For several weeks now, as the new virulent coronavirus strains have begun to circulate, I have called 2021 a foot race between those strains and the vaccination process. And I am thinking of the new strains circulating around the globe as doing so in much the way the original strain did in 2020. In the first case, it led to a global pandemic and lockdowns. The principal difference now is that we have learned from our mistakes over the past year and we have multiple vaccines rolling out that might create some level of herd immunity.
For me, this is relevant because no single event since the second world war has dominated the world's economy like this pandemic. Indeed, it is like a war against a common enemy because everything we do - even the most mundane like filling up the tank in our cars, taking public transport, or going shopping for groceries - has been altered by the pandemic. And we still don't know how permanent these changes are.
So, I was reading a recent back and forth from two epidemiologists on this foot race with great interest.
The mutant strain debate
Let me quote the most relevant point here and make a few points about the economy.
Paul Offit, director of the Vaccine Education Center and professor of pediatrics in the Division of Infectious Diseases at Children’s Hospital of Philadelphia, says the following about the US:
"roughly one of every three people is at some level of immunity. That’s not a lot. We need about 70 to 80 percent of the population to be immune in order to really stop the spread of this virus. But it would not be shocking that you’re slowing the spread of the virus.”
Michael Osterholm, director of the Center for Infectious Disease Research and Policy at the University of Minnesota and a member of Biden’s Covid-19 Advisory Board, writes the following in counter:
B117’s are doubling about every ten days in the United States. This is a harbinger of things to come. This is just a matter of time and no amount of happy talk is gonna change that.
“People will say — Paul does this — there’s so many people that are protected today because of infection. That’s simply not true. At best, CDC estimates that we’re somewhere in the ballpark of about 80 million people who have likely been infected by this virus who might have residual protection. That’s a far cry from 330 million. If we keep up the current rate of vaccination through the end of March, 30 million out of the 53 million individuals 65 years of age or older will not have had a drop of vaccine. That 30 million in the month of March is a powder keg waiting for this virus to hit.”
Now I don't know about you, but I see the two gentlemen as saying similar things despite Osterholm's contention they're not. They are basically saying that the mutant viral strains are proliferating faster than the vaccine rollouts are taking place. For me, the difference seems to be that Offit believes that the mutant spread has been slowed by the level of immunity we have developed so far and Osterholm doesn't.
You can read the rest of the debate. But, as a layperson, it struck me as relatively fundamental in nature, meaning there is no consensus in the epidemiological conclusion whether we can avoid another wave of coronavirus infection because of existing social distancing and vaccination efforts. The mutant strain debate is inconclusive.
The economic outcome
So what does that mean economically? This is especially important given that financial markets are bulled up on the reflation trade right now to the point that bond yields are screaming higher around the world.
In one scenario where the mutant strains win the footrace or the existing vaccines prove less effective against the mutants, we have at least another viral wave that forces economic rollbacks and lockdowns. And this could happen at any time from March forward. Osterholm, for example, said "Last summer in the hottest month in July the entire Sunbelt states lit up. It’s a natural wave. We’re not driving this tiger. We’re just riding it". So, if the mutant strains proliferate enough, we can see these rollbacks irrespective of seasonality.
But, in another scenario where we win the footrace with the virus, the economy opens up and we will be able to get a read on how much pent up demand there is and how changed consumption habits will be. Maybe this happens as soon as the summer in the UK given the progress they have made in vaccination and the lockdown they are undergoing to suppress the virus. Pandemic-affected sectors like travel rallied yesterday on the back of hopes of just this sort.
Either way, I think we will eventually get to a new normal by the beginning of 2022. So, the main difference between the two scenarios is in how quickly we get to the new normal. It could be sometime in the summer or Fall. Or it could be next Spring. We just don't know yet.
But, because this 'tunnel length' is the crucial economic difference between the two outcomes, it isn't meaningful from a long-term economic or earnings perspective for the vast majority of society. What matters between now and the end of the tunnel is the amount of permanent economic damage we inflict on the most vulnerable individuals, companies and sectors of the economy as well as the capacity of governments to sustain us through this fallow period and beyond.
For example, yesterday I wrote about the stability and growth pact rule suspension in the eurozone. I believe that a longer tunnel in Europe will negatively impact the finances of the Italian government enough to have a meaningful impact on post-tunnel thinking about Italian default or redenomination risk. Italy already has debt to GDP levels equivalent to Greece circa 2012. And so, ostensibly they are just as vulnerable to a crisis in a new normal where the stability and growth pact applies again and where the ECB is the enforcer of that policy.
The light at the end of the tunnel
But the private sector is where the biggest damage can be done. Governments cannot prevent it becoming harder for the long-term unemployed finding work. And they cannot prevent small businesses from buckling due to the rolling economic shutdowns and altered consumption patterns. The post-pandemic economic landscape will be very different.
So, for me, while I acknowledge there is light at the end of the tunnel and I also believe that tunnel is finite in length, I question what the new normal looks like. The old pre-pandemic normal wasn't amazing despite record low unemployment in the US. The whole last decade was one of populist outrage from the European sovereign debt crisis to Brexit to the European migrant crisis. That was just settling down as the pandemic hit. And it was doing so under the fog of a mooted secular stagnation in the west. That's not a gangbusters global economy.
The old normal was sub-standard. And we are adding to it a wholesale risk shift via government IOUs and debt onto government balance sheets. In a world that is still adjusting to changed consumption patterns, the hope for the new normal has to be that pandemic precautionary savings gets spent and a jumpstart from pent-up demand invigorates the economy enough to overcome any worries about inequality, waning productivity or secular stagnation.
Add to all of this the decoupling of China from the West and you have a sufficiently murky future that I question the reflation narrative that's taken hold in markets.
Bond bear and my view
That's where I am right now as bond markets melt. We've completely roundtripped on yields, meaning we're right back to where we were in February 2020 right before the pandemic forced the last upward salvo in bonds. And yet, share prices are even higher today than they were then. That's pure multiple expansion on the back of what I would call vaccine hopium driving animal spirits.
The best case outcome is a sideways trade until the full re-opening so that the economy can catch up to valuations. I mean, you can't justify higher valuations because of lower discount rates anymore. So clearly we are now at levels more elevated than we were at the tail end of an 11-year bull market in shares. That's not a good place to be if you are starting a bull market.
The outcome I am expecting is a stair-step move higher in global yields until one of three things occurs.
Policy makers could start to move against the higher yields or at least threaten to do so, as the ECB's Christine Lagarde has done. Whether the threats need to followed by action is up for debate.
Yields could move so high that they destabilize markets. It's the DCF, stupid! That's the new mantra regarding long-lived assets and the suppression of yields. In a world of reflation, yields will eventually go up to levels that test those assets most vulnerable to favorable discount rates. Tesla is but one example.
The third and most pernicious outcome that I usually don't speak of is the one where we have another major wave of coronavirus from the mutant strains. That could force lockdowns and would cause a full reversal in bearish momentum in bond markets - which brings this post full circle to the debate about mutant strains.
There are a lot of unknowns here. And equity markets are not priced for those unknowns crystallizing with downside risk. Increasingly sovereign debt markets are though. I continue to believe the cheapest tail risk protection is in betting on a crash up and then a crash down in yields. This may be the one last push for bonds before the bond bull market is truly over.