Ever Grander?

This week, markets were roiled by fears that China Evergrande Group, the heavily indebted mainland real estate behemoth, is tottering on the verge of default. While the impact of this is debatable, the bigger story is that markets are now highly vulnerable to risk. Global growth and earnings have slowed, stock and bond valuations are more stretched, and investors have been driven by TINA (There Is No Alternative—to stocks). This combination of factors makes markets prone to episodic selloffs and increased volatility.

Over the past several months, consensus growth forecasts have been falling. The Federal Reserve Bank of Atlanta’s “GDPNow”[1] estimate for third quarter growth nearly halved from over 6% in July to 3.7%.[2] Soft retail sales in China caught analysts by surprise.

The point is not that the United States or the world economy are rapidly slowing, nor on the precipice of a recession. But, when growth rates decelerate, equity investors must lower earnings estimates. At a time of high valuations, slowing earnings growth exposes markets to shocks that might otherwise be shrugged off.

Elevated inflation is another budding concern. While some early drivers of higher inflation—such as used car prices or airfares—have recently leveled off, the breadth of price pressures is proving to be greater than many observers anticipated. That’s the message from the Federal Reserve’s (Fed’s) “trimmed mean measure[3] .” To be sure, the Fed is not yet ready to taper asset purchases, much less hike interest rates. But uncertainty about inflation, in the context of central bank discussions of ending extraordinarily accommodative monetary policies, is another straw on the markets’ proverbial camel’s back.

Just ahead are all-but-certain acrimonious debates in Congress about lifting the US debt ceiling. With each side entrenched in its positions and thinking, the prospect of brinksmanship—neither side backing down until the last minute before the US government shuts down or even technically defaults on its debt—looks to be the most likely scenario. In 2011, when US debt was downgraded in a similar Congressional tiff, equity markets fell by over 15%.

Looking more specifically at Evergrande, with over US$300 billion in borrowings and scrambling to meet its obligations, the company appeared poised to become China’s version of Lehman Brothers, a massive default that could unleash contagion across global debt and equity markets. For reasons we outline below, that scenario is unlikely to materialize.

First, unlike the 2008 financial crisis, where debt structures were opaque and leveraged and risk was widely held, Evergrande’s financial stresses are well-known and largely contained. Analysts have long known its vulnerabilities. It is highly likely that creditors and regulators are also well informed.

Second, China has extensive experience with real estate debt workout and the resolution of non-performing loans. This is not a new challenge for Chinese bankers or regulators.

Third, credit losses during the financial crisis immediately impaired the capital position of major financial actors, but China does not play by the same accounting and regulatory rules. Various measures of forbearance, including informal measures, mean that losses borne by banks and other creditors are not likely to impair their business models nor broader credit formation in the economy. Evergrande will not be permitted to become a source of Chinese economic or broader financial risk.

In other words, concerns about forced liquidation of assets at fire-sale prices or other hasty responses to market pressures on debtors and creditors is just not the way that China resolves default. And, as noted, China has dealt with similar problems in the past, including the recapitalization of banks using China’s vast foreign exchange reserves.

But those observations do not mean that investors can overlook the importance of recent market volatility. The lesson from Evergrande is less about China and more about the risks posed by less positive fundamentals, high valuations and crowded positioning in global capital markets.

The days of rising markets accompanied by low volatility and absent major setbacks are over. It took Evergrande to make that point clear.

For Franklin Templeton Fixed Income views on rules from recent years meant to de-risk China’s real estate sector, read China Real Estate – Taming the Grey Rhino.

US: China Real Estate – Taming the Grey Rhino

Non-US: China Real Estate – Taming the Grey Rhino

What Are the Risks?

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There is no assurance any estimate, forecast or projection will be realized.

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[1] Source: GDPNow forecasting model provides a "nowcast" of the official estimate prior to its release by estimating gross domestic product growth.

[2] Source: Federal Reserve Bank of Atlanta. GDPNow. September 21, 2021

[3]  Source: Investopedia. A trimmed mean (similar to an adjusted mean) is a method of averaging that removes a small, designated percentage of the largest and smallest values before calculating the mean.