COVID-19 vaccine bearish scenario

Last I left off, I had explained how the introduction of a vaccine can be extremely bullish for the market place and how everyone is supposed to benefit from it’s introduction. However, I did mention that with such an increase in demand, something sinister is hiding right around the corner. That’s inflation.

You always hear that inflation has been down for such a long time and that Central Banks have been trying their best to prop up inflation as per their mandate. However, there’s an old proverb that I’m reminded of at this time ‘Take care for what you pray; for the Gods may one day grant it to you.’

I believe that the most bearish scenario that can emerge from a COVID-19 Vaccine is the radical increase in inflation.

The Return of Inflation

As 2020 draws to a close, most of the developed world remains stuck in various stages of lockdown, attempting to prevent what many experts believe is a seasonal surge in Covid-19 infections. But with much positive news on the vaccine front, it is highly likely that, as fears recede, pent-up demand for all manner of economic activity will be released.

While impossible to model, the amount of pent-up demand could be unusually large for a variety of reasons. Many people, feeling a sense of existential relief, are likely to spend more than they normally would following a typical downturn. And given the amount of stimulus still circulating through the system, the necessary credit and liquidity is likely to be on hand for those who may have developed a ‘YOLO’ (You Only Live Once) mentality during 2020.

But consider the widespread evidence of lingering supply backlogs and bottlenecks, signs energy prices have hit bottom, rapidly rising food prices and huge excess liquidity. If pent-up demand is released in 2021 amid this backdrop, prices may be driven much higher and faster than would be the case under more normal economic recovery circumstances.

The ‘Grey Swan’ of 2021

The fear isn’t that inflation rises, but it overshoots and rises above the target of multiple large economies. What would happen then? The implications are scary to think about. What would the reaction of central banks be? That is a question that’s on my mind, but I believe it would be best left for another time. Let’s focus on the implications on markets should inflation turn to hyperinflation.

So how would the market react to the introduction of inflation in the markets? Looking at equities, in general they are likely to hold up better than bonds, as corporate profits tend to rise with inflation. However, the sectors performing best will be those in defensive industries with strong pricing power. Value will outperform growth. Strong balance sheets will once again be in vogue, as will dividends.

Let’s take what happened in the 1970s as a guide. Commodity prices are likely to rise and, in many cases, commodities and basic industrials will outperform both bonds and stocks generally. Metals are likely to do best of all, especially precious (better keep an eye on Gold). Whether Cryptocurrencies would join this particular party is unclear, but they certainly have the potential to do so given current market sentiment.

This would also hit the economic structure of an economy as the poverty rate will increase ten folds which in turn will affect the economy and hence the currency. So, more likely than not, investors will start to seek safe-havens such as the USD and JPY. We will most likely see a huge increase in the value of these instruments while a huge decrease in the value of risky instruments such as AUD, and NZD.

Beyond a certain point, central banks might decide they have created too much of a good thing. Reversing such expectations is indeed possible, but remember: once inflation psychology shifts, this will only be possible by raising rates in excess of whatever is already priced in, perhaps significantly so.

This worked for Paul Volcker’s Fed after all. But the market consequences of such action could well be severe, as indeed they were in the early 1980s. That particular Grey Swan, however, is unlikely to take flight already in 2021; rather a year or two further out.