There has been precious little to celebrate in recent months, but the news of a potential covid-19 vaccine has got markets excited.
The have all rallied, but economically-sensitive areas have been particularly strong.
But to what extent is this enthusiasm justified? Are we really heading back to business as usual?
Central banks and bonds
The results from Stage 3 trials for the Pfizer/BioNTech vaccine show 90% efficacy. While the vaccine still needs regulatory approval and to be distributed effectively, it appears to put a brake on further lockdowns and therefore a floor on economic weakness.
For some at-risk sectors, such as travel and leisure, it has been the catalyst for a major rally.
The prospect of a vaccine raises a number of important questions. The most important is that of inflation and therefore the likely direction of interest rates. There is considerable stimulus still in the system and no immediate sign of the central banks turning off the taps. At the margin, higher inflation would appear to be a risk and ultimately, a rate rise seems a little closer.
This would certainly be bad for bonds.
Rupert Thompson, chief investment officer at Kingswood, says: “Return prospects look particularly dire for conventional government bonds[…]. Even though central banks have all but confirmed there will be no rise in rates for the foreseeable future, bond yields still look set to edge higher as inflation pressures slowly build.
“This in turn will lead to capital losses and could produce negative returns overall.”
The impact is already being felt in the European bond market.
The German 10-year bond yield has moved from –0.64% on 4 November to 0.48% on 11 November, while the French 10-year bond yield has seen a similar movement, from 0.36% to 0.24%.
These shifts should be viewed in the context of historically low levels, however. In many cases, they only take bond yields back to their level in October before the latest round of lockdowns were announced.
This potential shift in inflation and interest rates is also being felt in equity markets. A higher risk free rate would mean that future cash flows have less value.
The market has supported relatively high valuations in some sectors because a low risk free rate has flattered their future cash flows. If inflation rears its head, the highest valued stocks could start to look vulnerable.
The most obvious targets are the US technology stocks, where valuations are extremely high.
However, Europe has its own high growth stocks that could weaken – notably in the consumer area.
Mark Philips, a European equity analyst from Ned Davis Research, says there is already a rotation to more cyclical stocks: “Economically sensitive sectors have been performing well, even before the news of a vaccine breakthrough, which bodes well for the broader European market.
“In the past, cyclical sectors have tended to underperform the broader market during significant drawdowns.
“The recent market decline stands out as unusual in terms of the relative strength of three economically sensitive sectors. The announcement of a vaccine candidate served to confirm these trends further. The economically sensitive consumer, industrials and materials sectors outperformed the broader market over the three months up until 6 November.
“Most notably, the consumer discretionary sector reached a new all-time relative high on the same day. Such trends point to a cyclical economic recovery.”
Long-term viability question
However, Dhaval Joshi, chief strategist at BCA Research, sounds a note of caution: “The world is unlikely to go back to business as usual. We won’t go back to full time office work, so won’t need as much office space. Cafes that serve the office market in big cities may not longer be viable.
“We have permanently changed our attitude to online retail and to business travel.”
This means there is likely to be some level of persistent unemployment, which will act as a brake on economic growth. Joshi also disputes the inflation thesis: “There is an automatic stabiliser in that if the pandemic gets better, governments around the world will withdraw stimulus […] this should prevent an inflationary environment.”
He believes investors need to be more nuanced in the way they approach buoyant markets.
It is not enough, he says, to say that everything that has gone down must go up: “There are certain sectors where the long-term viability is in question. Companies could be a terminal decline, so the correct value is zero. In others, there has been a major shock, but it is recoverable.
“Investors need to distinguish between those companies that have sold off in a justified way and those that can recover.”
Airlines are a good example: while regional airlines serving the holiday market may survive, but it could be more difficult for those who rely on business travel.
The vaccine is good news for economic recovery and for some companies may have come in time to prevent permanent decline.
However, the pandemic has prompted structural changes that will see some businesses slip into permanent decline.
This, along with the withdrawal of stimulus, may prevent any surge in inflation and halt investor enthusiasm for some beaten-up areas.