Pallett Wealth Management Team
Global Economic Update
10/01/2021
Stock market and bond market volatility has returned after having been absent from the investing landscape over the past few months. Many global markets experienced some pressure in recent weeks, although the bouts of weakness have been orderly in nature. A host of issues has contributed to volatility, including concerns about U.S. government funding and debt limits, contagion risks from China’s real estate sector, inflation and supply chain concerns, and a sharp move higher in bond yields. 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 a new case of political gridlock in recent weeks, which 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 have occurred fourteen times since 1980, with the most recent experience just a few years ago. In recent days, Republicans and Democrats negotiated 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, as it has so many times before, or risk default. The current deadline lands in mid-October. The Republicans and Democrats both acknowledge the need to raise the ceiling, but both parties disagree on the procedures under which it should be lifted, largely because of political posturing.
The impact of a debt default would be serious. It would be destabilizing for the world’s largest economy. We expect, however, one of two outcomes. Either an agreement will eventually be reached between the two sides or, alternatively, the Democrats will 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. Its bonds and share price have sold off significantly, suggesting a 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 make interest payments on several of its bonds, and has now entered a thirty-day grace period. Default is a real possibility at the end of the grace period.
There are a few reasons that Evergrande’s circumstances are important for global investors:
1) the risk of financial contagion given the sheer size of Evergrande 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 have performed relatively well in the face of the Evergrande debacle. This suggests that the risk of contagion outside of Chinese financial markets may be low. The bigger risk may be impacts on 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 risen abruptly. Bond prices and yields have an inverse relationship. A rise in bond yields suggests that 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. This move drove weakness in equities, in particular “high growth” stocks like those in the technology sector. Growth stocks are particularly vulnerable to increases in bond yields and the interest rate outlook, given that expected net cash flows are more heavily weighted to future years. Earlier this year, bond markets eventually settled down and yields gradually declined.
We believe that the recent volatility of bond yields can be attributed to two issues. First, the U.S. Federal Reserve recently confirmed that it will begin to reduce its monthly purchases of bonds, given that there is less need to support the lending markets and overall economy. It also indicated that it may begin to raise interest rates late in 2022. 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 this recently and indicated that pressures are likely to persist into mid-2022 and then subside. As a result, we expect continuing periods of volatility and the tug of war between growth and so-called value or cyclical stocks through the remainder of this year and into 2022.
Should you have any questions, please feel free to contact us.
Drew M. Pallett LL.B. CFP www.pallett.ca