What makes this vaccine so effective is its unique approach, which has never before been used in a licensed pharmaceutical. Indeed, following early experiments in this space, the technology had largely been written-off by major pharmaceutical companies. That left just a small community of researchers to explore this niche area, of which BioNTech was a leading name. In many ways, the coronavirus crisis established the right set of circumstances, and the opportunity, for BioNTech to demonstrate the technology’s full potential, which goes far beyond the virus and could ultimately revolutionise the entire industry. As Victor Hugo once said: ‘Nothing is more powerful than an idea whose time has come’.

Market Reaction

The market reaction was extreme. Shares in International Airline Group, the parent company for British Airways, rose 25% whilst Rolls Royce, which makes jet engines, rose 44%. Those sectors of the economy that had been hardest hit, including energy, finance, real estate, retail and hospitality surged in value whilst those that had previously played to the pandemic play book, fell back. 

Given the news, such a reaction could perhaps be expected, yet the magnitude and severity of the rotation cannot be understated.

The above sectors can be broadly lumped into “growth” and “value” categories. Growth stocks typically score well on actual and projected sales/earnings growth whereas value stocks are those whose price/book, price/earnings and price/dividend ratios are relatively low. On Monday, global value stocks outperformed growth stocks by the widest margin in well over 20 years.

The following charts help put that move into historical context. In the US, growth stocks have outperformed value by a considerable margin over the last few years and this differential is now unusually large. In fact, over the last 25 years or so for which we have data, it has never been wider, eclipsing the prior height of the dot com bubble. Growth stocks are sometimes associated with the idea of new and upcoming companies, in the process of breaking-through, but in reality the index is dominated by a small number of well-established giants, such as the FAAMGs, which is an acronym for the top five companies in the S&P 500 (Facebook, Amazon, Apple, Microsoft and Alphabet – formerly Google). These stocks have performed extremely well over the last few months and as such they now account for over 20% of the S&P 500 total market capitalisation.

Last week was significant because we saw relative price action break out of its late stage napalm-run. The question is whether this dramatic move merely reflects short-term trading behaviour or the start of a more meaningful rotation?

To answer that question, we should start with tech stocks as any rotation, out of growth towards value, would be partly driven by these large names.

As shown in the chart below, the performance of the Nasdaq 100, relative to the MSCI World, has also fallen out of its upward channel and through its 50-day moving average. On the face of it, that looks quite bearish. We first raised the prospect of tech underperformance in The Bigger They Are The Harder They Fall, and at the time we booked profits on the considerable gains made since inception. We raised the issue again in early September, when the FT unmasked SoftBank as the ‘Nasdaq Whale’ responsible for driving US tech stocks to extreme levels.   

Whilst tech is clearly a dominant force, we can’t rule out the possibility that this index bottomed on the 23rd March and topped on November 9th on news of a vaccine. Tech stocks have undoubtedly benefited from the ‘work from home’ theme and with little alternatives, investors piled in. For the first time in quite some time, valuations once again apply to this sector.

There is a link between the performance of tech stocks and bonds. Whilst many of the larger companies are increasingly perceived as quality stocks, given strong balance sheets, as growth companies they also benefit from falling bond yields. This is because a lower interest rate denominator flatters the present value of future discounted earnings. There is also an overlap between bonds and other sectors of the economy. For example, expectations for an economic recovery and rising investor sentiment typically contributes towards higher bond yields which ordinarily benefit more cyclical sectors of the economy, such as small cap stocks, or financials. The chart below demonstrates this positive relationship between long-dated Treasuries, in red, and a ratio of the Nasdaq 100 to US small cap stocks, in white. The key takeaway is a necessary precondition for a more sustain rotation in global equity markets is likely higher bond yields. 

The trend towards higher bond yields is exactly what we’ve seen over the last few days following the vaccine announcement. Whilst this trend has been global in nature, the leading debt market, which constitutes the largest share of global bond indices, is the US and our preferred proxy for long-dated US Treasuries is the iShares 20 Year+ ETF. As shown in the below chart, the price of this ETF recently re-entered its prior channel. Further falls in price would be consistent with this theme of higher bond yields. This is also demonstrated in the second chart which shows the 10-Year Treasury yield since 1999 and our forecast for higher yields over the coming months and years. We believe the 10-Year yield could easily move towards 1% over the next month.

At $41 billion, last week’s 10-year Treasury auction was the largest on record. Yet despite the highest yield in 8 months, of 0.96%, demand was soft as evidenced by the bid to cover ratio of 2.32 versus the one-year average of 2.46. It was a similar story for the 30-year auction later in the week with the second lowest bid to cover ratio in a year.

Why would the highest yields since March fail to attract notable interest from buyers? This is likely due to the significant supply of bonds overwhelming the market (notwithstanding the Fed’s help), the end of the US election and positive news on a vaccine which implies better economic growth next year. This should lead to rising inflation expectations, which we consider another key requirement for a more sustained equity market rotation. As shown below, our outlook for US inflation continues to improve, with easing financial conditions pointing to higher prices over the coming year.

The recent divergence between inflation expectations and the ratio of growth to value stocks offers considerable scope for catch-up gains. The catalyst for this convergence would be the realisation of actual inflation. This remains one of our key themes because if the vaccine is successful, then there is a good chance the demand side of the economy can come back faster than the supply side can adjust, leading to a spike in prices. We are already seeing this in food and transportation prices although not yet in the headline numbers, as evidenced by the October CPI reading which remained flat month-on-month. Inflation is a process.  

The future direction of nominal Treasury yields, and inflation expectations, will also determine US real yields which is a key driver of other asset classes, as demonstrated by its high correlation to the gold price. Gold forms a core part of our commodity carve-out, providing diversification benefits and protection against the ongoing devaluation of fiat currencies and potential for rising inflation. We have benefited from falling real yields for much of the last two-years via an allocation to gold mining stocks as well as the physical commodity. Whilst we expect this trend to continue, we are mindful of the recent rise in real yields which looks set to test its two-year channel. A breakout could prove near term bearish for the yellow metal and would be consistent with a rotation towards more cyclical sub-sectors of the broad commodity index, such as copper. 

Setting aside the abundant optimism, there are reasons for caution

BioNTech’s vaccine must still pass safety checks by US and EU regulators. Then there is the daunting logistical aspects of vaccine distribution, as this particular vaccine requires storage at sub-freezing temperature. That said, at the time of writing Moderna has just announced its own Covid-19 vaccine which has shown 94.5% efficacy in late-stage clinical trials and can be stored for 30 days at between 2C and 8C for 30 days, which makes it far easier to distribute.

Operationally, a vaccine could still take months to roll-out, during a period when Europe and the US appear to have lost control of the virus. We could be in for a hard winter and many workers, who may have been furloughed or placed on short-term working schemes, could nonetheless become unemployed as companies struggle under ongoing debt burdens. There is also the question of virus mutation. In Denmark, the virus has re-entered the animal world. Denmark is one of the world’s biggest producers of mink coats and the country’s huge population of mink, estimated at around 17 million, now seems at risk. The reason this is meaningful is there are signs the virus has run rampant throughout this population, mutated and then then re-entered the human population. This new variant of the virus ‘has the potential to be resistant to the very vaccines and therapies that we have just been celebrating.’

Should these risks materialise, the narrative would shift decisively, de-railing prospects for an ongoing market rotation whilst re-establishing the status quo. We saw mini versions of this play out in June and July this year as shown by the left hand chart where bottoms in the rate of change between growth/value stocks, in red, corresponded to a brief pause in the S&P 500 before a subsequent resumption of the upward trend. The potential for a near-term pause is also evident from current retail investor positioning, which has reached its most bullish level since January 2018. From a contrarian perspective, this is negative for the short term.

The tug-of-war between positive news on the vaccine and the potential for short-term economic pain may also play out in bonds, stemming a more meaningful rise in the 10-Year Treasury yield towards 1.25%, which would further drive the market rotation.  

That said, I believe any weakening of economic data over the next few months may well get a ‘free pass’ because it will be considered pre-vaccine as investors look-through the COVID-19 tunnel to the shining light that lies beyond.  

Summary

Markets have been given a good reason to be optimistic. The vaccine breakthrough and US election outcome have removed a large dose of uncertainty and there is now real hope for a return to normality. This is reflected in a steepening of the yield curve, revamped reflation trade and partial rotation into value stocks. It’s too early to tell if this will morph into a more meaningful rotation and we will only know for certain with hindsight.

It’s easy to be cynical about the prospects for value investing. Prior attempts to breakout, in 2016 and 2018, ultimately failed. The same could be said for the so-called ‘big rotation’ out of bonds and into equities which some investors have been calling for decades. But even if this is not ‘the’ rotation, the prospect for one, at some point in the future, is highly likely. This is because when valuations reach such extremes, a turning point becomes inevitable.

The portfolios have performed exceptionally well over the last few months. This is partly due to the fact we have a strong bias for high quality assets that have benefited directly from the pandemic playbook. Whilst we don’t have a crystal ball, it is increasingly apparent to me that a disciplined and gradual shift towards contrarian investing, by averaging-into under-owned and under-valued stocks look better today than it has for some time.

For the particularly brave, one way to play this theme is UK equities although investors will need cast iron conviction and a strong stomach to navigate the interim volatility.