PULSe Indicator Rang the Alarm in Q3 2021

PULSe is a composite indicator that is designed to monitor the state of global financial markets since the coronavirus crisis. It stands for Pandemic, Uncertainty, Liquidity, and Sentiment—four factors that we believe encompass much of the market’s dynamics. High positive values of PULSe are typically a negative sign for market stability.¹

The PULSe composite indicator decreased modestly in September and was characterized as stable as of the end of the month as improvements in the Pandemic, the Uncertainty, and the Liquidity factors made up for the deterioration in the Sentiment factor. As of September 30, 2021:

• The Pandemic factor abated as daily new cases continued to drop in the U.S., Europe, and Japan, which was confirmed by the reduced positive test ratios.
• The Uncertainty factor declined notably as the Bloomberg U.S. economic surprise index bottomed, long‑term government bond yields rose, and earnings forecasts in Europe and Japan showed signs of reacceleration.
• The Liquidity factor decreased modestly as competing forces canceled each other out: The widening trend of the spreads of U.S. three-month commercial paper and euro investment-grade financial corporate credit slowed down, while the U.S. high yield spread reversed higher again.
• The Sentiment factor shot up as all four sub‑factors deteriorated: The equity put/call ratio rose, the implied volatility surged, carry currencies underperformed the safer currencies, and the gold/copper price ratio climbed.

Background Note

In this note, we highlight three factors that contributed meaningfully to the PULSe indicator over September, the last month of the third quarter. The delta variant wave abated in the U.S., long‑term government bond yields rose, and implied volatility surged.

1. The Delta Variant Is Abating in the U.S.

In the current Pandemic factor model, we look at three key metrics: (1) daily new cases to track the spread of COVID-19, (2) Positive testing ratios to confirm the trend of the diffusion curves, and (3) Google retail mobility data to assess the ongoing impact of the pandemic on consumer behavior.

Starting from July, signs of overwhelmed hospitals in some regions of the U.S., which initially moved faster to vaccinate its population, suggested that vaccine efficacy may drop over time. As a result, Pfizer/BioNTech submitted trial data to the U.S. FDA seeking approval for booster shots for the general population and so far has received authorization for individuals over 65 years old and those 18 through 64 years of age at high risk of severe COVID‑19. We will wait and see what percentage of the population can be boosted ahead of the 2021 holiday season.

Soon after the positive test ratio peaked in late August, daily new cases started to drop rapidly, leading to a decline in the Pandemic factor score. Interestingly, during this round of outbreak, the Google retail mobility data have not been drastically impacted as people seemed to have adapted to the new norm of living with COVID‑19.

On Friday, October 1, Merck and Ridgeback announced positive interim results for their orally administered COVID‑19 drug, molnupiravir. In the interim analysis, it reduced the risk of hospitalization by 50%. More encouragingly, through Day 29, no deaths were reported in patients who received the drug, as compared with eight deaths in patients who received a placebo.

Our medium‑term view is that COVID‑19 will be treated like a flu once enough of the global population gets vaccinated and receives regular booster shots or drugs. This should allow the cyclical part of the economy to fully recover and benefit from the excess spending reserves of businesses and consumers. However, this view has been delayed by the new delta variant. We still believe that the COVID‑off destination remains our base case, and getting there has only been delayed, not derailed.

2. Long-Term Government Bond Yields Rose

Our Uncertainty factor includes the 10‑year U.S. government bond yields to estimate changes in the market’s view of long‑term growth, inflation, and the term premium. Yields rise when investors see brighter economic prospects or expect higher inflation, and they drop when economic and market risks escalate.

In September, after the Federal Reserve’s two‑day policy meeting, policymakers announced that they would soon consider tapering the central bank’s purchases of Treasuries and mortgage‑backed securities. The Fed’s release of its quarterly survey of individual policymakers’ forecasts of future official short‑term interest rates showed a small increase in their median rate expectations, which some investors interpreted as a modestly hawkish signal. The coming wind‑down of the Fed’s monthly asset purchases and mildly hawkish revisions to its interest rate forecasts helped push the 10-year U.S. Treasury yield significantly higher. Our fixed income portfolio management team believes that reaccelerating economic growth, a stabilizing CPI, peaking liquidity, moderating regulatory crackdown, and abating coronavirus cases were all partially responsible for the recent movement in rates. Higher yields above all indicated lower economic uncertainty.

3. Implied Volatility Surged

The implied volatility of a market index derived from option prices reflects investors’ forecasts of the likely movement in security prices in that market, and it’s often thought to be a good proxy for market risk.

In early September, implied volatility surged, which could be largely attributed to the uncertainty of President Joe Biden’s spending plan and inflation worries. It was reported that Democratic Senator Joe Manchin backed as little as USD 1 trillion of Biden’s USD 3.5 trillion spending plan, highlighting the wide gap between Democrat moderates and progressives. According to the Job Openings and Labor Turnover Survey (JOLTS) data release, there were a record 10.93 million positions waiting to be filled in July, putting upward pressure on wages, which will further challenge corporate profit margins.

In the week after, implied volatilities in the U.S. and Europe continued to push higher, likely due to contagion worries from China’s Evergrande and U.S. Treasury Secretary Janet Yellen’s op‑ed on debt ceiling risks. Our colleagues in the emerging markets credit team, Sheldon Chan and Anna Zhang, believe Evergrande’s troubles are unlikely to cause systematic risk in China, not to mention other parts of the world. Despite being the second‑largest property developer in China by contracted sales, it has only a 5% market share in the fragmented industry. Chan and Zhang expect that any impact to the banking system should be manageable and that the government will instead focus on the social fallout of unfinished housing units and payables to suppliers.

Implied volatility spiked again toward the end of the month, as investors anticipated the Federal Reserve moving away from the current highly accommodative policy and were concerned about the impact of rising Treasury yields on asset valuations. It appears we will continue to observe some volatility over the last three months of the year, driven by pandemic, Fed discussions, fiscal spending, energy prices, and regulatory crackdowns.