LIGHT AT THE END OF THE TUNNEL - BUT WE'RE STILL IN THE TUNNEL

Marcel von Pfyffer, Arminius Capital

20 January 2021

• Coronavirus vaccines will help us return to normal, but there will be risks, obstacles, and delays through 2021.

• 2021 will bring a W-shaped recovery in the economy and the share market: two steps forward, one step back.

• The Australian dollar is headed toward USD 90c much faster than we expected.

After the grim events of 2020, the November news of three coronavirus vaccines set off a surge of investor optimism about the future. But the existence of coronavirus vaccines does not guarantee that life will automatically return to normal in the near future. For Australia and the world, there are many hazards to be avoided or overcome before we can find our way out of the dark tunnel of the pandemic.

First, there are the logistical complexities of distributing the vaccines throughout the world at very cold temperatures, followed by the administrative challenges of administering them to millions of people. In developed countries like Australia, the public health system will accomplish this task quickly and without difficulty. In poor countries with weaker healthcare systems, the task will be much slower and harder.

We should not underestimate the size of vaccine wary members of the population. Recent polls indicate that more than 40% of US citizens are unwilling to get vaccinated at present, and even in Australia a quarter of survey respondents have expressed reservations. These numbers are important because - depending on the complex epidemiological assumptions and calculations - herd immunity may only be achievable if 80% of the population is vaccinated. The US has a history of being very slow to adopt public health measures, and the failures of the initial US response to the 2020 pandemic raises doubts about the speed, breadth, and adequacy of the US vaccination program. Globally, the recent double-digit deaths of people who had just been vaccinated has not helped the smooth marketing plan that the drug companies' PR machines were probably hoping for.

Then there are the potential problems with the vaccines themselves. Although the clinical trials have been rigorous, they have not been large enough or long enough to remove all uncertainties about the vaccines. Therefore, as is obligatory with all newly approved drugs, the public health authorities in each country will track what happens to those who have been vaccinated. Clinical experience with new vaccines over the last century points to eight important risk areas:

• Manufacturing quality must be carefully monitored. In 1955, more than 200,000 children in five US States received a defective polio vaccine from bad batches manufactured by Cutter Laboratories. This mistake caused 40,000 cases of polio and 10 deaths.

• One or more of the vaccines may generate problematic side-effects in some classes of people. Minor allergic responses to vaccines and vaccine components are common, but none of the three vaccines triggered a pattern of serious adverse events during clinical trials. It should be borne in mind, however, that each of the Phase III trials only covered 40,000 to 50,000 volunteers. Administering the vaccines to billions of people expands the sample size by a factor of nearly one million, so there may be some surprises.

• Because of the timeline acceleration caused by "Operation Warp Speed", clinical tracking of the volunteers in the trials is less than three months so far. It is not unknown for new drugs to demonstrate negative side-effects in the longer term. For example, in September 2004 Merck voluntarily withdrew its osteoarthritis drug Vioxx (Rofecoxib) from the market, because evidence had built up since the drug's 1999 approval that it was associated with increased risk of stroke and heart attack.

• Because of the short follow-up period, it is not yet clear how long COVID-19 immunity lasts after vaccination.

• For safety reasons, children, the immunocompromised, and women who are pregnant or breast-feeding were excluded from the clinical trials, so we know little about the effects of vaccination on people in these classes.

• Vaccines are often less effective in the elderly because their immune systems no longer function as well as they used to. The complex and lasting symptoms observed in many cases of COVID-19 suggest that vaccination may not provide complete or durable immunity.

• Although the vaccines reduce or prevent COVID-19, we do not yet know how effective they are at preventing disease transmission to other people. If they do not prevent transmission, herd immunity will take longer to achieve.

• The normal mutation processes of the coronavirus may make some vaccines less effective.

Any setbacks in the global vaccination program would cause temporary damage to investor sentiment. In the longer term, other more effective vaccines will be developed - there are currently 18 candidates in Phase III trials. In the short term, travel and tourism stocks, as the sectors worst affected by COVID-19, would give up much of their recent gains.

For these reasons, we continue to expect a W-shaped recovery in the Australian economy and share market. We forecast this sort of recovery back in June, when it became obvious that COVID-19 would have recurrent outbreaks until herd immunity was achieved. The subsequent outbreaks in Melbourne and Sydney have confirmed our forecast. The additional possibility of setbacks in the vaccine rollout reinforces our belief that two steps forward will often be followed by one step backward.

For Australian investors, we recommend riding the Australian market up, buying the dips but avoiding risky sectors. Over the next six months, economic recovery will propel the Australian share market upward even if there are minor corrections. In the second half of 2021, however, the risks will increase as any vaccine problems emerge. In addition, the Australian government needs to find its way to a truce, if not a peace treaty, in the trade war with China.

While the broad market will keep rising in the long term, some sectors will become over-priced as optimism outruns reality. As noted above, the longer herd immunity is delayed, the longer it will take the tourism and travel sectors to return to profitability. Speculative stocks, e.g. in fintech, mining, and biotech, have floated upward on a tide of stimulus money, and the withdrawal of stimulus payments means that the tide will go out and leave many investors stranded.

Back in June, we forecast that the Australian dollar (AUD) would rise against the US dollar (USD) over the next three years, reaching at least USD 84 cents and possibly USD 90 cents. Since then, our prediction has been coming true faster than we expected. The AUD has risen 11% against the USD since end-June, and it could rise another 10% to 20% within twelve months, thanks to the US mishandling of the pandemic, debt-funded multi-trillion dollar stimulus packages en route in 2021 and the ongoing dysfunctionality of US politics.