Real Impacts from China’s Evergrande Crisis on U.S. Markets

By Hightower St. Louis on September 22, 2021

…But First, Immediate Takeaways from Today’s Federal Open Market Committee (FOMC) Meeting

The Federal Reserve (Fed) was more hawkish on their commentary compared to what we’ve previously heard, and a November start to tapering their emergency bond purchasing program is likely. Tapering will probably last through mid-2022. The Fed also unanimously voted to maintain the target range for its benchmark policy rate at zero to 0.25%, and they stressed any tightening will be economic dependent (primarily related to unemployment and inflation).

We support a Fed decision to taper their purchasing program because we no longer need emergency policy given the economic progress. We anticipate earnings will remain strong because the economy is strong, driven by consumer demand and evidenced by strong retail sales and industrial production.

The Fed downgraded GDP for the current year because of Delta-related slowdowns and supply chain challenges, but raised growth expectations for next year, which is encouraging. However, we believe the Fed’s inflation expectation for 2022 is too low and is worth watching.

Breaking News: Following Months of Ratings Downgrades and Fire Sales, Chinese Property Firm Continues to Miss Obligations and Moves Closer Towards Default

Breaking news generates market reactions driven by emotion and defensive instinct. Investors should remain steadfast and opportunistic during these periods.

This week’s headline regarding Evergrande was the culmination of months-long anticipation as the firm’s liabilities expanded and it failed to meet payment deadlines. Beijing, in August 2020, placed a cap on the amount of debt that property developers could take on their balance sheets as the risk started to bubble. Evergrande had been borrowing for over a decade and spending on everything from an FC soccer club to bottled mineral water to an electric car unit (remember, this is a real estate developer). Evergrande’s liabilities account for over $300 billion (2% of China’s GDP) and that’s where fears really spilled over into U.S. equity markets. The fear of wider repercussions from China that drove volatility in U.S. equity markets on Monday (9/20) were not reflected in the credit markets as the Bloomberg U.S. Aggregate Bond index yield fell only -3 bps on the day.

To protect its financial markets, Beijing is stepping in and organizing a debt resolution along with potential liquidation of Evergrande’s assets. Bondholders are preparing to incur losses, though the risk was well known. Some Evergrande bonds have been trading above 50% yield to maturity since July, with prices falling steadily since May and incurring successive cuts to its credit ratings from multiple agencies over the same time period. Banks have already reportedly been instructed to roll over Evergrande’s maturing loans, to stave off creditors and avoid more widespread financial implications.¹ The property sector accounts for around 25% of China’s GDP and China’s government is expected to use Evergrande’s real estate collateral to provide value to creditors and stabilize real estate market prices.

While other Chinese real estate developers may also be at risk of being overleveraged with inefficient revenues, the impact on global markets and comparison to Lehman’s bankruptcy, which triggered the 2008 financial crises, is misleading. Evergrande’s onshore debt is well collateralized, which can provide relief to banks and trusts that have been the primary lenders. The United States government allowed Lehman to fail though Lehman also provided securitized products, which were held widely across balance sheets of other financial firms. Evergrande does not appear to maintain such far-reaching consequences, though the potential for further corporate defaults because of continued regulation remains a real risk to the Chinese economy.

Recent String of Chinese Regulatory Crackdowns

The caps on leverage that Beijing introduced to real estate firms in August 2020 is part of a trend of similar regulatory action implemented to reign in the power of massive enterprises within the Chinese economy. In addition to property, other industries that have recently been subject to new policy moves include internet companies, for-profit education, online gaming and casinos.

Last week, according to Reuters, China Securities Regulatory Commission (CSRC) Vice Chairman Fang Xinghai told Wall Street attendees during a private gathering that regulatory actions being implemented are part of an overall goal to promote “common prosperity” and ease inequality.² Recent actions by Beijing have contributed to increased worries by foreign investors, and Beijing is trying to re-affirm confidence in their markets and the growth of enterprises within. While Beijing’s goals are forward-thinking, inflated fears of slowing growth and a market pullback are impacting the valuation of companies exposed to the region. GDP growth expectations in China for Q3 and the full year are also indicating a significant slowdown due to impacts from COVID outbreaks and real estate market outlook.³

According to data from FactSet, there are thirty companies in the S&P 500 that derive over 20% of their revenue from China, and as a group they are trading at a 40% last twelve months price-to-earnings (LTM P/E) valuation discount to their historical five period average.⁴ It’s important to note that the group is 70% information technology names, according to GICS sector classifications.

A Buying Opportunity: Quality Fundamentals and Secular Growth

We do maintain positions in our equity portfolios with revenue exposure to China. We do not maintain positions that are domiciled in China. The difference requires emphasis. While China does have the power to regulate industries, their goals and interests do not align with narrowing the growth and profitability of a global economy. A competitive, capitalistic economy remains a fundamental goal for China and they continue to invest in enterprise profitability. At the same time, they are leaning more heavily into an economic model that favors more equitable growth and allows more opportunities for smaller enterprises. Achieving these goals entails a manipulative influence from Beijing and is a risk to foreign investors. Meanwhile, the United States is seeking to reign in the power of big technology companies and their monopolistic advantages on labor, pricing, marketing and overall efficiencies, but regulatory action has been limited thus far.

China is the world’s second largest economy and includes some of the fastest growing industries. Our view is that U.S. companies that can maintain quality earnings and strong balance sheets should strive to achieve the same secular growth and competitive opportunities in economies like China once they reach such a scale. At the same time, we are highly cautious about investing in China-domiciled companies that provide limited transparency into their financials and maintain significant audit oversight risk; we do not directly invest.

A strong macro-background remains, uninterrupted by the limited impacts from the default prospects of a Chinese real estate firm. Infrastructure spending is being passed by governments around the world; with a focus on renewable power, affordable housing, transportation and 5G. Economies continue to re-open around the globe and consumers with pent-up demand are spending on experiences. Excess savings are continuing to flow into risk-assets, like equities, while job openings remain active and unemployment rates decline. We’re buying the dip and maintaining conviction in a drawn-out cyclical, consumer-driven recovery.

SOURCES

1. Reuters

2. Reuters

3. Bloomberg

4. FactSet

Disclosures

Investment Solutions at Hightower Advisors is a team of investment professionals registered with Hightower Securities, LLC, member FINRA/SIPC, & Hightower Advisors, LLC a registered investment advisor with the SEC. All securities are offered through Hightower Securities, LLC and advisory services are offered through Hightower Advisors, LLC. This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee. In preparing these materials, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public and internal sources; as such, neither the information nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Hightower shall not in any way be liable for claims and make no expressed or implied representations or warranties as to their accuracy or completeness or for statements or errors contained in or omissions from them. This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of Hightower Advisors, LLC or any of its affiliates.

Securities offered through Hightower Securities, LLC member FINRA/SIPC. Hightower Advisors, LLC is a SEC registered investment advisor. This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of Hightower Advisors, LLC or any of its affiliates.

Hightower Advisors does not provide tax or legal advice. This material was not intended or written to be used or presented to any person or entity as tax advice and information, or legal advice and information. Tax laws vary based on the client’s individual circumstances and can change at any time without notice. You are urged to consult your tax and legal advisor before taking any action.

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