The worse than expected U.S. purchasing managers index (PMI) released days ago seems to suggest the economy is indeed slowing down. But wait. The manufacturing PMI still stood near 60, a level which was never reached between mid-2004 and end-2017. In fact, the recent high near 65 has never been seen since 1983. Even the month-on-month (MoM) growth of personal spending released last week was not bad at all: It rose at 1 percent in June where such fast growth had never been seen since 2009, suggesting the U.S. economy is still in a good shape.
As real economic activity growth lowers, one will see the corresponding prices to follow. Thus, inflation and other price growth expectations would also ease, which partly explains the decline of long bond yield since April. But is merely such lowering expectation strong enough to offset that arisen from the observed surging inflation? It is hard to simply assume the Wall Street has blindly accepted what Federal Reserve’s claims about transitory inflation. Expectation converges to reality; only the former cannot fully explain the declining yield.
Given the negative correlation between long bond yield growth and stock index growth has been well established, one should conjecture whether a flattening of the curve over past four months would mean a kind of risk-off. This is not easily seen if one compares between long bond yield and traditional indexes like the three major ones. But if a small cap index like Russell 2000 is used, then the picture will be clear. From chart 1, it is obvious that whenever 10-year Treasury yield comes down, the Russell 2000 index stays flat at the same time.
This means most stocks (2000 in Russell index) have not been moving much since April despite the top ones (30 in Dow Jones) keep breaking record high. The volatility trend also poses a cautious picture. The standard measure volatility index (VIX) has been on downtrend since the outbreak of Covid-19, but the trend is somehow tilted in July exhibiting a bottoming out pattern. The picture is even sharper by looking at the volatility of volatility index (VVIX). It has been flat before but is now sloping upward since April, matching the declining yield.
History somehow confirms this pattern of rising volatility from a seasonal perspective. Using the full historical series of the Dow Jones Industrial Average index (DJI) since May 1896 and that of the Nasdaq index since February 1971, the mean and volatility (which is by definition “standard deviation”) of the quarterly return are computed. However, the quarters are not the traditional Q1-Q4 following typical calendar year, but are split by end-January, April, July, and October to reflect the seasons from spring to winter. The results are shown in Chart 2.
One can see the returns of both indexes are the worst in autumn, i.e., August to October, among all four seasons. On volatility, it is generally rising towards yearend depending on which index: For DJI the peak is in autumn while for Nasdaq the peak is in winter. Statistics suggest the three months ahead would go with high risk low return. Should the 10-year yield really approaching 1 percent as a bank strategist claimed, the current uptrend of volatilities would intensify which might probably trigger a more decent correction for the major indexes.
China just released composite and services PMI indexes compiled by Caixin. The latter beat expectations while both series rebounded, yet both are still on downtrend over the past three quarters. However, these are unlikely to reverse the stock market downtrend in either China or Hong Kong. The arbitrarily and unreasonable “rectifications” imposed to sectors one by one means any business can be closed down anytime whenever the Beijing government wants to. It amounts to getting rid of not only funds but also investments as well as production.
All governments would try hard to rescue business and market confidence which is fragile, but the Chinese government destroyed it in just one day. Any strong rebound of the stock market after a fire sale is regarded as a final chance to cut down or even to empty the portfolio. Arbitraging volatility between China (long) and U.S. (short) seems to be a good strategy, despite both have been trending up as is projected by the seasonal pattern discussed above.
