February 4, 2021
Our last post (The music's playing so we gotta dance) was by-far the most read in this blog’s short history. In brief, I was positive on markets given the strength of liquidity and risk sentiment, driven by the “Vaccines + Stimulus” story.
Now, I’m worried that we may be at the doorstep of a new surge of coronavirus cases and potential lockdowns that the market isn’t expecting. What if the worst days of the pandemic are ahead of us, rather than being in the rearview mirror? I won’t even talk about the grim human toll if that were true. Suffice it to say, from a heartless market perspective, that would dampen sentiment in the short-term and cause an “air pocket” or a sharp drop in asset prices.
Let’s back-track a little. I broadly see two States of the World (SOW) in 2021:
SOW+: This is a so-called reflationary state. Virus infections have peaked, vaccine deployment continues in earnest, and this allows the economy to re-open by the summer. Higher savings and pent-up demand unleashes economic activity, and 2021 real GDP growth in US is over 6%. In this state, we would generally expect:
Weaker US Dollar, Higher U.S. Treasury yields, Potentially higher inflation
Re-opening “value” sectors (airlines, energy etc. ) outperform work-from-home “growth” sectors (tech)
Commodities outperform equities. Bonds underperform because of rising yields.
SOW-: This is a disinflationary or deflationary state. Virus infections surge despite continuing vaccine deployment, leading to broad lockdowns. This delays economic reopening to the third or fourth quarter. 2021 real GDP growth in the US and globally is under 3%. In this state, we would generally expect:
Stronger US Dollar, Lower U.S. Treasury yields, Lower inflation expectations
Re-opening “value” sectors (airlines, energy etc. ) strongly underperform work-from-home “growth” sectors (tech)
Commodities and growth-sensitive equities underperform versus bonds because of falling yields.
At the end of 2020, I saw the probability of SOW+ at 90% or higher and SOW- at 10% at most. However, I now see the probabilities as much more balanced (SOW+ ~60%, SOW- ~40% ), while the market continues to see SOW+ having a 90% or higher probability.
So, what changed? In one word, variants.
I’ve generally been very optimistic on winning the war over the virus, and have consistently looked through the global waves of infections, including the large wave that began in the winter of 2020. I had considered variants an outside risk, of course, but wasn’t particularly concerned because coronaviruses tend to be more stable than influenza viruses. Moreover, we hadn’t seen troubling news on the variant front for the first 9 months of the pandemic.
I initially dismissed the risk when stories about the UK variant (“B.1.1.7” with 23 total mutations, including 8 on the spike protein) first emerged, and I wasn’t terribly concerned when different variants were subsequently reported in South Africa and Brazil. The UK variant was initially seen as more transmissible, but not more deadly.
Things started moving quickly for me in late Jan.
On Jan 15, the CDC (Centers for Disease Control and Prevention) said the UK strain could fuel exponential growth in new cases in the US and was likely to become the dominant strain in the country in March. Because it was more transmissible, it would infect more people and thus raise hospitalizations and deaths, adding even more stress on stretched health-care systems.
On Jan 22, UK PM Boris Johnson said that the UK variant may be more deadly. The country’s top scientific adviser said four separate preliminary studies indicated that the variant may be between 30% to 40% deadlier than previous variants.
On Jan 25, Moderna, which I see as a very promotional company, admitted that the neutralizing antibodies produced by its vaccine were six-fold lower (so less effective) against the South Africa variant (B.1.351). This variant has a large number of mutations in the spike protein, which is the primary target of vaccines and antibody treatments, raising the risk that this variant could evade the immune response from vaccination.
On Jan 28 and Jan 29, we got decent headline vaccine efficacy results from Novavax and Johnson & Johnson, respectively. Both vaccines were effective against the UK variant, and J&J notably reported zero serious cases and hospitalizations across the entire vaccine group, including participants in South Africa. However, we learned that Novavax's vaccine was only 49.4% effective against the South Africa variant (with a large 95% Confidence Interval of 6.1 – 72.8), while the J&J vaccine was 57% effective against that variant.
On Jan 31, Michael Osterholm, a highly respected epidemiologist who is on Biden’s advisory committee (and has been my #1 follow for virus developments) said he expected a big surge in a downright chilling interview with NBC’s Meet the Press. The seven-and-a-half minute interview is well worth the time, but here are some quotes:
The fact is that the surge that is likely to occur with this new variant from England is going to happen in the next six to 14 weeks. And if we see that happen, which my 45 years in the trenches tells we will, we are going to see something like we have not seen yet in this country. England, for example, is hospitalizing twice as many people as we ever hospitalized at our highest number.
We're really good in this country at pumping the brakes after we wrap the car around the tree. You know, what we have to do now is also anticipate this and understand that we're going to have change quickly. As fast as we're opening restaurants, we're likely going to be closing them in the near term.
These viruses have come up quickly, and they have actually caused us more and more surprises. And just expect the unexpected in the days ahead.
Manaus, a city of 2 million people in Brazil, saw a massive surge in cases in January despite the fact that most experts believed that the city had reached herd immunity in October last year (75% of the population was estimated to have already been infected). This raises concerns over how effective herd immunity really is against new variants. Also, note that the higher the transmission rate, the higher the herd immunity threshold is. Unfortunately, that’s just how the math works*.
* The formula for calculating the herd-immunity threshold is 1–1/R0, where R0 is the basic reproduction number
These developments are alarming, at least to me. In addition, there is also the risk that there are antibody-resistant variants already in circulation that have not yet been identified. There is already a 20C-US variant that appears to have become especially prevalent in the US. Sadly, while the UK is sequencing around 10% of all virus samples from coronavirus test results, the US is barely sequencing 0.3% of cases, ranking 38th out of 130 countries. We’re “flying blind” as Osterholm puts it.
Osterholm has three key questions to consider every time a new variant rears its ugly head: One, do they cause more transmission? Two, do they cause more severe illness? Three, do they evade immune protection from either vaccines or from natural infection. He believes that the UK variant checks boxes 1) and 2), while the South Africa variant checks all three boxes.
Worryingly, it’s now looking like the Brazilian P.1 variant also checks all the boxes, especially box 3) — it may be able to evade immunity and re-infect people who already had Covid-19. The Wall Street Journal writes: the new P1 variant contains the E484K mutation, which has been linked to the virus’s ability to escape neutralizing antibodies, allowing it to reinfect people who have already had Covid-19.
Indeed, the E484K (“Eeek") mutation on the spike protein appears to be a key determinant of the virus’s elusiveness. It is extremely troubling that on Feb 2, authorities in the UK said that some of the B117 variants in the UK have developed the Eeek mutation.
Overall, I’m extremely concerned that Osterholm will be proven right. Maybe we aren’t out of the woods yet — perhaps, not even close. In that case, the UK strain (which is more transmissible and potentially more deadly) will become the dominant strain in the US in the next 6 to 14 weeks, leading to an as-yet unanticipated wave of new cases that stresses a stretched medical system. It will be exponentially worse if we also see the “Eeek" mutation develop in the dominant strain.
But, what about the vaccines - aren’t they going to prevent a frightening surge? It’s quite possible that current vaccines will be effective against the variants, but I’ll note that the Pfizer and Moderna vaccines were developed almost a year ago against the dominant strain of the virus prevailing at that time, and the virus has mutated since. So, it’s not clear how effective they will be against variants. It’s very possible that we’ll need booster shots to tackle variants, but those are likely to take several weeks/months for development/testing/approval/deployment. Further, even if the Pfizer and Moderna vaccines are effective, the surge is projected to arrive well before enough people are vaccinated: Despite the US vaccinating over 1 million people per day, the country will not get close to herd immunity in 6 to 14 weeks. As Osterholm suggests, we should consider postponing administering second doses in favor of inoculating as many people as possible with one dose, a strategy that the UK is pursuing.
In response to a new wave of infections, the proactive and pro-science Biden administration is likely to impose lockdowns, severely curtailing economic activity, and making the economy more dependent on a continuing stream of stimulus. This could lead to a risk-off period where risk assets sell-off while the U.S. dollar strengthens as a safe-haven asset.
While I believe stimulus would eventually be forthcoming, there would still be questions about the timing and size of the stimulus, which could dampen risk sentiment. Continued stimulus would further erode the US’s fiscal position and debt metrics, and eventfully heighten scrutiny on the dollar’s role as the world’s reserve currency in the coming years.
In the meantime, the Mack thinks the band’s leaving and the music’s about to stop — at least temporarily, until Jay and Janet (JaJa) get the band together again. That’s a story for another day…
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Mack Row
I’m a Global Macro investor with years of investing experience at some of the largest hedge funds and institutional investment firms in the world. My goal is to educate people about investing and hopefully make them more thoughtful investors. I also want to help investors navigate their way through the treacherous investing environment of the 2020s.
Disclaimer: All the opinions expressed herein are mine alone, and do not in any way represent the views of my employer. I am not a licensed or registered sales representative, and am not making any solicitation to buy or sell securities.