Friday 24th September, 2021
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It has been a busy fortnight with no shortage of economic data releases, policy statements, and corporate and political events for market participants to price (or at least try to). The reactions to the barrage of news flow have been decidedly back and forth so we certainly breathed a sigh of relief to see both US (+0.4%) and European (+1.2%) equities positive for the week at Thursday’s close. This looked like an unlikely place to find ourselves at the start of the week, when rising concerns over the looming default by troubled Chinese property developer Evergrande and worries over contagion across the global financial and economic system produced the S&P 500’s worst daily performance since May. On the heels of two consecutive weekly declines for global equities, things were looking grim indeed. However, as has so often been the case in recent times, markets bounced back quickly – even if this surprisingly followed a string of hawkish central bank meetings – and if things do not take a decidedly southwards turn today, we may just avoid a third consecutive week in the red.
We will begin with a discussion of Evergrande, China’s second-largest property developer. It is sitting on a balance sheet worth c.$360bn, which encompasses an eye-watering $300bn of debt and 800 ongoing development projects across 200+ Chinese cities. The company has faced increasing difficulties servicing this debt as both home sales and house price appreciation have slowed massively in China this year and the situation reached a head this week with two large coupon payments due. While Evergrande announced that it had managed to “resolve” the payment of the onshore bond coupon, it missed an $83mn coupon payment on a USD-denominated bond on Thursday. It is not technically a default until the 30-day grace period is up, but we doubt that the financial regulator’s polite request for Evergrande to simply not default on its dollar bonds will be doing much to comfort investors who bought at par. There is no doubt that the company has found itself in serious financial trouble (bonds pricing in the 20s are a sure sign) and that a significant restructuring will have to take place at some point, so the main question now remaining is to what extent the state will be willing to intervene. This is not an easy question to answer. On the one hand, the CCP has consistently iterated its intent to deleverage the economy and the real estate sector has been in the crosshairs of this reform for some time. The shake-out of an aggressively leveraged developer who not quite toed the party line would be well within the scope of this. On the other hand, the sheer scale of Evergrande means the collapse would have far-reaching consequences. To make matters more complicated, Chinese retail investors have a significant stake in Evergrande’s well-being via both debt investments and down payments on projects in development, and the CCP will not want the little guys to bear the brunt of any fallout. So far, there has been no direct intervention and the only policy response has been an injection of short-term liquidity into the banking sector to ease broader market turmoil. However, this is very much an ongoing situation and regulators will be closely watching the evolution for signs of systemic risks. As to the risk of contagion to the broader financial system, we think that this should be minimal for now. The vast majority of Evergrande’s debt is held by onshore investors in RMB-denominated instruments, so the direct impact of a default to offshore investors will be limited to “only” c.$20bn of USD-denominated debt. Both Powell and Lagarde have taken the same stance, reassuring markets that they expect the fallout to be largely domestic. However, there certainly are grounds for concern that this is symptomatic of issues in the Chinese real estate sector, and the economy more broadly. The property sector accounts for just under a third of China’s GDP and a meaningful slowdown there (which the collapse in house sales certainly indicates) would have a significant impact on economic growth. Given China’s importance in driving global demand, we certainly do not think that Evergrande’s restructuring can be dismissed by investors and we will be carefully monitoring its evolution.
The other major subject this week has been the flurry of central bank meetings. Announcements from the Fed, the Bank of England, and Norges Bank (Norway’s central bank) all struck a similar tone, highlighting a reasonably solid if slowing growth outlook, higher and more sustained inflation, and a more hawkish outlook for monetary policy. Starting with the Fed, the first topic in focus was the tapering of their $120bn/month bond purchase programme, which has played a huge role in keeping borrowing costs in the US near all-time-lows. Powell announced that the Fed could begin tapering their purchases as early as November “if the economy continues to progress broadly in line with expectations”. While this was more a confirmation of the Fed’s previous commitments as opposed to anything new, he also highlighted that the programme could be fully withdrawn by mid-2022 if the same conditions were met. This represents a more aggressive tapering pathway than previously anticipated. Beyond the tapering, the dot plot also revealed that Fed members had brought forward their expectations for the start of the hiking cycle, with half of the 18-person committee now foreseeing a hike in 2022. Elsewhere, the Bank of England held rates at 0.1% as expected, but the committee pointed to building inflationary pressures – highlighting the surge in energy prices as a further upside risk to inflation forecasts – and appeared to open the door for rate rises in 2022. Norges Bank then took things one step further and became the first developed market central bank to actually raise rates, hiking their policy rate 25bps to 0.25%. While the Fed’s initial announcement failed to move bond markets far on Wednesday, the combination of three hawkish central banks proved too much to handle, and yields moved significantly higher on Thursday. The US 10Y yield was up 13bps on the day and is currently sitting at ~1.35%, while the 10Y bund rose 7bps and is now sitting at -0.23%. If yields remain where they are today, we will complete a fifth consecutive week of rising rates. We are thankful for our short duration positioning.
The equity market’s positive reaction to an accelerated tightening of monetary conditions and higher yields was certainly not what we initially anticipated. While sectors that you would expect to do well in an inflationary/higher rate environment outperformed – energy, materials, and financials were the standouts – the strength was fairly broad based. This is a meaningful deviation from the behaviour we have seen over the last 18 months, where liquidity has been king and any suggestion of its withdrawal has been poorly received, regardless of the rationale. “Bad news is good news” has certainly been said often enough. The move was doubly strange given the relatively disappointing flash PMIs for the US, the Eurozone, and the UK that were released on Thursday. While the headline numbers still indicated expansion, the composite PMIs all fell short of expectations. Rising inflation, tighter monetary conditions, and slowing growth does not sound like a winning recipe for risk assets, yet here we are. That said, the move could also have simply been a repricing of contagion risks from Evergrande. Or one of many other things. The market moves in mysterious ways. We will take comfort in the fact that this indicates that we might be able to avoid a taper tantrum when the liquidity taps are inevitably turned off.
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