Market implications of the Evergrande-induced gut check

Keith Lerner, CFA, CMT

Co-Chief Investment Officer,
Chief Marketing Strategist
Portfolio & Market Strategy
Truist Advisory Services, Inc.

 

Eylem Senyuz

Senior Global Macro Strategist
Portfolio & Market Strategy
Truist Advisory Services, Inc.

What happened?

Markets opened sharply lower this week as details emerged around the potential debt default by Evergrande, China’s second-largest property developer. Evergrande’s crushing debt load is well documented, but last week’s company-issued warning of a potential default amidst a down cycle in Chinese real estate has moved this from a long-term concern to a short-term catalyst. The Hang Seng Index in Hong Kong, where Evergrande is listed, dropped more than 3% overnight, and Evergrande shares were down about 10%.

This news comes as investors were already on edge after markets have seen a few weeks of losses following seven straight months of gains. Markets are also in a seasonally-weak period, and the ongoing carousel of concerns continues: ranging from COVID concerns, the political wrangling in Washington, including the spending bill and the debt ceiling, potentially higher taxes, to the Federal Reserve’s (Fed) taper. These are all reasons why we have been expecting a sloppy September. Evergrande adds to the mix and is providing investors a gut check.

Our take

As we discussed in our September Market Navigator, we expected to see at least one gut check before year end, and that would likely be caused by something that wasn’t front and center as we began the month. Evergrande appears to be that headline.

This is an event that will lead to market turbulence. Ultimately, we don’t see this as a systemic risk or changing the market’s primary uptrend. The unwinding of Evergrande will be sloppy and cause disruptions, but we expect the Chinese government will manage this default to avoid a hard-landing, and foreign investors will be asked to accept a haircut and maturity extension on their bond holdings.

As global markets sell off, some encouraging signs have been the relatively minor drop in the 10-year U.S. treasury yield, high yield credit remaining relatively firm, and the price of gold staying relatively flat. This is further evidence that the market does not see the Evergrande event as a systemic risk.

No matter what happens, this will cool Chinese demand for commodities which is good for the developed markets.

A closer look at Evergrande

The Chinese government has been put in a position to decide between increasing moral hazard and potentially letting the fallout of Evergrande’s debt default ripple through the financial system.

The significance of a potential Evergrande default lies in the fact that it would have a significant effect on the Chinese financial system (the world’s top four banks are Chinese in terms of total assets), with potential—thus far unknown—knock-on effects to the world’s financial system.

Ultimately, we expect the Chinese government to step in, restructure the company, and force international investors to accept 10-20 cents on the dollar (a haircut of 80% to 90%) with extended maturities. This would likely push up the yields of other Chinese bonds, as most investors assumed these bonds were solid and that the Chinese government would step in to rescue investors, hence the moral hazard.

The central bank, People’s Bank of China, can cut short-term rates and bring additional liquidity to the system. In the worst-case scenario, it can directly inject liquidity into the banks to keep them running at current levels. During the pandemic, China was the only major economy to not use massive monetary stimulus. Thus it has plenty of room to add liquidity.

This whole event has the potential to push down property prices in China—and that is what the Chinese authorities would like to see. One of the communist party’s biggest “Common Prosperity” stories is the high cost of living due to high property prices. The Chinese government could decide to punish speculators that have been buying multiple properties. However, they have to be careful because if they punish speculators too much, it could spark a property crisis.

No matter what happens, this will cool Chinese demand for commodities which is good for the developed markets. There are months of pent-up demand waiting to be fulfilled, and inventory levels are at historically low levels. A cooling in China’s economy should keep prices depressed for developed markets consumers. This keeps inflation in check and consumption at healthy levels.

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