Shifting to the New Playbook
Markets had an eventful week as volatility picked up at the start of the week, but faded as stocks finished positive while bonds ended lower. The S&P 500 began the week down nearly -2% through Tuesday’s close, but a strong rally on Wednesday and Thursday led to a modest gain of +0.6%. Bonds however, retreated at weeks end to finish down -0.4%. A confluence of events around a potential default of Evergrande, a larger Chinese property company, updated policy stemming from this week’s Federal Reserve Open Market (FOMC) meeting, and political rhetoric around a looming fiscal cliff all influenced the market.
The week started with concerns around Evergrande, which was required to make multiple interest payments. Its payment on yuan denominated debt, was as the company put it ‘resolved’, while a payment on dollar denominated bonds was not made by week’s end. At $300 billion of liabilities and accounting for roughly 4.5% of the market share of the property market in China, a default by Evergrande would be noteworthy. The property market in China has been a significant driver of GDP growth and had a sizable impact on the net worth of the country’s citizens. A combination of added regulations designed to slow the property market and improve its stability, in tandem with a slowing Chinese economy, have contributed to challenges faced by highly leveraged companies in the property sector such as Evergrande. Chinese authorities are having to grapple with supporting the stability of the market and financial system, while also remaining firm with those companies whose actions may be counter to their objectives around market stability. Should the Evergrande situation deteriorate further, it seems less likely it will cause widespread (systemic) issues, but it will have some impact to these with exposure to company and the China property sector overall.
Another notable item this week was updated guidance from the Federal Reserve, which indicated that it will soon start to slow the pace of their monthly bond purchases (i.e., tapering). Forecasts from the Fed governors, which are released every three months, indicated that half expected interest rates to begin increasing as early as next year. This was likely influenced by the notion that many governors expect inflation to remain elevated longer than previously thought. While interest rates were relatively unchanged following the Fed’s announcement, a similar statement on Thursday by the Bank of England served as catalyst to push rates higher, with bond prices retreating. It seems possible that we may be hitting a minor inflection point in the market as investors may look to reposition portfolios for an environment that includes less liquidity supplied by central banks along with the possibility for modestly higher interest rates.
Rhetoric around the looming debt ceiling was heighted during the week. Given the highly different policy preferences, many are concerned that Democrats and Republicans in the Senate will be unable to come to an agreement to raise the debt ceiling before the government runs out of available cash. We’ve seen this debate occur at other points over the past decade. It can be unnerving to think of the U.S. defaulting on its debt payments, and should we get close to the brink, it is likely to rattle markets a bit. However, its unlikely that a political battle such as this will last for an extended period of time. Moreover, given the uncertainty across the globe, a politically driven default is unlikely to lead to a change in long-term demand for U.S. Treasuries. We are hopeful that an amicable resolution can be agreed to long before this possibility arises. Should it occur, our expectation would for near-term downside volatility, but no long-term or lasting repercussions.
The actions that transpired this week support our view that we may be likely to see an uptick in volatility, with markets trending higher and lower at a greater magnitude. Shifts in policy could drive investors toward repositioning their portfolios, thereby fueling swings in market leadership, similar to what we witnessed this past week. The stimulus era playbook that has been in place for much of the past 18 months may be drawing to a close, with it remaining uncertain exactly what the new playbook might emphasize.
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