This past week, financial markets wobbled on fears that one of China’s largest real estate developers and conglomerates, Evergrande, might default on its colossal $300 billion in debt. In some quarters, investors even feared a disorderly ‘Lehman moment’, where an Evergrande default might set off a broader Chinese and global financial crises.
That disaster scenario, while not impossible to rule out, was never very likely. Of course, it is true that many of China’s urban property markets are overextended. Affordability is low, speculation high, and construction excessive. But the financial Armageddon that some breathless commentators feared betrayed a lack of understanding about how risk is managed in China.
China has had decades of experience with bad property lending and real estate insolvency. That familiarity informs how China deals with excessive debt. Moreover, China also plays by different rules. Those factors make it unlikely that a western style debt crisis will be allowed to play out in China.
For example, two decades ago non-performing loans in the Chinese banking system were estimated to account for some 40% of all bank credit. That is a staggering figure, but the presence of so much bad debt did not create runs on the banks, force emergency liquidation of their assets, or even impair ongoing credit and economic growth. Under western accounting standards, banks would have been forced to recognize losses, write down debt and either shrink their balance sheets (hence curbing credit to the economy) or seek expensive new capital. In China, instead, banks were permitted to gradually recapitalize (including with the use of China’s vast foreign exchange reserves). They were also encouraged to continue their ordinary deposit-taking and lending activities.
Simply put, China has never been willing to let markets fully dictate outcomes, particularly not when growth and social stability are at stake.
Indeed, aghast by the tremendous financial, economic, and social dislocations caused by the global financial crisis, China’s current leadership can be safely assumed to believe that allowing market forces, alone, to determine the timing and scope of defaults is out of the question. Hence, not matter how poor Evergrande’s financial position may have recently become, a chaotic default and liquidation scenario was never probable.
The recovery of global financial markets late last week suggests that investors have also now concluded that whatever risk Evergrande poses, it is not systemic and will be managed by creditors and the Chinese authorities with as little disruption to the broader economy as possible. Although China’s authorities are committed to curbing property speculation and even malfeasance, economic growth will not be subordinated to those objectives.
That also explains why global bond yields have resumed rising, with much of the increase in the past two weeks being led by real interest rates. Investors were overly pessimistic about global growth prospects and are once again willing to embrace a more solid ‘post-Covid’ expansion.
But even if Evergrande isn’t that grand, it doesn’t mean that it can be completely dismissed. Indeed, it offers an important teaching moment for investors.
Specifically, the latest market jitters serve as reminders that following a powerful 18-month global equity rally, valuations are stretched, making markets more vulnerable to shocks. And although global growth may chug along at a moderate rate, the recovery has peaked, and rates of growth are decelerating. Corporate profits growth has also slowed. The combination of high equity valuations and ‘negative second derivatives’ for GDP and profits’ growth means that markets are now less resilient to bad news.
The implications are clear. Investors must gird for lower returns and more frequent bouts of volatility. The ‘bar’ which good news must now exceed, is relatively high.
In the near-term, markets will face stern tests. This week, a host of Fed officials are slated to speak. As recent Fed minutes make clear, the Federal Open Market Committee (FOMC) is inching toward a ‘tapering’ of Fed asset purchases. Divisions between ‘hawks’ and ‘doves’ on the FOMC are becoming more pronounced. The Fed hopes that, like its Chinese counterparts, it can engineer a soft landing for its policy and the economy, but even if it does the approach is likely to be bumpy.
Also, as the turn of the month arrives, so too will a range of key economic indicators that will inform investor views about the economy and likely Fed response. Core and headline personal consumption expenditures inflation and purchasing manager indices are on tap this week, while the September employment report looms the following week.
In sum, grander challenges than Evergrande await investors. Stocks may still be the best asset class on offer, but that’s only because of how poor bond valuations and returns stack up in comparison.
