September 26, 2021

Ain’t Life Evergrande

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Bottom Line:

 

Capital markets kept us on our toes this week. Monday started with the worst equity market performance in months but rallied three of the next four days to finish the week positive. Equities were dealing with the potential fallout from a failing Chinese real estate developer along with gridlock in Washington as we near the debt ceiling and a potential government shutdown. Bond markets were dealing with the latest Fed announcement. Let’s address all the factors at play…  

 

The Full Story:

 

The major stock indexes overcame adversity this week to grind slightly higher. Monday’s decline of 1.7% for the S&P 500 and 1.9% for the MSCI All Country World Index was their worst single-day performance since May. And even though the previous two weeks of equity market activity had been choppy, it was the first daily move of more than 1% since August 18th.

 

I will address the Chinese real estate developer/conglomerate Evergrande’s financial woes that received most of the blame for Monday’s market turmoil. However, as always, there are multiple factors at play.

 

September Seasonality

 

There are limits to using seasonality, but the September historical data bears out (literally). September is the only calendar month where stocks are historically more likely to be down than up – only positive 44.4% of the time, with average negative returns of -0.5%. And there is not one massive downturn that skews the average; it is fairly consistently weak.

 

 

Economic Forecasts Moderating

 

Economists have been lowering economic gross domestic product (GDP) projections to reflect some deceleration in economic activities and output. We covered it in a recent Insight, but forecasts probably needed some adjustments for the impact of the COVID-19 Delta variant as well as abundant shortages (labor and inventories). Lower growth expectations, if borne out, could impact corporate earnings and stock fundamentals.

 

 

Fiscal Policy or Lack Thereof

 

Policy decisions are either uncertain or untenable. Congress and the entire legislative apparatus appear to be in gridlock, which imperils the bipartisan infrastructure bill and the ability to keep the government running and paying bills. Unless Congress passes a funding bill by September 30th, the federal government will face its first shutdown since 2019. From a historic stock market perspective, there has been relatively little impact in prior shutdowns. As you will note in the table below, the market actually rose 10%+ during the last lengthy shutdown in 2018-19.

 

 

What’s more concerning is the lack of progress in raising the debt ceiling. Infamously, the 2011 political showdown over the debt ceiling contributed to a stock market correction and Standard & Poor’s downgrading the long-term U.S. credit rating from AAA to AA+ for the first time in history. There are a couple of weeks for Congress to work through it this time as the Treasury Department expects that it will have funding through mid-October.

 

The Fed and the Taper

 

On Wednesday, the Federal Reserve’s Federal Open Market Committee (FOMC) announced its September policy decision. Although there were no explicit changes, the signals point towards the tapering of bond purchases this year. That is based on the language in their statement (slower bond buys “may soon be warranted”) and from Fed Chair Jerome Powell during his press conference (“meeting our substantial further progress test for prices and jobs could be the case by next meeting”). The expectation is that the FOMC will directly announce tapering in November to start in December.

 

As for how long the taper will run, Powell later said that “tapering ending around mid-2022 may be appropriate”. He tried to stress that “taper timing doesn’t carry a direct signal on (interest rate) liftoff”.

 

Evergrande

 

The financial stress of one of China’s leading property developers, Evergrande, came to a climax last weekend with the reports that they would pay out some investors with properties in varying stages of completion. The crisis had been building for months as their offshore bonds started tanking in June and came into the week trading at only 25 cents on the dollar.

 

So, why is the Chinese government essentially letting Evergrande fail? Actually, fail may be too strong of a word. It will probably be “restructured” over a period of time. Some of the Chinese government and Xi Jinping’s new economic growth initiatives run counterintuitive to Evergrande’s business.

 

  • They are attempting to pivot their economy away from a reliance on residential property investment as a key engine of growth and towards household consumption and investment in technology. Currently, Chinese real estate investment represents 10% of GDP versus 4% in the U.S.
  • Real estate investment and scale has made some Chinese cities unaffordable.
  • China has been working on de-leveraging/reducing overall debt levels.
  • They would prefer to have a properly functioning bond market with price discovery, which means some investors must take losses on bad debts.

 

The biggest questions this week for U.S. investors were does this turn into a contagion event (Lehman Brothers was referenced in every other article), and does this further decelerate Chinese GDP growth and global growth as the #2 economy in the world?

 

Our best guess is that it has little spillover to broader markets. Of Evergrande’s $300 billion in liabilities, only $28 billion were offshore, and there has been minimal spread widening in other credit markets including bank credit default swaps. In order to limit negative spillovers to economic growth, it will be important for the Chinese government to restructure the company to protect their customers and suppliers (about $150 billion in liabilities) so that it can prevent a sharper deceleration in property sales and prices. Given the importance of real estate investment for the Chinese economy and its secondary impact for household consumption through the wealth effect, this would be key to providing a floor to overall Chinese economic growth.

 

All That Said

 

Despite all the concerns that I have addressed, equity markets still rallied through the rest of the week to finish positive. The bottom line is that the economy is growing despite challenges, and investor balance sheets are incredibly strong. If fundamentals remain positive and there is healthy market skepticism, stocks will likely continue to climb the proverbial wall of worry.

 

Have a great Sunday!

 

Timothy W. Ellis, Jr., CPA/PFS, CFP®

Senior Investment Strategist, Wealth Strategist

 

 

 

Sources: The Irrelevant Investor, Calculated Risk Blog, Barrons, Bespoke Investment Group, JP Morgan
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Author: Senior Investment Strategist Wealth StrategistSince joining W&A in 2014, Tim has been responsible for managing relationships with clients and providing financial planning services covering the areas of retirement, income tax, estate and gift, risk management, and education. In addition to client responsibilities, Tim serves on the firm’s investment committee assisting in portfolio construction and allocation as well as the searching and vetting of portfolio strategies. He is also an occasional author of W&A’s Weekly Strategic Insight commentary. Tim received his Bachelors in Accountancy and Masters in Taxation from the University of Mississippi in 2008 and 2009, respectively. He completed the CPA exam in 2011 and is a licensed CPA in the state of Tennessee. He earned the CERTIFIED FINANCIAL PLANNER™ (CFP®) certification in 2014 and Personal Financial Specialist (PFS) credential in 2015. After completing his Masters at Ole Miss, Tim started his career at Reynolds, Bone & Griesbeck PLC as a tax associate in 2009. While at RBG, Tim worked with a wide range of clients, performing tax compliance and planning services for individuals, estates, trusts, partnerships, and corporations. Tim is a member and/or serves on the following organizations: • The American Institute of Certified Public Accountants • The Tennessee Society of Certified Public Accountants (Council member and VP of Programs and board of directors for the Memphis Chapter) • The Financial Planning Association (President-elect and board of directors for the Greater Memphis Chapter) Tim is originally from Marks, Mississippi, but has lived in East Memphis since starting his career. He is married, and he and his wife, Mary Agnes, are the proud parents to a son, Wilkes, daughter, Edie, and Goldendoodle, Penny.

Author

Timothy W. Ellis, Jr., CPA/PFS, CFP®

Senior Investment Strategist

Wealth Strategist

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