19 vaccine but the public may not be aware that this mRNA biotechnology was not developed in response to the pandemic, but for regular vaccines, cancer vaccines, and therapeutic cancer treatments. There are now exciting growth opportunities within the healthcare sector due to the better molecular understanding of disease. Genome sequencing is available at a lower cost and this technology is being used in countries like New Zealand to trace back the exact source of any new coronavirus cases. These developments mean it is possible to understand what the disease looks like and how proteins work in different diseases which will lead to targeted drug design and drug application for different individuals depending on their DNA. It will be possible to look at individuals and see exactly what mutations they have and what treatments are more suitable. The old ways relied on a much wider base, but a less targeted approach of antibodies and therapeutics.
In gene therapy, Moderna is one of the global leaders, with Alnylam Pharmaceuticals, which has RNAi biotechnology, working on the problem from the opposite end of the spectrum as they look to decrease certain protein levels in patients. In the past, biotech companies were one hit wonders but many of the better-run businesses now have a wide platform of potential applications for their technology and the market has latched on to the prospect of sustainable profitability for certain companies in this sector.
It is likely that 2021 will allow the world to return to normality due to the success of the vaccines, but the ‘new normal’ will be different from the pre-pandemic world. Structural changes in the economy have been accelerated and will result in permanent change. One of the main differences will be the higher prevalence of working from home, and this is likely to impact on demand for office space going forward. Some businesses have done well but there will be more bankruptcies and job losses. Capitalism has thrived on the process of creative destruction but in the short-term, there will be an economic hit with lower levels of output and higher unemployment. Technological benefits, together with demographics such as ageing populations and globalisation, means that inflationary pressures will not pick up dramatically over the medium term. Technological pressures may also help keep wages low with working from home a lower cost option for many employees.
Looking at debt to GDP ratios globally, there is now approximately 16% more debt than at the start of 2020. Debt levels were high coming out of World War II but there was a huge amount of catchup on infrastructure spending and demographics through the baby boom which were positive elements. Potential growth rates today are much lower than before suggesting that over the medium term, a low growth and low inflation scenario will continue and the global economy is likely to remain in a demand-deficient world where there is a continued high level of excess savings. One difference between now and the post GFC recovery is that, while both periods saw low interest rates, a belief a decade ago in fiscal orthodoxy meant that most governments put in place austerity measures to reduce debt. With high levels of unemployment once more and the growth of populism, these past policies are unlikely to be repeated. It’s too early to say whether the still massive amount of stimulus for global economies that will be present in the first half of next year will result in a cyclical uptick in inflation, although structural disinflationary forces will remain as a longer-term influence.
The ability of stock markets to look through shorter term problems has been demonstrated by the reaction of markets to the November vaccine news. Markets have rallied strongly despite the emergence of a second coronavirus wave in most northern hemisphere countries. There is now a belief that economic scarring won’t be as bad as the Financial Crisis if the vaccine news remains positive. Geopolitical concerns for stock markets have also receded, but these could re-surface on investors horizons, post the inauguration of Biden in the States where different policy stances on either China or Russia could emerge. The election of Biden as US President without a so called ‘blue wave’ has led investors to believe that the current goldilocks scenario of moderate economic growth but continued easy monitory policy can continue for several years.
The greatest potential for an upset to equity markets would be a sustained rise in bond yields if investors believed current loose central bank monetary policy would result in markedly higher levels of inflation leading to significant monetary tightening down the road. Forward inflation expectations in the States have risen but they remain below the Fed’s long-term inflation target of 2%. A modest steepening of yield curves is likely but with continued central bank QE policies around the world suppressing the level of government bond yields, this may not be a problem in the first half of next year. Investor complacency is always a danger and perhaps the most worrying aspect for markets is that there are now much higher levels of optimism than six months ago. Short-term valuations remain elevated, although an economic rebound will see multiples fall quickly if the expected earnings improvement comes through. Over the course of 2020, many companies have reduced their cost base, so the recovery in corporate earnings, combined with the inherent operational gearing of most businesses, means earnings can recover much more rapidly to previous peak levels than GDP.
Overall, over the next few months, with further positive vaccine announcements likely, a normalisation of economic activity, combined with the extremely low level of bond yields and cash interest rates, investors should remain exposed to equity markets while keeping an eye on shorter-term cyclical inflationary pressures which could induce periods of volatility, as could any delays to the rollout of the vaccine.
Graham O'Neill, Senior Investment Consultant, RSMR
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