Pinpointing the catalyst for movements in asset prices across the world is not easy, particularly when there is a lot of uncertainty over the direction of markets. Even when sentiment is bearish, and investors expect a sharp sell-off, there is often disagreement over the precise trigger for falls in prices.
The sudden drop in global stocks on Monday, with the benchmark S&P 500 index suffering its worst day of trading since May, was widely attributed to the deepening liquidity crisis at China Evergrande Group, the country’s second-largest property developer, and the world’s most indebted.
This was definitely the case in Hong Kong’s equity market. The Hang Seng Property sub-index plunged 6.7 per cent, its sharpest daily decline since May 2020, amid fears that Beijing may extend its clampdown on the real estate sector to Hong Kong.
The link between the further declines in commodity prices, particularly industrial metals, and the plight of Evergrande was also clear. China consumes half the world’s steel, with the real estate sector alone accounting for approximately one-fifth of global demand.
Iron ore prices, which are down a staggering 25 per cent this month, could suffer even sharper falls if the cash crunch at Evergrande ends up inflicting severe damage on China’s property market and the broader economy.
What was less clear, however, was the selling pressure in markets where the channels of contagion from China are much weaker. There was little reason for the Russell 2000 index – a gauge of smaller stocks in the United States with less international exposure than the S&P 500 – to fall 2.5 per cent.
Nor did it make sense for an index of emerging market exchange traded funds that exclude China to lose more than the main gauge of Asia-Pacific stocks.
This suggests that, while the imminent prospect of an Evergrande default sparked Monday’s sell-off, markets were vulnerable to begin with, and are contending with a number of threats. The Evergrande crisis is important only insofar as it feeds into a broader narrative around the slowdown in global growth and the risk of a major policy mistake.
The key question is whether the highly leveraged developer poses a systemic risk, or whether its troubles constitute an idiosyncratic event limited to China’s property and financial sectors.
To be sure, even the latter scenario has major implications for the global economy and markets. It is telling in itself that angst over Evergrande – which accounts for 16 per cent of China’s high-yield dollar-denominated corporate debt market, by far the largest in Asia – displaced intense speculation over the details of the Federal Reserve’s timetable to begin raising interest rates.
A full-blown crisis at a dominant company in a systemically important industry in the world’s second-largest economy will inevitably cause spillovers. The debate revolves around whether these effects are financial or economic in nature.
A screen displays a statement by Federal Reserve chair Jerome Powell as a trader works on the floor of the New York Stock Exchange on September 22. Angst over Evergrande displaced speculation over the US central bank’s timetable for raising interest rates. Photo: Reuters
The initial reaction from emerging market corporate bond markets, a crucial gauge of sentiment, is revealing. Spreads on an index of emerging market corporate debt excluding Chinese issuers have barely moved over the past month, data from JPMorgan shows. A gauge of Asian corporate bonds excluding Chinese borrowers has also proved resilient.
There are several factors that help explain the limited contagion outside China. One is that Wall Street’s big banks have practically no direct lending exposure to Evergrande, making comparisons with the collapse of Lehman Brothers in 2008 inapt.
The most important one, however, is investors’ faith in Beijing’s ability and willingness to avert a disorderly bankruptcy of the developer. China’s state-controlled economy, its prioritisation of social and economic stability and its reassertion of control over the private sector in recent months give policymakers more credibility when it comes to doing what it takes to forestall a debt crisis.
The bigger risk is that deleveraging in the property sector, while avoiding a messy default, takes its toll on Chinese growth, exacerbating concerns about the disconnect between lofty valuations and mounting threats to the post-pandemic recovery.
A residential area in Beijing on July 6. Investors fear that deleveraging in China’s property sector could take a toll on the country’s economic growth. Photo: EPA-EFE
Monday’s sharp sell-off came just when the global economy was showing increasing signs of slowing sharply, mainly because of the rapid spread of the Delta variant. Survey data published earlier this month revealed that global manufacturing and service sector activity slumped to a seven-month low last month, dragged down by contractions in output in Japan and China.
Yet, a gauge of global stocks is still only 3 per cent shy of its all-time high on September 6. The biggest risk in markets right now is not the fallout from the Evergrande crisis, it is the dangerously stretched valuations across many asset classes, particularly in the US where concerns about the virus and inflation have already knocked consumer confidence.
On Wednesday, the Fed presented updated forecasts pointing to a faster timeline for interest rate increases, and signalled it would begin scaling back its asset purchases in November. A more hawkish Fed in the face of a global slowdown increases the risk of a policy blunder.
Evergrande is a wake-up call for investors, not because they did not see the crisis coming, but because it is unfolding when markets are priced for perfection.
Nicholas Spiro is a partner at Lauressa Advisory