Market Insights 10/01/2021

Oct 01, 2021 | Travis Stringer


Volatility has returned after having been absent from the investing landscape over the past few months. As a result, many global markets have experienced some pressure in recent weeks, although the bouts of weakness have been orderly in nature. There appears to be a host of issues to blame: concerns about U.S. government funding and debt limits, contagion risks from China’s real estate sector, and a sharp move higher in bond yields, to name a few. We briefly address each of these issues and the implications for the investment outlook going forward.

U.S. government funding and debt
The U.S. government has been grappling with yet another case of political gridlock in recent weeks that had it teetering on the edge of having to shut down. Such a situation occurs when Congress is unable to approve funding for the government’s upcoming fiscal year. While sounding dramatic, these episodes are more common that one would expect, with the government having done so fourteen times since 1980, with the most recent experience just a few years ago. In recent days, Republicans and Democrats were able to negotiate a short-term agreement that will avoid a shut down for the time being.

More concerning is the risk of government default. The U.S. government is approaching its debt ceiling, a limit on the amount of money it is allowed to borrow. As a result, it needs to raise the limit, like it has so many times before, or risk default. The current deadline is expected to be mid-October. The Republicans and Democrats both acknowledge the need to raise it. But, both parties disagree on the procedures by which it should be lifted, largely because of political posturing more than anything.

The risk of default is a serious threat. It would be destabilizing for the world’s largest economy. We expect one of two outcomes, though we acknowledge it may come down to the wire. Either an agreement may eventually be reached between the two sides. Alternatively, the Democrats may lift the limit on their own, despite their preference of having the backing of their Republican colleagues. The Democrats have control of both chambers of Congress and should have the required votes to raise the limit.

China and Evergrande
China’s second largest property developer, Evergrande, has been under stress this year, with its bonds and share price selling off significantly, suggesting high risk of bankruptcy. An excessive use of leverage, and forays into businesses outside of its core real estate operations are to blame. The company recently missed a deadline to pay interest payments on a few of its bonds, and has now entered a thirty-day grace period, with default being a real possibility if that deadline passes with no payment.

There are a few reasons this is important for global investors: 1) the risk of financial contagion given the sheer size of the property developer and the interconnectedness of global credit markets; and 2) the risk to the Chinese economy, which is the world’s second largest.

Encouragingly, global credit markets, where bonds of companies from around the world are bought and sold by investors, are behaving relatively well in the face of the Evergrande debacle. This suggests the risk of contagion outside of Chinese financial markets may be low. The bigger risk may be the Chinese economy which has already seen its momentum wane this year. It is at risk of slowing further given the size and importance of the property market and ancillary activities. The Chinese government has a delicate situation on its hands as it aims to ensure stability and affordability of housing, while attempting to rein in corporate mismanagement, monopolistic behaviour, and excess leverage.

Bond yields
In the past week, Canadian and U.S. government bond yields have abruptly risen. Bond prices and yields have an inverse relationship. So, a rise in bond yields suggests investors are selling bonds, thereby driving prices lower. There was an even sharper move in bond yields earlier this year when investors grew concerned about rising inflationary pressures. That move drove weakness in equities, and in particular “high growth” stocks like those in the technology sector which are particularly vulnerable to bond yields and the interest rate outlook given how future cash flows are valued by investors. Bond markets eventually settled down and yields gradually declined for the past few months

We suspect the recent bout of bond yield volatility can be attributed to two issues. First, the U.S. Federal Reserve recently confirmed that it will reduce its monthly purchases of bonds given there is less need to support the lending markets and overall economy. It also indicated that it may begin to raise interest rates later next year. Investors are now preparing for a less accommodative central bank. Secondly, inflationary pressures continue to mount, and are being exacerbated by supply chain issues across the globe. Not surprisingly, growth stocks have borne the brunt of the equity market weakness through this recent move higher in bond yields, just as they did earlier this year.

We believe the inflation outlook is difficult to assess. Even Jerome Powell, Chairman of the U.S. Federal Reserve, acknowledged as much recently and indicated that pressures are likely to persist into next year. As a result, periods of volatility and the tug of war between growth and so-called value or cyclical stocks, is something we continue to be prepared for as we move through the rest of the year and into 2022.

We are pleased to share the latest investment strategy report from RBC Wealth Management: Global Insight Weekly.

Slow down, look around
Given the tear it’s been on since the pandemic lows, it shouldn’t come as a surprise that the stock market would take a much-needed rest, even more so as it’s navigating through some challenges. And while there could be more volatility ahead, we think the bull market can work through the headwinds and ultimately move higher.
Regional developments: Canadian food inflation hits consumers; U.S. Congress looks to dodge crisis but policy risks loom; Is the British pound behaving like an emerging market currency?; Power shortages threaten China’s growth outlook

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