The Index Investor
September 2020

Our 12-month regime forecast probabilities have not changed over the past month. The probability of the Persistent Deflation Regime remains 65%; the High Uncertainty Regime 15%; the High Inflation Regime 15%, and the Normal Regime 5%.

Over the next twelve months, evidence will very likely continue to accumulate that the real economy is in worse shape that equity market investors apparently believe.

As cold weather returns to the northern hemisphere, COVID cases will likely increase, assuming more people congregate in enclosed areas with insufficient ventilation and other measures to limit the accumulation of coronavirus aerosols to a level that can trigger superspreader events. The interaction of COVID and influenza infections risks overloading hospitals, and, more dangerously, recombinations of viral material when a person is infected with both viruses, with very unpredictable results.

Bankruptcies continue to increase; in the case of small and medium enterprises, this is often leading not to Chapter 11 restructurings but Chapter 7 liquidations, which represent a permanent loss of jobs and productive human and physical capital.

The continuing failure of the politically polarized US Congress to pass another stimulus plan will very likely accelerate these trends. Recent studies have also found that in the US company support programs have been very inefficient, and it would have been better to directly provide support to individuals.

We have made no change to our 36-month regime forecasts. The probability the United States will be in the Persistent Deflation Regime remains 50%, as evidence continues to accumulate that the economy will very likely suffer a deeper and longer downturn than many investors currently expect.

It also seems very likely that the US will experience a constitutional crisis after the November election. This will sharply increase uncertainty, with its attendant negative impact on the economy. At this point, it does not appear that this has been fully incorporated into asset market prices.

It is also still very likely that the probability of an intensifying political crisis in the United States regardless of who is eventually sworn in as the nation’s next president has not yet been fully incorporated into the dominant narratives driving current asset class valuations.

August saw intensifying rioting and looting in the United States, as well as Democratic and Republican Conventions that left many voters underwhelmed. Neither party managed to give people what they most need in a crisis: Truth and Hope.

This past month, China took further aggressive actions, including swift implementation of the new national security law in Hong Kong, arrest of a well-known Australian-Chinese journalist (in a further display of its penchant for “hostage diplomacy”), and increased intrusions by military jets into Taiwanese airspace. Also, evidence continues to accumulate that the COVID-19 pandemic was caused by a lab accident at the Wuhan Institute of Virology (from which China continues to bar international teams investigating the origin of the virus). If this continues, a tipping point will be reached and this will become the dominant narrative, which will almost certainly further increase conflict between China and many other nations.

Finally, it is important to keep in mind that the headwinds that were restraining aggregate demand growth before the devastating arrival of the COVID-19 pandemic either have not improved or are worsening. These include slower population growth and faster aging (which was further emphasized in August by a new report on declining US fertility), weak productivity growth, declining labor share of GDP, rising levels of both inequality and debt, and the growing threat of job displacement as increasingly capable automation and artificial intelligence technologies are deployed.

As students returned to a mix of online, hybrid, and in-person schooling in the northern hemisphere, it is not at all clear that education leaders have grasped the extent of learning losses students have suffered as a result of various pandemic related disruptions, much less the urgency of recovering them. If this does not happen, the negative impact on future productivity growth could be substantial, at a time when that growth will be more important than ever.

Our 36-month forecast probability for being in the High Inflation Regime remains at 35%.

Whether the High Inflation Regime comes to pass will depend on the interaction between COVID19’s shocks to demand and supply, along with even more important political factors. New analyses this month have found that the former has been much more severe, which, for now, makes a sudden increase in inflation less likely than deflation.

In our view, the most logical cause of a return to the High Inflation regime over the next 36 months would be a crisis of confidence in the US government and/or economy that causes a flight from the US dollar and a sharp rise in the price of imported goods (and very likely gold as well).

Another potential cause of such a crisis would be the outbreak of open conflict between the China and the United States (e.g., a Chinese invasion of Taiwan or rapid escalation of a kinetic encounter in the South China Sea) in which American forces were defeated and/or global supply chains were severely disrupted.

Finally, at the 36-month time horizon, our forecast probabilities for the High Uncertainty (10%) and Normal Regimes (5%) also remain unchanged. The former regime could occur if the Democrats win the White House and both houses of Congress in November, and struggle to revive the economy with good policy initiatives, but without an effective coronavirus vaccine while facing intensifying conflict with China.

Return to the Normal Regime would require the same political wins and policy initiatives, avoidance of new uncertainty shocks, early deployment of a highly effective vaccine, and a sharp reduction in US-China tensions (e.g., due to the removal of Xi Jinping from office).

In reviewing the current situation, we are again reminded that when uncertainty is high, people rely more heavily on social learning and copying what others are doing. Not only does this slow the diffusion of new information throughout social systems like economies and financial markets, but it also causes these systems to coalesce around a small number of increasingly fragile narratives. Under these conditions, rapid, non-linear changes are very likely to occur.

That certainly appears to be the case today in global financial markets.

Portfolio Allocation Implications of Our Forecast

We take two approaches to deriving the tactical asset allocation implications from our analyses (i.e., deviations from our "neutral" or base case model portfolio).

The first takes a systematic approach, and is based on relative asset class valuations. Our starting point is our neutral model portfolio, which is equally weighted across nine broad asset classes, and also includes 5% allocations to alpha strategies (equity market neutral and global macro) that are designed to have a low correlation to returns on broad asset classes.

Based on asset class valuations, we systematically vary the asset class weights (but not the active strategy weight), increasing from 10% to 15% when an asset class is likely undervalued, and 15% when it is very likely undervalued. In the case of overvaluations, we go to 5% and then into cash, if there are no undervalued asset classes with room for an increase. In effect, this replicates the systematic rebalancing strategy we used for 15 years in our previous model portfolios.Based on subscriber requests, this month we are re-introducing a feature from the previous version of The Index Investor: Tactical Asset Allocation Implications from our analyses.

The second tactical approach is based on our subjective view not only of current asset class valuations, but also of the implications of the broader macro trends and uncertainties that we analyze each month. Importantly, this subjective view reflects our primary goal of avoiding large downside losses, rather than seeking large upside gains.

Three final notes: First, with respect to US fixed income, we include credit products (investment grade and high yield) in the same asset class as government debt, and will shift into the former when their valuations become attractive.

Second, we regard gold not as a separate asset class to be held long-term, but rather as a complement to cash, into which we shift in periods of substantial overvaluation across multiple asset classes.

Third, we continue to be deeply concerned by the distortion in asset class valuations that have been created by negative real interest rates on sovereign bonds, which are the foundation of most asset pricing models. In August, we decided to address this distortion by using in our asset class valuation models our estimate of the economically logical real yield on inflation protected US government bonds (TIPs). This brings our quantitative valuation conclusions much closer to those based on our qualitative analysis.

More information about our investment beliefs, including our core philosophy, approach to asset allocation (including our model portfolios and their long-term track record), and views on various approaches to active and passive management can all be found here.

Here is our latest asset allocation view:

Implications of the Most Recent Three Month Asset Class Returns

Our quantitative forecast methodology focuses on the level and change in three-month returns, over the most recent and previous three-month periods, for those asset classes, which should perform best under different regimes (in this sense, our regimes can be regarded as macro factors). We assume that relatively higher returns are associated with more widely held investor belief in the probability that a given macro regime will develop in the future.

Note: The language we use to describe our estimated likelihood of asset class over or undervaluation is based on US Intelligence Community Directive 203 on Analytic Standards, which includes the following table:

Market Stress Indicators (@31Aug20)

As always, this month’s Evidence File contains important new indicators and surprises observed over the past month in addition to those cited in our forecast update. Overall, these new pieces of evidence indicate that a substantial increase in uncertainty very likely lies ahead, that is not yet reflected either in dominant popular narratives or financial market prices. Key indicators include:

• Base on the largest seroprevalence study conducted to date (involving over 100,000 people), UK authorities estimated that only 6% of the population has had COVID-19. Other studies have concluded that between 45% and 60% of the population need to have COVID-19 antibodies in order to achieve so-called “herd immunity.” This means that vaccine must play a crucial role in achieving this. Unfortunately, as detailed in this month’s feature article, current optimism about the vaccines under development is very likely misplaced. If and when the current optimism is dashed, there will be another uncertainty shock to public confidence and financial markets.

• A number of new reports, including the US Department of Defense’s annual analysis of Chinese Military Power, concluded that China’s military capabilities are improving faster than many people realize, which significantly increases the chance of conflict with the United States. Urban rioting continued in the United States in August, with a critical red line being crossed when weapons were used by members of far right and far left groups to take each other’s lives. Martin Gurri, author of the book “The Revolt of the Public and the Crisis of Authority in the New Millennium” offered an insightful analysis in his article, “Why Were the Protests and Riots So Explosive?” “The riots connect to something bigger and deeper: The tectonic collision between a public empowered by digital platforms and the elites who control the ruling institutions of modern society”… “Protestors visions of the future diverge wildly, but they are united and mobilized by a shared loathing of the established order. They stand ferociously against … Any hint of a positive program would likely shatter the movement into its component war-bands, so revolt has come to mean an exercise in pure negation, in the repudiation of the status quo without an alternative in sight. At this point, the question of nihilism becomes impossible to avoid.”

• In the US, both the Democratic and Republican parties held their national conventions in August. Neither was able to provide the public with what people need to hear when confronted with unprecedented uncertainty and anxiety: Truth and Hope. This did not restore the public’s confidence in elites, which means that public opinion will likely be increasingly volatile in the runup to the November election, which Donald Trump still could win – however improbable that seemed not so long ago.

Pre-Mortem Analysis

One of the most important forecasting disciplines is to ask yourself why your forecast could be wrong. Dr. Gary Klein’s research has shown that a very powerful and insightful way to do this is via a “pre-mortem analysis.” This method asks you to assume that it is a point in the future, and your forecast has been proven wrong (or your strategy or company has failed). You are then asked to look backward from this imagined point in the future, to explain why you failed, what you missed, and what you could have done differently to avoid your fate.

The pre-mortem method takes advantage of the fact that humans reason much more concretely and in more detail when explaining the past than they do when trying to forecast the future.

So let us assume that it is one year from now, and our current forecast has turned out to be wrong.

How did this happen? What developments did we fail to anticipate?

• A number of world leaders – Xi Jinping and Donald Trump, and to a lesser extent Vladimir Putin and Ali Khamenei are all facing sharply weakened economies and declining political popularity. History teaches us that this can lead to increased “foreign adventurism” to distract the public from worsening domestic conditions, as a nation rallies around its leader in a period of heightened external conflict. Should a “kinetic” conflict develop between China and the United States, or Iran and Israel, Saudi Arabia, and/ or the US, or between Russia and one or more European countries (e.g., due to a Russian incursion into the Baltics), it would generate a very sharp increase in uncertainty that would likely accelerate the already sharp COVID-19 economic slowdown. Given given high debt levels, this would very likely accelerate the arrival of the Persistent Deflation Regime.

• On the other hand, the removal from office (by one means or another) of Xi Jinping or Donald Trump * could * lead to a reduction in the dangerously growing conflict between the two nations, and increase cooperation in both the fight against COVID19 and the recovery of the global economy. This would somewhat reduce the probability of both the Persistent Deflation and High Inflation Regimes, and raise the relative probabilities of the High Uncertainty and Normal Times Regimes.

• A supply side shock of some type – beyond the disruption of global supply chains caused by COVID-19 -- could produce a sudden increase in inflation. The most likely scenario is a reduction in oil supplies due to a prolonged kinetic conflict between Iran and the US. An unlikely scenario could be major crop failures associated with the next solar cycle, which NASA forecasts will be the weakest in 200 years. McKinsey recently concluded that the probability of such a failure has increased due to changes in the environment, and now stands at about 10% over the next five years ("Will the World’s Breadbaskets Become Less Reliable?”).

• Another route to the high inflation regime (repeatedly noted by Bridgewater’s Ray Dalio) would be a sudden loss of confidence in the US dollar relative to other currencies (driving up import prices), perhaps because of increasing deficit monetization and policy paralysis if a severe downturn continues without meaningful policy reforms to address critical structural challenges. However, a sharp rise in import prices due to a collapse in the USD exchange rate also requires relatively higher confidence in another currency, with the Euro being the most likely candidate. This currently seems unlikely, given both the Eurozone’s economic and political uncertainty, and the prospect of an intensifying conflict between the West and China. If confidence collapsed in all major currencies, the price of gold would rise, and price inflation would only occur in terms of gold.

Note: Combining Our Forecasts with Others From Other Sources and Extremizing the Result Should Increase Your Predictive Accuracy

Research has found that three steps can improve forecast accuracy. The first is seeking forecasts based on different forecasting methodologies, or prepared by forecasters with significantly different backgrounds (as a proxy for different mental models and information). The second is combining those forecasts (using a simple average if few are included, or the median if many are). The final step, which significantly improved the performance of the Good Judgment Project team in the IARPA forecasting tournament, is to “extremize” the average (mean) or median forecast by moving it closer to 0% or 100%.

Forecasts for binary events (e.g., the probability an event will or will not happen within a given time frame) are most useful to decision makers when they are closer to 0% or 100% than the uninformative “coin toss” 50%. As described by Baron et al in “Two Reasons to Make Aggregated Probability Forecasts More Extreme”, forecasters will often shrink their probability estimates towards 50% to take into account their subjective belief about the extent of potentially useful information that they are missing.

When you average multiple forecasters’ estimates, you are including more information, which should increase forecast confidence and push the mean estimate closer to 0% or 100%. However, this doesn’t happen when you use simple averaging. For this reason, forecast accuracy is increased when you employ a structured “extremizing” technique to move the mean estimate closer to 0% or 100%.

You can download an extremizing model from our website to use when combining the forecasts you use in your decision process.

The extremizing factors in our model are those that the Good Judgment Project found maximized the accuracy of combined forecasts. Note that the extremizing factor is lower when average forecaster expertise is higher. This is based on the assumption that a group of expert forecasters will incorporate more of the full amount of potentially useful information than will novice forecasters.

Feature Article: An Assessment of COVID-19 Vaccine Uncertainties and Probabilities

In terms of physical, economic, and mental health, a lot is riding on the world’s ability to develop and deploy and effective vaccine against the SARS-Cov-2 virus that causes COVID-19.

In this analysis, we attempt to answer two critical questions: How realistic are our current hopes? And what happens if they are dashed?

Implicit in our hopes are assumptions that five critical uncertainties will be favorably resolved over a given time horizon:

1) Development of a vaccine that stimulates the production of antibodies;

2) Ability to produce the vaccine in large volumes;

3) Ability to distribute large volumes of the vaccine to billions of people around the world;

4) Willingness of a large percent of the population to be inoculated with the vaccine;

5) The vaccine remaining effective for a long period of time.

In quantitative terms, the probability of a successful vaccine equals the joint (multiplicative) probability of that each of these sub-goals will be met. For example, putting a 95% probability on the achievement of each sub-goal by the end of 2021 means that the overall probability of vaccine success is just 77%.

Let’s look at the evidence in each of these areas.

Vaccine Development

As a general rule, it normally takes 15 to 20 years to develop a vaccine. In their “Clinical Success Rates, 2006-2015” study of the drug development process, the Biotechnology Innovation Association found that the overall “Likelihood of Success” (i.e., final approval and deployment) for 9,985 drug development processes studied was 9.6%. However, the LOA for drugs targeted at infectious diseases was 19.1%.

In a separate study published in 2018, Gouglas found that development of vaccines against epidemic infectious diseases has only a 6% chance of success (“Estimating the Cost of Vaccine Development Against Epidemic Infectious Disease”).

However, according to the Milken Institute (https://covid-19tracker.milkeninstitute.org/), there are now 211 vaccines for SARS-CoV-2 coronavirus under development. Applying a historical 6% success rate to this implies that this massively parallel and accelerated development effort will yield about 13 successful vaccines.

Conclusion: 99% estimated probability that a vaccine will be developed that generates an immune response with minimal side effects by the end of 2021.

Vaccine Production

On the surface, the outlook for mass production of successful vaccine candidates is encouraging. Manufacturers have announced capacity construction projects that they claim will be able to produce nine billion doses by the end of 2021.

Moreover, as the Congressional Research Service notes, obstacles related to vaccine manufacturers’ potential liability risks will likely be removed: “A COVID-19 vaccine is likely to be subject to specialized rules limiting legal liability under the Public Readiness and Emergency Preparedness (PREP) Act. To encourage the expeditious development and deployment of medical countermeasures, the Secretary of HHS has declared COVID-19 to be a public health emergency and invoked the PREP Act to limit liability for losses relating to the use of covered medical countermeasures during the public health emergency.

“Under HHS’s declaration, covered persons—including COVID-19 vaccine developers, manufacturers, distributors, and health care professionals who administer a vaccine—are generally immune from legal liability for losses relating to administration or use of an FDA-approved COVID-19 vaccine, except for willful misconduct resulting in death or serious physical injury. However, individuals who are injured or die as a result of receiving a COVID-19 vaccine may seek compensation through the Countermeasures Injury Compensation Program, a regulatory process administered by HHS” (“Legal Issues in COVID-19 Vaccine Development”).

However, in “Vaccines Use Bizarre Stuff. We Need a Supply Chain Now”, Kominers and Tabarrok highlight other production issues beyond manufacturing capacity. “Vaccine supply chains contain some unusual links, including horseshoe crab blood, shark liver oil and an enzyme that’s one of the world’s most expensive products. Other links rely on novel manufacturing processes that have not yet been implemented at scale. Each link in the chain needs to be stress-tested and strengthened. For the potential weak spots, alternative manufacturing processes need to be considered and prepared.”

In another story, “Without Vials and Needles, a Virus Vaccine Is Just a Formula”, Samanth Subramanian observes that, “In a whistleblower complaint, Rick Bright, then the director of the U.S. Biomedical Advanced Research and Development Authority (Barda), wrote that his agency had estimated as far back as January that the country would need from 650 million to 850 million needles and syringes for a Covid-19 vaccination drive. The Strategic National Stockpile held just 15 million at the time, and Bright kept hearing that other countries, aware that scientists were predicting a 12- to 18-month timeline for the release of a vaccine, were buying up stocks of syringes and needles from the U.S. Yet the American government didn’t place its first order for needles and syringes until May 1, he told Congress. When a vaccine is finally approved for manufacture, the rush to stock up on ancillary products will be unprecedented.”

Conclusion: 67% estimated probability that nine billion doses of a vaccine will produced by the end of 2021.

Vaccine Distribution

There are two big issues with vaccine distribution, one physical and one political.

Regarding the former, “Two-thirds of the world’s population is unlikely to have easy access to any Covid-19 vaccine that needs to be stored at freezing temperatures, the German logistics giant Deutsche Post DHL has warned.

“Research by DHL and consultancy firm McKinsey has found that insufficient “last mile cooling facilities in the final delivery stages and a lack of storage at clinics in large parts of Africa, Asia and South America would pose the biggest challenge to delivering a vaccine at scale. Existing “cold-chain” infrastructure, which allows for temperatures to be controlled throughout the delivery process, is only sufficient to bring a frozen vaccine to 2.5bn people in approximately 25 developed countries [or about 33% of the world’s population]” (“DHL Warns Of COVID-19 Vaccine Delivery Problems”, Financial Times).

On its website, UPS agreed, stating, “Let’s face a hard truth: Our pharmaceutical cold chains at this time do not have the equipment and scale to comprehensively deliver a temperature-sensitive vaccine for the COVID-19 pandemic.”

Moreover, even in the United States, a report by the Inspector General of the Department of Health and Human Services found the cold chain for vaccines was very fragile and resulted in vaccine spoilage (“Vaccines For Children Program: Vulnerabilities In Vaccine Management”).

Regarding political obstacles, RAND and others have noted that, with limited quantities of a vaccine initially available, there are abound to be conflicts over who receives it first.

“The US [and other countries] need an equitable distribution plan that reflects social realities. The vaccine should go first to health workers, essential workers, teachers, the elderly, and people whose living circumstances—from prisons to apartments—make it impossible to self-isolate if they get the disease. We need to ensure there is no discrimination, racial or otherwise, in the distribution process. And vaccinating teachers is particularly important because we cannot expect them to risk their lives to teach their students. There is broad agreement that keeping the schools closed will increase the gap between advantaged and disadvantaged children; a generation is at stake” (“It’s Going to be the Vaccine, Stupid!” by Brook and Rydzewski).

Conclusion: 67% estimated probability that the supply chain can deliver the vaccine to at least 5 billion people [67% of the world’s population] by the end of 2021.

Vaccine Acceptance

Herd immunity occurs when enough people in a community become immune to an infectious disease that it stops spreading. Traditionally, the herd immunity threshold has been estimated to be 60% of a population. However, recent research finds that it may be as low as 43% (“A Mathematical Model Reveals The Influence Of Population Heterogeneity On Herd Immunity To SARS-Cov-2”, by Britton et al).

Immunity can theoretically be acquired either by having had the disease (assuming a strong, prolonged, and effective immune response) or through vaccination (which makes the same underlying assumptions).

Seroprevalence tests by the US Centers for Disease Control and Prevention have estimated that, depending on location, between 1% and 7% of the US population has contracted COVID-19 (“Seroprevalence of Antibodies to SARS-CoV-2 in 10 Sites in the United States, March 23-May 12, 2020”, by Havers et al). That means that achieving herd immunity will require substantial takeup of new vaccines when they become available.

That raises a critical question: How enthusiastic will you be about taking a vaccine of as yet known long-term efficacy that has been developed in record time?

According to a Yahoo News/YouGov poll taken at the end of July, only 41% of US Adults said they would take the vaccine when it becomes available. 25% said they would not. The other 34% weren’t sure.

As Jonathan Ellen notes in “The Dangers of Herd Skepticism”, “substantial numbers of people already avoid routine immunizations. Most individuals who don’t accept vaccines such as routine childhood immunizations or the annual flu shot do so out of concern about side effects and doubts about effectiveness.

“Almost 15 percent of parents refuse recommended childhood vaccines, including the mumps-measles-rubella series, because of their belief in a link between vaccination and autism… In recent years, the percentage of U.S. residents 18 or older who reported receiving the annual flu vaccine was between 40 percent and 45 percent.

“Reasons for choosing not to receive the flu vaccine include a sense of invulnerability to the illness; belief that the vaccine isn’t effective; confidence in the body’s immune system to fight infection; concern that the vaccine will make one sick; and fear of neurological damage. An FDA-approved COVID-19 vaccine will present similar concerns.

“The FDA has set the standard for approval at an historically low level—the vaccine needs to protect only half of its recipients from infection over six months. In addition, when the vaccine is approved, the duration of its effectiveness will be unknown—will it require boosters or annual reformulations? Questions will also arise about side effects beyond the six to nine month period that participants in the trials were observed. Such realities could dampen enthusiasm for acceptance of the vaccine.”

Given the consequences of widespread resistance to voluntary vaccination, some are considering more coercive methods. In “An Overview of State and Federal Authority to Impose Vaccination Requirements”, the US Congressional Research Service wrote that, “Under the federalist system of the United States, state governments have the general authority, within constitutional limits, to enact laws ‘to provide for the public health, safety, and morals’ of the states’ inhabitants. In contrast to this general police power, as discussed below, Congress’s power to legislate is confined to those powers enumerated in the Constitution.

“The states’ general police power to promote public health and safety encompasses the authority to require mandatory vaccinations. Pursuant to this authority, states and localities have long enacted various compulsory vaccination laws for certain populations and circumstances, including for school children and certain health care workers and in cases of public health emergency. In the early part of the 20th Century, the Supreme Court twice considered constitutional challenges to such mandatory vaccination requirements. Each time, the Court rejected the challenges and recognized such laws to fall squarely within the states’ police power.”

The authors of the previously mentioned RAND study proposed a different approach: “We should consider whether and how to provide, at the time of vaccination, an electronic readable card confirming that the person had been vaccinated. We should also consider whether it is good policy—or even legal—to require employees, guests, students, or others to present a readable card proving they have been vaccinated if they want to work, fly, eat at a restaurant, study in a classroom, go to the opera, take a cruise ship, etc” (e.g., a vaccination based version of China’s Social Credit System).

In sum, it seems quite clear that vaccine acceptance is going to be an obstacle to achieving herd immunity.

Conclusion: 50% estimated probability that at least half the US population will be vaccinated by the end of 2021.

Vaccine Efficacy

Vaccines provide protection against infectious disease via two pathways. The first, “humoral response”, refers to a vaccine triggering the production of antibodies that directly attack a viral invader. The second, “cellular response”, refers to the enhancement of the body’s cell-level response (via T-Cells) to a viral infection.

Today, the extent to which a vaccine will trigger these responses, their efficacy in repelling infection, and the length of time they will persist all remain unknown.

Data about these responses in patients who have recovered from COVID-19 still vary widely.

The results of attempts to develop a vaccine for MERS (a coronavirus that is far more deadly than SARS-CoV-2 that was first identified in Saudi Arabia in 2012) are instructive.

According to The Gouglas paper cited above, 21 initiatives were undertaken to develop a MERS vaccine. Only four of them progressed to Phase 1 clinical studies. Of these, only one reported successful results (in 2016 by a team at Walter Reed US Army Medical Center).

In their paper, “Safety and Immunogenicity of an Anti-Middle East Respiratory Syndrome Coronavirus DNA Vaccine: A Phase 1, Open-Label, Single-Arm, Dose-Escalation Trial”, Modjarrad et al reported that, “This study showed that the GLS-5300 MERS coronavirus DNA vaccine was tolerable and immunogenic in humans. [Three doses of the] vaccine induced both antibody-based and cellular MERS coronavirus-specific immune responses.

"The study also compared vaccine-specific responses with those from individuals who had recovered from natural MERS coronavirus infections during a 2015 outbreak in Korea. The results showed that the immune responses generated in vaccinated study participants [over 12 months] were similar to convalescent responses after natural infection.”

However, the study could not test the extent to which the levels of immune system responses it found were sufficient to protect vaccinated patients against the disease, or for how long that protection would last.

Equally important, about one third of the patients in the study experienced mild or moderate side effects from the vaccine, including fatigue, head and body aches, and/or nausea.

Earlier this year, results from tests of a different MERS vaccine on animals reported that it did confer protection on them against deliberate exposure to MERS infection (“A Single Dose Of Chadox1 MERS Provides Broad Protective Immunity Against A Variety Of MERS-Cov Strains”, by van Doremalen et al). However this vaccine has not yet proceeded to human trials.

With respect to the efficacy of a SARS-CoV-2 vaccine, a final concern is the rate at which the virus will evolve in the future. A fast rate of evolution is what makes developing accurate vaccines against seasonal influenza so difficult. The consequence is that we have to get vaccinated once a year, and the degree of protection against infection that they provide varies from year to year.

Thus far, the rate at which SARS-CoV-2 has been evolving has been much slower than is the case for influenza, which, all else being equal, implies that a vaccine’s protection could last for a longer time (see, “On The Evolutionary Epidemiology Of SARS-Cov-2”, by Day et al). However, as noted in this month’s Evidence File, coinfection of patients with both SARS-CoV-2 and seasonal influenza virus could cause faster evolution in one or both of them.

Conclusion: 90% estimated probability that immune system response produced by the vaccine will protect people from infection by SARS-CoV-2 for at least one year.

Estimated Joint Probability of Overall Success by December 2021

To summarize, our estimates of successfully overcoming obstacles in five key areas are as follows:

• Vaccine Development = 99%
• Vaccine Production = 67%
• Vaccine Distribution = 67%
• Vaccine Acceptance = 50%
• Vaccine Efficacy = 95%

These estimates produce an overall joint probability of successful vaccine development and deployment by the end of 2021, and efficacy for one year thereafter of about 20% -- a one in five chance of meeting the overly optimistic expectations that almost certainly underlie many individuals’, companies’ and governments’ hopes today.

What Happens If Vaccine Hopes Are Dashed?

When unrealistic optimism gives way to more realistic expectations of how long it will take to develop and deploy a successful vaccine, there will almost certainly be another uncertainty shock to consumers, companies, and financial markets that will further slow the economic recovery.

It will also very likely trigger a sharp increase in mental health problems, which could produce hostile acts (e.g., violent protests) directed towards those perceived to be responsible should the critical failures be in vaccine production or deployment.

On the other hand, if the key failure lies in vaccine acceptance, protests will almost certainly be aimed at government authorities that try to compel vaccination (with some version of RAND’s vaccine “Social Credit System” likely to emerge as a compromise solution).

On the positive side, the United States learned to live with the threat of polio for many years until a vaccine was developed and deployed. The same will undoubtedly happen if the COVID vaccine falls short of its goals.

Besides continuing mandates regarding masks and social distancing, the most important initiative we expect to see is much greater focus on, and investment in, indoor air quality and associated HVAC systems, by both school districts and commercial property owners.
 
 

High Value Information Observed In August 2020

In our model of the complex global macro system, change drivers are arrayed across a roughly chronological process (albeit one with many feedback loops), in which technological and environmental changes precede changes in the economy and national security, which in turn lead to changes in society and politics, all of which produce the effects we observe in investor behavior and financial market valuations and returns.


In our methodology, we classify new information as significant and highly valuable if either it (1) is an “indicator”, which reduces our uncertainty about the value of a parameter in our mental model for making sense of the dynamic macro system, or (2) it is a “surprise” which increases our uncertainty about either the range of potential values for a parameter or the structure of our model. With respect to indicators, the higher our priori probability is for a regime, the more we look for indicators that it will not occur, and the lower our prior probability for a regime, the more we look for indicators that it will occur. Put differently, we tend to look for high value indicators that disconfirm our prior views.

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System Tipping Points/Critical Threshold Analysis

Like Professors Andrew Lo, Doyne Farmer and others, we regard financial markets as a complex adaptive system (CAS), that exist as part of a larger macro system comprised of other CAS between which there are multiple feedback loops. These other systems include those that produce technology innovations, and economic, environmental, national security (including cyber), social, demographic, and political outcomes.

We also find that these systems tend to operate and generate effects in a rough chronological sequence, albeit with many feedback loops between them. The following chart highlights that the changes we observe in different areas at any point in time are actually part of a much more complex evolutionary process.

While most media coverage of these systems focused on flows (e.g., the size of the government deficit), rapid non-linear change in complex adaptive systems is often caused by a key stock (e.g., the amount of outstanding government debt) exceeding a critical threshold.

The next table highlights the key macro system stocks that we monitor.

In the next section, we will discuss information received over the past month that is related to these stocks, and which we believe is significant to our assessment of the probabilities that a critical threshold will be reached and a regime change will occur. We will conclude with our estimate, at the end of this month, of how close the macro system is to these critical thresholds, and the implications for financial market regime change probabilities.

How Close is the Macro System to One or More Critical Thresholds?

As we have noted, the macro drivers of financial market regime changes typically follow a rough chronological sequence, from technology to economic, security, social, and political causes and effects. Yet there are many feedbacks loops between them, creating complex root causes for many of the critical thresholds we have identified.

Understanding the time dynamics in this complex system is critical to avoiding substantial downside investment risk.

We use the UK Met Office Warning Model to communicate our assessment of these time dynamics. We estimate the time remaining before a critical macro system threshold is reached that could trigger a regime change, which is usually accompanied by substantial changes in asset class valuations.

The model uses three increasingly serious levels of warning, from “Be Aware” (condition yellow), to “Be Prepared” (condition orange), to “Take Action” (condition red).

For our purposes, we denote as “Be Aware” (yellow) critical thresholds that we assess to be three or more years away. We estimate that “Be Prepared” (orange) thresholds could be reached within 1 to 3 years. “Take Action” thresholds are very likely to be reached within one year.

Given their nature, we also note that in our three “wildcard” areas (Environment and Energy related; Disease and Human Caused Bioevents; and Cyber and Electromagnetic Events), our forecasts have higher levels of uncertainty.

The following charts summarize our current estimate of the time remaining before different critical thresholds will be reached.

Conclusion

At the highest level, we believe the complex adaptive global macro system can be in one of four states, based on its degree of order versus disorder, and degree of social cooperation versus conflict. A very coarse-grained reading of history suggests that these states evolve in a predictable cycle, from ordered/cooperative, to disordered/cooperative, to disordered/conflicted, to ordered/conflicted.

We believe that the system is currently in its most uncertain state, characterized by high degrees of underlying disorder and social conflict, both domestically and internationally. Beyond some point, intensifying conflict eventually increases the degree of order in the system. That appears to be happening now, via the increasing conflict between China, Russia, and Iran and the United States and other Western nations.