By Tim Sharp, Hottinger & Co
By the end of October financial markets in Europe and the US were back under pressure as the second wave of COVID-19 gathered pace and the threat of a Democratic “blue wave” unnerved investors. Europe and the UK were already re-introducing lockdowns and infections in the US were rising significantly. This led to the reversal of the reflation trade where long duration bond yields tightened again and commodity prices weakened once more, while the dollar remained broadly unchanged.
The closing of economies led to many government stimulus plans being extended in Europe and increased anticipation that the recovery would be checked in the fourth quarter despite positive third quarter earnings surprises in both Europe and the US[i]. The outcome of the US Presidential election may still be open to question in some quarters but for markets the existing situation did lead to a relief rally as results would indicate that the Republicans would hold the Senate, the Democrats the House on a reduced majority, and Joe Biden became the President – Elect. This drastically reduced the likelihood of major policy changes being agreed, leading to greater certainty for markets, although President Trump is yet to concede office.
However, everything changed last Monday with the announcement by Pfizer / BioNTech that their potential COVID vaccine, in third phase trials, had produced results suggesting 90% efficacy. Very few experts had imagined such a strong outcome and, although the trials are ongoing, it led markets to think about pricing in a time frame for the re-opening of economies. After much contemplation as to the shape of the global recovery many commentators had settled on the K-shaped recovery with the beneficiaries, or those unaffected by the effects of the pandemic, showing strong results while the clear losers from social distancing protocols continued to be supported by fiscal stimulus[ii]. Many citizens are longing for an opportunity to return to normal and investors are no different using the information to instigate another attempt at a rotation in sectors from growth stocks into value stocks.
The strength of the rally we have experienced would suggest a number of technical aspects have also been in play. Many of the stocks that recovered the most were also the stocks carrying the highest levels of short sellers, as well as sectors that have been most damaged by the pandemic[iii]. The reversal in momentum suggests that the switch underway into sectors that will benefit from re-opening may last and the confidence regarding the sustainability of earnings over 2021 has increased. Furthermore, the vaccine uses the same mRNA technology as other vaccines in late stage trials, such as Moderna, Oxford / Astra Zeneca, and Sputnik, which suggests that those trials may provide similar results, increasing the potential for increased doses and a shorter perceived timeline back to normality.
As markets await a post-election fiscal lifeline for struggling sectors, many bond market analysts began to refer to the vaccine as further stimulus for ailing economies with a further rotation back to the reflation toolbox[iv]. It is our opinion that the shape of sovereign yield curves could hold the key for further gains in risk assets as long duration government bonds consider the inflation threat once more, with short term interest rates firmly anchored at close to zero by central bankers. We believe the steepening yield curve is one of the keys to unlocking bank revenues through a revival in net interest margin, and it is no surprise that European and US bank shares saw strong gains during this reflation rally. The potential for European economies to recover is seen by many as heavily related to the fortunes of the banking sector which is still the provider of the majority of corporate funding.
Furthermore, it is our opinion that the relative value of long duration government bonds will have a significant effect on the ability of risk assets to rally further from current levels when historical valuations are still so expensive. When yield curves are flat, as they have been over the last few quarters, we believe that the relative value of equities keeps investors active, leading to acronyms such as the TINA trade (There Is No Alternative). Conversely, when yields start to rise to compensate for the perceived threat of inflation, equities start to look less attractive on a relative basis. The re-pricing of the reflation trade has been a multi-asset event affecting equities, bonds, precious metals, basic commodities and the future direction of the dollar.
The future path of the US dollar could have a material effect on the flow of money into riskier assets and regions. If the final effect of the reflation trade is a weaker dollar then historically this would point to increased investment into emerging markets, and could also take the pressure off the dollar debt burdens of many emerging countries, thereby increasing the attractiveness of emerging market debt as an alternative to high yield, where debt burdens are still worrisome in our opinion.
We believe the vaccine news gives rise to increased optimism towards the re-opening trade allowing stagnant areas of the economy to recover, which favours value stocks. This may shorten the bridge that unprecedented levels of fiscal stimulus have to build on the road back to normality. However, it could also bring forward inflation concerns which may challenge the central bank’s stipulation that rates will stay lower for longer and threaten the relative valuation of equities, which could change the investment thesis of the recovery so far.
[i] ASR – Investment Committee Briefing – November 2, 2020
[ii] https://www.bloomberg.com/opinion/articles/2020-09-02/the-k-shaped-recovery-is-real-and-it-perfectly-captures-the-economy
[iii] ASR – Quantitative Strategy – November 11, 2020
[iv] https://www.ft.com/content/48b41db0-24de-4bff-a58d-1f26963d8bcc
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