Lexicon Financial Group Weekly Update

Monday, December 13, 2021


Looking Back

The first full week of December and markets continued to show just how jittery they can be. For the first three days major markets posted modest gains, in spite of uncertainty surrounding the economic impact of the Omicron variant of COVID-19. That all changed mid-week, when Chinese company Evergrande missed a critical debt payment.

Evergrande held the dubious title of being the property developer with the most debt in the entire world – more than $300 billion. Its borrowing helped it grow to an enormous size: It has more than 100,000 employees, achieved sales of more than $110 billion in 2020, and owns more than 1,300 developments in more than 280 cities. But now it truly seems to be cracking under the weight of that debt. Last week, credit ratings firm Fitch Ratings said that it is in default of its obligations to pay back its creditors.

Evergrande is a good example of how interconnected the global economy actually is. As a Chinese firm, the vast majority of its creditors are indeed based in China – it even borrowed from its own employees to try and stay afloat. As Matt Levine wrote in Bloomberg back in September “Evergrande owes money to Chinese banks. It owes money to foreign hedge funds, and investors own its stock.”

Beyond the capital investors, think about all of the companies involved in the development of the properties that Evergrande was selling – construction and design firms, materials suppliers, shipping, and transportation. All of these sectors are also at risk of not being paid, which has a trickledown effect across the global economy.

This, combined with uncertainty around Omicron makes the markets feel over-caffeinated.

 

Looking Ahead

While investors and markets try to make sense of Evergrande and Omicron, they do so while still scratching their heads about inflation and interest rates. As we wrote last week, analysts are largely expecting the Fed to begin a slow and steady increase in interest rates at some point in 2022. This will help to combat inflation. The Federal Open Market Committee (“FOMC”) meets on December 14-15. As a reminder, the FOMC is the monetary policy body of the US Federal Reserve System and meets 8 times per year.

The FOMC group is charged under US federal law to conduct monetary policy – generally by adjusting short-term interest rates -- to achieve maximum employment and stable prices. Employment figures in the US are much improved in the last 18 months, with an unemployment rate of 4.2% for November 2021, which is at the pre-pandemic level. (Unemployment rate in March 2020 was at 4.4%). (1)

 

However, the notion of stable prices ties directly to inflation, which has some analysts worried that they might accelerate the timetable on raising interest rates.

It’s a delicate balance. Raising rates too quickly will hurt businesses that have incurred significant debt through the pandemic. Raising rates too slowly may allow inflation to continue, which is in and of itself a way investors lose purchasing power.

 

Looking Deeper

In financial markets, there is a concept known as the “real rate of return”. This is the annual percentage of profit earned on an investment adjusted for inflation. So, if you had an investment that returned 10%, and inflation was 2%, that investment increased your purchasing power by 8%.

Right now this is especially a problem for more conservative investors, or for those who have portfolios significantly weighted in fixed income products. For the period ending October 29, 2021, the annual compounded rate of return over a five year period for fixed income (as measured by BMO Aggregate Bond Index ETF “ZAG”) was a mere 2.13%. Over the same period, inflation averaged out to be at 2% (as measured by CPI in Canada), implying a real rate of return of 0.13%. (2)

Fixed income plays a role in portfolios – but in situations like this, its role is to defend from potential equity market declines. Fixed income investors have suffered because their real rate of return has been virtually non-existent over this time.

 

Further Reading

Markets & Investing – Raymond James

What both US and China get wrong on economic policy and trade negotiations

 

The opinions expressed are those of Craig Swistun and not necessarily those of Raymond James Investment Counsel which is a subsidiary of Raymond James Ltd. Statistics and factual data and other information presented are from sources believed to be reliable but their accuracy cannot be guaranteed. It is furnished on the basis and understanding that Raymond James is to be under no liability whatsoever in respect thereof. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities. Raymond James advisors are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax-related matters.

  1. Data provided by Factset showing the Unempmloyment rate in the United States for the period from January 2020 until November 2021.
  2. Data provided by Factset and BMO ETFs website showing the Canadian Inflation data and Annualized performance for "ZAG" ETF from November 2016 until October 2021.

 

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