By Justin Pawl, CFA, CAIA, CFP®
Last Week Today.
- Core CPI rose 0.3% month-over-month in August, slightly below expectations of a 0.4% rise. On a year-over-year basis, Core CPI rose 4.0%, decelerating from the 4.5% and 4.3% YOY increases in June and July, respectively. Despite the pricing relief, It’s too early to call a victory on inflation as supply chain constraints and labor shortages will continue to put upward pressure on prices. Moreover, the deflated prices registered during the lockdown last year will continue to inflate the YOY comparisons well into 2022.
- August’s retail sales report confounded economists predicting a decline of 0.7% from the prior month. Instead, retail sales rose 0.7% on strength in furniture sales, building materials, and online shopping, indicating the economy was still going strong in August.
- Global equities have been stuck in the mud moving sideways to slightly lower for the last four weeks. The MSCI ACWI Index and the S&P 500 recorded their second weekly declines, albeit losses were modest at -1% and -0.5%, respectively. Despite the market’s listless nature, the S&P 500 is only 2.3% off its all-time high as investors weigh the conflicting forces of a strong economy, higher inflation, Fed monetary policy uncertainty, and concerns about the Delta variant. The yield on the benchmark 10-year US Treasury crept higher by 0.02% to 1.36%. However, the yield on the 30-year bond declined by 0.03% to 1.90%. Precious metals and their industrial counterpart, copper, fell on the week, while WTI Crude rose 3.2% to $71.97 per barrel. For more detail on asset class performance, please click on the table below.
Evergrande. Most people had never heard of the Chinese company Evergrande, but it was a difficult subject to avoid last week for even casual readers of financial headlines. It will be even more challenging to avoid the topic today as global equities are falling in response to problems with the company. So what is Evergrande and why are investors concerned?
Evergrande was founded in 1996 as a real estate company, buying land and developing it into residential real estate for sale primarily to upper and middle-income families. The company grew to become the second-largest Chinese property developer with $110 billion in sales last year and is said to own more than 1,300 projects in some 280 Chinese cities. Evergrande also has plans for another 3,000 projects underway in China. While real estate remains Evergrande’s core business, the company expanded into electric vehicles, internet, and media production, a theme park, a soccer club, and a mineral water and food company.
The company’s rapid growth was fueled by aggressive borrowing, and it holds the dubious honor as the world’s most indebted developer, according to Bloomberg. Indeed the company is so large, and its debt so massive, in 2018 China’s central bank highlighted Evergrande as a potential systemic threat to the Chinese economy. As of today, Evergrande is carrying $300 billion of liabilities, including ~$200 billion in pre-sale deposits and publicly traded debt. Indeed, investors’ concerns that Evergrande will create a significant credit event in China are impacting high yield debt pricing. The Bloomberg China High Yield Index yield nearly doubled from ~7.5% at the beginning of the year to 14% and is at a similar level to March 2020. In other words, investors in high-yield Chinese debt are demanding interest rates equivalent to when the global economy initially shut down during the first Covid wave.
Reflecting the company’s growing problems, Evergrande’s stock price fell 90% from a high of $28.00 in 2020 to $2.54 per share on Friday. Meanwhile, the company’s publicly traded debt due in 2025 recently traded for only 25.2 cents on the dollar, indicating a high probability of default. According to Bank of America Corp., Evergande is China’s largest high-yield dollar issuer and accounts for 16% of outstanding notes. If the company fails, the default rate on China’s junk dollar bond market will skyrocket from 3% to 14%.
Investors in Evergrande’s publicly traded securities are not the only group impacted by Evergrande:
- The company’s web of borrowing includes loans from more than 128 different banks and 121 non-banking institutions, including wealth management companies that sold some 70,000 clients high-yielding investment products tied to Evergrande.
- Evergrande collected pre-sale deposits from apartment buyers on more than one million unfinished projects, which the would-be buyers could lose if the company fails.
- Evergrande employs a staff of 200,000 and hires 3.8 million workers every year for project developments.
Evergrande’s total liabilities equate to about 2% of China’s GDP, which is bad enough for the Chinese economy. However, the situation in China could go from bad to worse if Evergrande is forced to sell projects at fire-sale prices to meet debt obligations. Such sales would depress housing prices and compress margins across the real estate development supply chain. Analysts say the impact on Chinese residents would be significant as real estate accounts for 40% of household assets. A correction in the real estate market would depress consumer demand, further slowing economic growth.
The Evergrande situation is extremely complicated and has the potential to significantly impact the Chinese economy. The broader concern is that an uncontrolled failure of Evergrande could affect international commerce, as China represents 16.3% of the global economy, according to The World Bank. Property construction is estimated to comprise 20% – 25% of China’s annual GDP, and a significant slowdown would hurt commodity demand and unleash deflationary forces across the world.
The Chinese government hasn’t turned a blind eye to Evergrande, but what (if any) action the government will take is unknown. Most believe the government will not allow a full-blown collapse because it could lead to social unrest from falling housing prices, lost deposits, and imploding investment products. Already, angry investors and homebuyers are staging protests at government offices and Evergrande’s headquarters in Shenzhen. These are troubling developments for a government that relies on maintaining social order and has little tolerance for public protests (remember Tiananmen Square?). Moreover, China’s economy is already slowing due to aggressive measures to control outbreaks of Covid-19 that are impacting retail sales and travel. As signs of financial contagion increase, pressure on Beijing to act is growing.
Options available to the Chinese government include allowing the company to go bankrupt, breaking it up, and bailing it out. While the Chinese government decides how to handle Evergrande, they’ve been actively injecting cash into the financial system to ensure the credit markets remain liquid. Last week the People’s Bank of China (PBOC) injected $14 billion of funds into the market, including a single-day record of $1.5 billion.
Although the Chinese government has regularly bailed out troubled companies in the past, Beijing’s current priorities include promoting “common prosperity” and curbing the type of excessive risk-taking that has created credit bubbles. Thus, the government’s conundrum is maintaining social stability while reigning in moral hazard and increasing financial discipline – a fine line to walk.
We may get our first indication of the government’s plan this week. On Tuesday, Evergrande is scheduled to make interest payments on some of its bank loans. Then, on Thursday, interest payments equating to ~$120 million on two Evergrande publicly traded notes are due. Most analysts believe Evergrande will fail to make these payments, which will force the Chinese government to reveal at least a portion of their plan for the troubled company.