What happened yesterday?
Stocks around the world were sharply lower Monday afternoon. If you read the headlines, it’s all about the potential impact of the collapse of debt-laden property developer Evergrande in China and a two-day meeting of Federal Reserve policy makers that begins today.
Microsoft, Google, Amazon, Apple, Facebook and Tesla were among the biggest drags on the S&P 500 but all of the 11 major S&P 500 sectors were lower, with economically sensitive groups like energy down the most. The banking sub-index shed more than 4% as worries about the default of Evergrande appeared to affect the broader market. Wednesday will bring the results of the Fed's policy meeting, where the central bank is expected to lay the groundwork for a tapering. Tapering is the gradual slowing of the pace of the Fed's large scale asset purchases.
While the Evergrande situation is front and center, reality is that stock market valuations are overstretched, and that the market has enjoyed too long of a break from volatility. Everything else is just a trigger, not the reason.
But Evergrande does touch on a quite large issue. Real estate construction and investment has been both driver and outlet for China’s burgeoning wealth, accounting for a large portion of their gross domestic product. A booming housing market causes prices and rents to go up and when the Chinese government interfered by setting ‘reference prices’ for secondary apartment sales in large Chinese cities, the result was overleveraged developers, like Evergrande and spooked foreign investors.
So, why does Evergrande matters to us?
All global financial markets are interconnected either directly or indirectly. Evergrande is nursing more than $300 billion in debt and remains on the brink of default. That was sending global equities tumbling Monday as investors, who had previously ignored the situation, sat up and took notice.
Fears of a bursting property bubble have long been a concern for investors when it comes to China. A heavily leveraged real-estate sector makes up more than 28% of China’s economy.
Meanwhile, holders of Evergrande’s approximately $19 billion in dollar-denominated bonds are left to wonder what will become of their investments, while other investors attempt to gauge the potential spillover effects a collapse could have on China’s property sector and global financial markets.
Evergrande faces an $83.5 million interest payment Sept. 23 on its March 2-22 bonds and a $42.5 million payment on Sept. 29 on its March 2024 notes Failure to settle those payments within 30 days of their due date would put Evergrande in default.
Evergrande’s market share in 2020 was only around 4%, so the risk of significant pressure on house prices in the event of a default would be low, unless the restructuring or liquidation of its assets becomes disorderly.
It is expected that a default by Evergrande would cause some disturbance but would unlikely lead to a tidal wave of defaults.
The potential for market spillovers will depend on whether Evergrande restructures or fully liquidates. The Chinese government should be very interested in restructuring and could provide support, but their stance is unclear and there have been many questionable decisions over the last little while.
In my opinion there isn’t that much global contagion risk with Evergrande because in the end, the loans to Evergrande were made by Chinese banks that are implicitly backstopped by the Chinese government, and the Chinese government’s balance sheet can easily handle the Evergrande losses which are valued at around $303 billion of liabilities. But the uncertainty about how this could affect global economies will certainly stick around for a while.
As always, if you are trading be very careful for the next little while…if you are invested in a properly balanced and diversified portfolio, you will be fine.
