The speed at which the words ‘Evergrande’ and ‘bankruptcy’ spread on Friday morning suggest this episode could have an outsized impact on already weakened sentiment.
News that China’s seemingly eternally beleaguered property giant Evergrande has sought bankruptcy protection in New York only adds to the strange feeling the financial world has turned upside down.
As 2023 began, the consensus was clear: China’s economy would surge out of COVID-19 lockdowns, with monetary and fiscal stimulus providing tailwinds, while the US would fall into a brief recession that would likely lead to equity market correction.
But instead, the US economy has proven extraordinarily resilient and equity markets have surged 22 per cent from their October 2022 lows. And it is China’s economy that is spluttering, with tepid growth worsening the long-standing crisis in the nation’s property market.
Evergrande’s bankruptcy filing is a warning that China’s three-headed monster – demand, debt and demographics – will loom over markets for a long time yet.
But in the US, the climb in long-term bond yields to levels not seen in more than a decade is a reminder that economic strength can also weigh on investors.
Indeed, the growing sense that the world faces a higher-for-longer interest rate regime – amplified by local earning season that has painted a picture of real economic resilience – should Australian policymakers, investors and households pause, too. A decade of low interest rates might have fuelled asset prices, but its also lifted debt levels to historic levels, and a prolonged period of higher rates will prove testing.
Ironically, Evergrande’s bankruptcy filing comes after a week when other Chinese institutions have been in the spotlight. Another developer, Country Garden, is teetering following debt defaults, while a shadow bank with heavy exposure to the property sector, Zhongzhi Enterprise Group, has also missed payments on its high-yield investment trust products.
But Evergrande, the second-largest developer in China, is the original poster child for the nation’s property woes. Concerns about its debt load surfaced as early as 2017, but it was in the middle of 2021 that the company started missing debt payments, and the crisis hit the global headlines. The group has been in a sort of permanent restructuring process since then.
It’s a task made all the more difficult by deepening pain in China’s property sector, where a combination of oversupply, huge debts carried by developers, and a loss of confidence by Chinese consumers – partly due to the pandemic, partly because of fears developers couldn’t complete buildings – has smashed activity.
The latest data is ugly, with new construction starts down 24.5 per cent in the first seven months of the year. Prices in some areas have fallen by as much as 25 per cent from their October 2021 peaks.
Evergrande has filed for something called chapter 15 bankruptcy protection, which allows a company to protect its US assets while restructuring deals are worked out elsewhere. In Evergrade’s case, its filing talks about restructuring in Hong Kong and the Cayman Islands, so seeking bankruptcy protection could be part of the debt deals it is seeking to put in place.
Nevertheless, the way headlines with the words “Evergrande” and “bankruptcy” spread across social media on Friday morning suggest this episode could have an outsized impact on already weakened sentiment.
While the problems in the Chinese property sector are far better understood than they were when Evergrande teetered two years ago, China’s post-lockdown economic troubles – perhaps best typified by the nation’s slide into deflation – add a new and worrying link in what seems increasingly like a negative feedback loop.
Poor property market activity slows the wider economy; property developers struggle to make debt repayments; the investment trusts that lend to the property developers then struggle to make their debt repayments; and property sentiment worsens even further.
The monetary stimulus China has tried in the form of rate cuts has done little to help, and strategists like Macquarie’s Viktor Shvets continue to insist fiscal stimulus – including a real estate sector bailout – is a matter of when, not if.
But the size of the task facing Chinese authorities is clearly mounting. This is no mere dip in confidence that can be rescued by a few policy initiatives. Instead, this is a deep, structural crisis in property and construction caused by debt and demographical problems that will take years to resolve.
Broad restructuring is needed in a nation where the population is rapidly ageing and youth unemployment is at least 21.3 per cent (we say at least, because China refused to publish this week’s latest numbers) – not just the posturing President Xi Jinping has so far offered.
While Australian investors are painfully aware of their exposure to the Chinese economy, they can’t afford to ignore the striking move up in bond yields caused in part by the resilience of the US economy.
US 30-year Treasuries rose another 0.07 per cent on Thursday night (Friday AEST) to 4.42 per cent, the highest level since 2011, as German and British 10-year bonds rose to 15- and 12-year highs respectively.
The benchmark US 10-yield Treasury yield rose nearly 0.08 per cent to 4.33 per cent. While that only takes the 10-year back to October 2022 levels, it’s worth noting that equity markets were 20 per cent lower then than they are now.
Yields have pushed higher this week after the minutes from the Federal Reserve’s August meeting suggested rate rises might not be done. Those fears have been compounded by a steady stream of data suggesting the US economy continues to hold up surprisingly well under the weight of the Fed’s rapid tightening cycle.
Even if the Fed is done for now, it seems investors are starting to believe that the rate cuts most economists had priced in for 2024 may not be the sure thing they seemed a few months ago.
But there are other factors at play in the rising yields.
Recent moves by the Bank of Japan to loosen its yield curve control have sent 10-year bond yields there higher, and an auction of 20-year bonds this week saw poor demand, suggesting investors are waiting for further policy adjustments. Rising bond yields in Japan are bad news for the rest of the world, given the Japanese have been big buyers of foreign bonds with yields at home so low.
America’s own surging debt levels and ballooning interest payments, which caused Fitch to downgrade the country’s credit rating, are another factor. The US Treasury’s rate of borrowing means it needs to sell a lot of bonds, putting further upward pressure on yields.
Whatever the reason, it seems equity investors are getting a little nervous. The S&P 500 is now down 4.8 per cent since the end of July, while the tech-heavy Nasdaq Composite is down 6.8 per cent.
The FOMO that was causing a dash-for-trash just a few weeks ago seems to be losing momentum. The Roundhill Meme Stock ETF is now down 20 per cent since the end of July.
So is this the pullback a frothy-looking market needed, or the start of something bigger? Much will depend on yields; if, as many expect, the deterioration in the US economy gathers a bit of steam, then yields should come back.
But if Fed chairman Jerome Powell uses his speech at the annual Jackson Hole symposium in Wyoming next week to strike a hawkish tone, then yields may push higher – and the threat that this causes something in markets to break shouldn’t be discounted.
Either way, Australian investors, who have seen the ASX 200 fall 3.8 per cent since the end of last month, should stay on alert: a slowdown in the US economy that brings bond yields down will have consequences, and so will a further rise in yields.
Investors around the globe, and particularly in Australia, also need to keep watching China closely. Further fallout from China’s stalled economy and crisis-ravaged property sector will weigh on sentiment – and the sort of big-bang stimulus the nation needs would have the opposite effect.