While the risk is palpable, we do not view China Evergrande’s debt-repayment problems as a threat to the global financial system. Comparisons to a “Lehman moment” overlook that then-Treasury Secretary Paulson decided to let Lehman Brothers go. China, on the other hand, has decided to actively steer Evergrande’s resolution, and the company’s $300 billion of unpaid debt must also be put in perspective: It amounts to only about 1% of all bank assets in China, and its holders outside China are relatively few.
Still, as a major residential developer in a nation where real estate and construction account for about 25% of GDP, Evergrande and its debt resolution will be watched closely – and will likely proceed along distinctly non-Western lines. Retail investors in Evergrande’s development projects are likely to take first priority, with construction workers employed by these projects coming in second, domestic debt holders third, and overseas investors in offshore debt last.
Only since 2014 has China gradually introduced the concept of default to its corporate debt system. The rules are still opaque, with the government trying to teach the markets to study the nature of the business behind the debt, and not to look for a government entity to back it – essentially, ‘Never letting a good crisis go to waste.’ While the visible hand of the government directs this orderly winddown, the People’s Bank of China (PBOC) will likely foam the runway by adding extensive liquidity into the system to ensure a margin of safety.
On the ground, where hundreds of Evergrande residential projects are stalled, state-owned enterprises with access to capital will be nudged to take over the remaining work, pay contractors, and sell the properties – at or above the government-declared minimums put in place to mitigate threats to the 40% of bank assets backed by real estate in some form. The solution will involve directing sufficient patience and liquidity to finish Evergrande’s projects, gradually selling its real estate (and most of Evergrande), while using the proceeds to make small investors and workers whole and only then retiring debt at a haircut.
The government, which is effectively subcontracting the winding down of Evergrande to provincial officials, is guided by several objectives: first, to contain the economic fallout; second, to punish Evergrande for failing to heed earlier warnings to deleverage; and third, to teach debt holders to evaluate the credit itself, instead of looking for backers. The government also wants to ensure that wealthy speculators who drove demand for Evergrande apartments bear their share of the pain while sparing those who made down payments on apartments they intended to live in. They would also like to slowly shrink the role of real estate in the economy and redirect China’s large savings into more productive investments; these include technology, clean energy, education, and other areas that will enhance China’s international competitiveness and further President’s Xi’s goal of “common prosperity.”
So far, outside the property sector, which investors are avoiding, we’ve observed minimal negative spillover effects on Chinese credit, which has seen only mild spread widening. Positive flows continue into China’s government debt, non-property credit, and equity markets. If Evergrande’s unwinding hastens government efforts to shrink the real estate sector, a decline in construction would slow China’s economy during the period while a transition is attempted elsewhere, while spilling over to the metals and materials sectors globally.
Critically, the extent of spillover from China’s slowing on regulatory sentiment is still not knowable. Before the Evergrande crisis, the government had been tightening regulations on industries it believed had demonstrated capitalistic excesses. That process has been on hold as Evergrande moves through dangerous territory. Whether heightened regulation resumes once Evergrande’s problems are resolved remains the biggest question mark.
Conviction Score (CS) and Investment Views
The Conviction Scores shown below reflect the investment team’s views on how portfolios should be positioned for the next six to nine months. 1=bullish, 5=bearish, and the change from the prior month is indicated in parentheses.
Markus Schomer, CFA
Global Economic Strategy
CS 2.75 (+0.25)
Stance: Above-average global GDP growth should prevail over the next 12 months, keeping our CS bullish but slightly less optimistic. Evidence of growth slipping below potential could turn mild optimism to mild pessimism.
Outlook: The Delta wave is subsiding in major developed markets (DMs) without having magnified economic disruptions, aside from Australia. But preliminary September purchasing managers’ indices (PMIs) show slowing in the US and Europe, with China’s PMIs slipping back below 50 in August. Global inflation remains elevated but should move past its peak in the coming months. Nevertheless, DM monetary policy is turning less supportive. South Korea and Norway raised rates, and New Zealand and the UK are likely to follow soon. US and European central banks punted on tapering this month but are likely to start in November. In the US, major fiscal policy issues affecting the next phase of recovery must be resolved soon. A downsized stimulus package – not a major growth booster, but one preventing a sharper fiscal cliff next year – is the most likely outcome.
Risks: Political risks are rising, with new, untested governments arriving in Germany and Japan. And how will investors react once the Fed removes its mostly imaginary market backstop? Overvalued equity markets and bond markets offering negative real yields form a fragile equilibrium subject to sudden changes in liquidity.
Gunter Seeger, CFA
Portfolio Manager, Developed
Markets Investment Grade
CS 4.00 (+0.50)
Fed tapering and jockeying over a debt-limit extension make us more bearish. Fed Chair Jerome Powell has stated numerous times that tapering will have ended by “midyear 2022,” which means a November start and $15 billion in tapering per month ($10 million in Treasuries, $5 billion in mortgages) over eight months. Through August, the US Treasury had issued only $885 billion in net new debt, of which the Fed purchased $640 billion, leaving an inadequate $245 billion for the private market. When she was Chair, Janet Yellen may have used the debt limit as a reason not to fund a $2 trillion-$3 trillion deficit, but that’s not the case now, which translates into lots of net issuance as the Fed exits. Failure to pass the $3.5 trillion spending bill would further lower this year’s supply, but the end result will be the same, just delayed.
Steven Oh, CFA
Global Head of Credit and Fixed Income
CS 2.75 (unchanged)
DM credit market conditions remain largely favorable. With the Fed taking a firmer stance on tapering and reducing its level of accommodation, there is potential for added volatility in the months ahead. But in credit all eyes are on China and the pending Evergrande restructuring, which has chilled investor sentiment and invites further downward volatility. DM credit spreads have ground tighter once again as Treasury yields have risen. Valuations for investment grade (IG) and high yield (HY) largely have reached our year-end target levels, so now it’s all about coupon clipping. Given this outlook, we continue to favor leveraged finance over IG, but the value differential has narrowed. While emerging market (EM) spreads, particularly in Asia HY, have become more attractive, we are tactically cautious on adding exposure as the value gap has the potential to widen in the near term.
Senior Sovereign Portfolio
Manager, Emerging Markets
CS 3.00 (unchanged)
Supporting factors for the US dollar have dissipated in recent months, with growth dynamics now favoring Europe and the urgency for the Fed to taper being slightly reduced. We maintain a 12-month forecast of 1.1750 to the euro with a preferred wider range of 1.1500-1.2000. The Fed’s inflation target for announcing a taper (not actual rate hikes) has been met, but it will probably wait for the September and October job numbers to be digested before being announcing its strategy. Positive real yields in EMs, hawkish central banks, and inflation generally nearing its peak in several major emerging markets suggest EM currencies should find support at current levels. Latin America local yields stand out as attractive, with the team favoring Brazil, Mexico, Peru, and Colombia.
Senior Vice President, Corporate
Portfolio Manager and Head of
Trading, Emerging Markets
USD EM (Sovereign and Corp.)
CS 2.50 (unchanged)
Local Markets (Sovereign)
CS 2.25 (unchanged)
We see above-average growth in the US and the eurozone well into 2022 and a return to trend growth in 2023 with tame inflation. We see slightly higher US Treasury 10-year yields over 2022, with a base-case range of 1.23% to 1.74%. JPM has increased its 2021 forecast default rate from 2.4% to 5.5%, driven by the increase of Asia from 2.6% to 9.0%. The China HY default rate is now expected to be 13% with the inclusion of Evergrande ($19 billion). More than 70 other securities totaling $30 billion are now trading at distressed levels. Ex-China HY, the default rate in Asia is 0.8% and the global EM default rate is 1.8%. We maintain our positive scores in US dollar-denominated and local market debt as well as our global scenario weights: 60% Cruise Along (base case) and 35% Bright Future and 5% Fly High (both bullish).
Senior Vice President, Portfolio
Manager, Global Multi-Asset
CS 3.00 (+0.15)
We have moved to a neutral score, reflecting our view that as central banks ease off stimulus, fundamentals will become responsible for moving markets higher without an assist from secularly improving capitalization rates. While the tapering of excess will be gradual, central banks will no longer be exacerbating the savings glut. Private sector demand for credit is returning after a decade-long absence. In China, the abrupt nature of regulatory changes in connection with President Xi’s goal of “common prosperity” has created uncertainty among private businesses, which will harm growth in the near to medium term. The longer-term impact depends on how the rules are implemented.
Principal, Real Estate
The focus on ESG has intensified over the past six to 12 months. While environmental issues have long been a concern, as property and construction sectors account for about 40% of all carbon dioxide emissions globally, the industry is grappling with how to measure social and governance factors, which had been largely neglected. Currently, changing use patterns are exacerbating dramatic undersupply issues in logistics, institutional rented residential, senior living, and student housing, all sectors that are attracting capital. While supply-chain bottlenecks are easing, risks include funding gaps due to hesitancy from traditional banks to finance development, profit erosion due to rising costs, and inflation-related interest rate increases, which would cause substantial value erosion.
Chris Pettine, CFA
Senior Vice President,
Senior Research Analyst
Global Focus Equities
CS 3.00 (unchanged)
Companies remain confident in their demand outlooks. Greater labor cost and supply pressures, as well as shipping and semiconductor bottlenecks, are still viewed by most as manageable. We continue to forecast broad improvement in consumer spending, manufacturing, and employment, despite some economic softening in August and September, and third quarter results now tracking similar to the second. Our score remains neutral as company fundamentals continue to improve but valuations stay above historical levels. We are still finding investment opportunities in some competitively advantaged companies with sufficient upside relative to their medium and long-term prospects.
Senior Vice President,
CS 2.50 (unchanged)
We remain modestly bullish as we see most of our companies beat estimates while valuations are down with recent market volatility. In China, worries about Evergrande pressed on equities. In India, many companies are well-placed to benefit from cyclical economic factors and secular microeconomic trends, especially in consumer discretionary, healthcare, and IT. In Latin America, our quality names in consumer and ecommerce/fintech continue gaining market share while reporting strong second-quarter results. In Emerging Europe, strong market performance is supported by robust fundamentals. Overall, we are selectively adding to healthcare while reducing financials and real estate.
Quantitative Fixed Income
Our US Market Cycle Indicator (MCI) remains unchanged. The BBB credit spread and yield slope are close to their previous month-end levels. Credit spreads look rich at the short ends of IG and HY. In industry selection, our model is heading toward more neutral risk in industry positioning, favoring brokerage and REITs versus transportation and financial (other). Our global rates model continues to forecast slightly lower yields and a flatter curve. The rates view expressed in our G10 model portfolio is overweight global duration, about neutral in North America, overweight in Europe, and underweight in Japan. Along the curve, we are still positioned on flattening and overweight the long end.