Lexicon Financial Group Weekly Update

Monday, October 4, 2021

 

Looking Back

This past week was marked by a number of key events. It’s hard to know where to start.

Germany continues to move towards a coalition government. It gets complicated, but there is an excellent article in the New Yorker that breaks it down nicely for those interested in reading more. Basically, the various parties are still trying to come together to form some type of coalition. What that means for Europe remains to be seen, but it makes for interesting reading and analysis.

Globally, stock markets did not fare well in September. This marks the second straight year that the third quarter has closed with a whimper. Last year, at the end of September, the S&P500 and the S&PTSX were down -4.64% and -3.15% respectively. (1) This year they fared pretty much the same, losing -4.79% and -2.99% as measured in their local currency.(2)

It’s really too early to draw parallels between 2020 and 2021. But I do find it interesting, that September 2020 markets were coming off of five straight months of gains, after bottoming-out in early April 2020 when the worst fears of COVID-19 gripped the globe. In 2021, markets have been coming off of seven straight months of gains, indeed reaching record levels in August. Still, year-over-year the S&P500 and S&PTSX are still up 28.09% and 24.49% respectively. (3) The one major difference, though, is that a year ago central governments were providing stimulus to the market. That stimulus has led to current rising inflation, so there is some sense that maybe central governments will start tightening their belt to rein in inflation. From a fiscal policy perspective, as a graduate in economics, this makes some sense to me. However, as a matter of public policy we need only look to the US, who looks prepared to enact a $1 trillion (that’s $1,000,000,000,000) infrastructure spending package to see that the money tap has not yet run dry.

What’s been lost in the shuffle this week was what dominated market news last week, and that’s the ongoing saga of Evergrande. The Chinese property developer missed another interest payment, and is now trying to sell its stake in a commercial bank to raise the money it owes. Nobody knows for sure if it will succeed in raising the capital, if it will fail, or if it will be broken up but it is looking increasingly unlikely that the Chinese government will bail it out.

 

Looking Ahead

All eyes once again turn to the United States in the coming days to see if they can avert yet another debt crisis. According the Secretary of the Treasury Yellin, the US has to raise its debt ceiling by October 18 or it will not be able to make its obligations. This is turning into another political fight and recent proposals made in the House are unlikely to get past Congress so we’re in for another staring down contest to see who will blink first.

It's hard not to think about inflation – everyone seems to be talking about it and we are seeing it first hand in rising energy and food costs. Of course, these are related since all don’t practice 100-mile diets (where you only consume products from within a 100 mile radius of where you live. In Canada, would that be a 160-mile diet?). That’s something to think about. Regardless inflation and interest rates are closely related so we will be keeping an eye on both. Historically, central governments could influence inflation by raising interest rates. Think about it this way: if interest rates are increased, people are less likely to borrow money. The end result is that there is less to spend in the economy, which means that there is less “demand” for goods and services, which keeps their prices down and in check. We’ve been living in a low-to-no interest rate world for some time, so reckless borrowing has flooded the market with cheap cash… hence, inflation.

 

Looking Out

Central governments are between a rock and a hard place. If they raise interest rates to curb inflation, will borrowers be able to meet their obligations? How will this impact small businesses, many of whom kept their doors open during the pandemic by borrowing? A recent report by the Canadian Federation of Independent Business estimated that small businesses now owe $139 billion because of COVID-19. An average small business owes close to $177,000 thanks to pandemic restrictions and closures. For businesses in the hospitality industry, that amount is almost double the average--$333,174.

On the flip side, keeping interest rates so low for so long has trained a generation of investors to rely on borrowing as a strategy for wealth creation, and so we end up with situations like Evergrande. For consumers who have been good stewards of capital low interest rates have been a boon. However, I worry about those who used the low rates to overextend themselves especially in the red-hot real estate market, for example.

 

Looking In

We’re watching interest rates closely. It’s confusing, but when interest rates increase bond prices fall. Here’s how:

Jerome borrows $100 in the morning at 10% interest for one year from Sarah. Essentially, Jerome promises to pay Sarah $10 one year from now plus the original $100. If Sarah does nothing, in a year she’ll get $110 from Jerome. The market is highly efficient, filled with people like Sarah who are willing to lend money at 10%

But if suddenly interest rates drop from 10% to 5%, lenders can only get 5% on their money. Their $100 loan will only generate $5 in coupon. They’d prefer to have the deal Sarah has and offer to buy it from her. But Sarah is savvy – she knows her 10% deal is more valuable because the going rate is 5%. For a lender to receive $110 in the future at 5% interest, they would need to lend $104.76 (a 5% annual return on $104.76 is $110). Rather than find a borrower, they might be willing to simply buy the contract from Sarah for that price. Sarah certainly wouldn’t sell it for less than that.

If she sells, she’ll pocket $4.76 in profit. The price of her bond increased because interest rates went down. The reverse happens as well… if interest rates rise, we can expect bond prices to decline at least over the short term. The good news in all of this is that a patient investor can simply wait for bonds to mature, collect their coupon, and move on.

 

Further Reading

 


 

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 price return of S&P500 and S&P TSX index from the period of September 1st, 2020 to September 30th 2020 in its respective local currency.
  2. Data provided by Factset showing the price return of S&P500 and S&P TSX index from the period of September 1st, 2021 to September 30th 2021 in its respective local currency.
  3. Data provided by Factset showing the price return of S&P500 and S&P TSX index from the period of September 30th, 2020 to September 30th 2021 in its respective local currency.

 

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