Market’s swooned earlier in the week on the Evergrande story, but didn’t stay down long. The prospect of a large company with a huge amount of debt possibly defaulting had echoes of Lehman all over it. But is that actually the case? More below.
But one thing was sure, it didn’t take much for investors to show signs of panic. For example, the number of put options bought on Monday soared to historic levels. If you buy a put option you are either betting the market will go down or trying to hedge your portfolio. Monday’s put volume on the S&P 500 hit the 9th highest of all time. Prior spikes marked capitulation selling with stocks bottoming shortly thereafter (the one exception being February 2020).
One thing is for sure, traders and investors are jittery and have one foot out of the door.
Coming into this week all eyes were on the Fed, not Evergrande. But surprisingly, the Fed meeting passed without much drama. A few key points:
– Tapering is coming, probably in November, and asset purchases will probably end a bit earlier than expected – say middle of next year. But this doesn’t mean the Fed’s balance sheet stops growing over the next few months. All we are talking about is a slowing rate of change until it flatlines in June or July.
– Members are evenly split on a rate hike in 2022. In June the consensus was for no hike.
– The trajectory of rates in 2023 and 2024 is higher than we thought a few months ago
All in all, the Fed is signaling they will be a bit more aggressive normalizing policy if nothing else changes over the next few months. But of course, something will change, it always does.
China’s Lehman Moment?
By now most people have read about the Chinese real estate development company that is having a spot of bother. This has been a long time coming. The Evergrande situation has been developing since last year when the Chinese government introduced their ‘three red lines’ to try and control leverage in the property sector. As you can see below, the stock has been sliding for a while.
But this week the situation made the front pages as it looked like the company might miss some interest payments. But this being China, nothing is totally clear.
What do we know for certain?
– Evergrande’s total balance sheet is about $368bn as of the end of June. Its business mainly involves buying land from local governments, developing it, and selling residential apartments to customers before construction is finished. The company uses the proceeds of those sales along with debt to finance further land purchases.
– Evergrande has 778 projects in progress across 223 Chinese cities as well as stakes in businesses ranging from an electric vehicle maker to a bottled water company. They also sell wealth management products.
– As with its assets, Evergrande’s $305bn of liabilities are overwhelmingly contained within China. It owes money to onshore banks and bondholders and guarantees some wealth management products. It only has about $20bn of debt held outside China.
– It’s been reported that over 50% of Evergrande’s liabilities consist of deposits from homebuyers that the company hasn’t delivered to yet. This number is a bit squishy, but I’ve seen it in a few reputable places.
– The liabilities on the wealth management side are also nebulous. Apparently when you walked into their real estate sales office you were pitched high yielding money market/cash products. These products were simultaneously (1) categorized as fixed-income products suitable for ‘conservative investors seeking steady returns’ and (2) sold with 11% yields. Sure…….But Evergrande apparently guaranteed the returns.
What’s getting everyone excited isn’t so much that there is a highly leveraged real estate development company in China, but more the fact that the Chinese government and the People’s Bank of China sound like they are prepared to let it go under. In fact, the state-run media outlet Global Times warned Evergrande not to expect a bailout… and that it shouldn’t assume it’s “too big to fail.” That phrase brings to mind the collapse of Lehman Brothers in the U.S.
But wait a minute – is this really another Lehman? One thing that looks pretty clear at the moment is that market/economic stress isn’t causing the Evergrande problem. It’s just the opposite The Chinese government’s actions are causing market stress. The government is on a mission to rebalance their economy.
And this isn’t new either. This summer it was various tech and education companies that were in the crosshairs of the Chinese authorities. These tech stocks went from being up +40% in the first two months of the year to losing close to -40%, as you can see below.
Back to Evergrande. The worry of course is that if the company defaults the knock on the banking sector will be severe. After all, Chinese bank exposures to property developers is significant, as you can see below.
Just a 5% loss on real estate loans will go a long way towards wiping out most of these banks’ capital. Of course, Beijing — which wields ultimate influence over a banking sector that is almost entirely state-owned — can issue an order at any time to bail Evergrande out. But most analysts think Beijing is intent on turning the screw. It has decided to make an example of Evergrande in order to make clear to other property developers that it is serious about the “three red lines” laid down last year to reduce debt levels in the sector and rein in a chronic oversupply of residential space.
But Beijing has a tiger by the tail. The property sector contributes close to 30% of total GDP, so they can’t push too far without causing a massive slowdown/recession. So, the question is where is Beijing’s pain threshold? At what point do they ease off? Beijing is engaged in a highly delicate exercise. It needs to inflict enough pain to show it is serious but not so much that it renders one of the most important engines of economic growth moribund.
No one knows the answer of course. But it doesn’t look like this is even close to another Lehman Brothers. Lehman was a bankruptcy that the US government tried to avert but didn’t have the power to stop. Evergrande is a bankruptcy the Chinese government has scripted.
Charts We Found Interesting
1. This latest wave looks like is has crested.
2. The worst recession since WWII and the highest growth in net-worth on record – didn’t see that coming.
3. Why do we even have a debt ceiling? It’s done absolutely nothing to prevent the growth in debt levels, despite which political party is in power.
4. If you think apartment prices are expensive in San Francisco!!
5. Where does all the water go in California?
6. Water prices are projected to be up as much as +70% by 2031, at least in San Diego.
7. She’s smiling because she can move in any direction.
Have a good weekend.
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