Will vaccines be a shot in the arm for markets?

News in November of several effective Covid-19 vaccines buoyed hopes for a quicker return to economic normality and sent global equity markets soaring to double-digit gains for the month. Economically sensitive assets, such as copper and oil, rallied at the expense of traditional haven assets, such as gold and government bonds. But it was the rotation within equity markets that is most noteworthy. Long-suffering banks, oil and other more cyclical sectors sparked into life, outperforming the ‘growth’ and ‘quality’ areas of the market, which tend to be less volatile and more defensive.

These include the mega-cap technology and consumer services companies with relatively resilient business models that have benefited most from the Covid-19 social restrictions. After numerous false dawns since the global financial crisis, the key question for investors is whether this rotation can be sustained. The recent shift into more cyclical corners of the equity market was supported by the spike in government bond yields, particularly in the US, in early November.

10 year government yields, often a reliable proxy for economic growth expectations, have drifted higher since the summer as markets increasingly looked ahead to the brightening prospects for recovery next year. This optimism feels at odds with what is likely to be a long and dark ‘Covid Winter’ ahead of us, despite encouraging news that Covid-19 vaccines will begin to be rolled out in the UK in the coming weeks. Further economic lockdowns, particularly in the UK and much of Europe, have again dented hopes of a V-shaped recovery.

But the recent market dynamics can offer insight into what may lie ahead in the event of a widespread, successful vaccine rollout in 2021. Signs of success early in the year are likely to mean consensus GDP forecasts move higher, with markets attributing a higher probability to the upper end of these projections. The headwinds for growth and high quality stocks going into next year are also worth examining.

The dispersion (or spread) in valuations between quality and value sectors has hit record highs. On the earnings front, many quality stocks face tough comparisons next year versus a bumper 2020. By contrast, many sectors hit hardest by the pandemic face very low hurdles going into 2021. The policy backdrop next year is likely to remain extremely accommodative.

Despite the potential for inflation to pick up further from their pandemic-stricken lows, higher unemployment and muted wage growth are likely to keep inflationary pressures relatively subdued. Central banks are expected to keep interest rates well-anchored at very low rates for the foreseeable future and are likely to tolerate modestly higher yields on longer dated bonds if coinciding with improving economic growth and inflation expectations. US 10 year yields are still well below pre-Covid levels.

But uncertainty remains high. How quickly, safely and pervasively the vaccines can be delivered will be the key question for early next year. Beyond 2021, elevated and still growing levels of government and corporate debt, as well as the longer term structural scars the pandemic has inflicted on global labour markets, are amongst a host of big issues to be addressed. But the significance of the vaccine news and its potential impact on markets cannot be ignored. A successful vaccine rollout could well be the shot in the arm needed to sustain the November market rotation.