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Investing

China’s Evergrande and the Fed caused brief, but meaningful turbulence

This week’s news offered up important clues on the potential direction of markets. What could it mean for your portfolio?


 

Our Top Market Takeaways for September 24, 2021.

MARKET THOUGHTS

Evergrande and the Fed cause some [brief] turbulence

In our note last week, we discussed five questions that investors were facing heading into the end of the year. Two of them, Chinese policymakers and the Federal Reserve, were main characters in the markets this week.

Deeply indebted Chinese property developer Evergrande caused a bout of volatility on Monday, while the Fed’s September meeting all but confirmed its path for tapering its asset purchase program. In today’s note, we will walk through how each story played out, and what it might tell us about the state of markets and the economy moving forward.

Let’s start at the beginning.

Evergrande is a Chinese real estate development company.1 It builds massive apartment complexes and sells them to the burgeoning urban middle class. It owns more than 1,300 projects in 280 cities in China. It also does a lot of other stuff (including healthcare, electric vehicles and, for some reason, soccer teams).

Its business model relies on debt. It borrows to buy land and develop real estate on that land. As long as the land appreciation and value-add from the development outpace the financing costs, everything should work out. The problem is that Chinese policymakers have been trying to rein in real estate speculation, which pressures real estate prices and disincentivizes banks to provide credit to property developers.

Now, Evergrande is on the verge of default. Even though it seems to have met an onshore coupon payment earlier this week, it had an additional $83.5 million interest payment due on Thursday, followed by another $47.5 million payment due next week, and it is doesn’t seem like either of those have been or will get paid. Bond holders have sensed that Evergrande is serious risk. Its bonds are trading at around 25 cents on the dollar. 

On Monday, the debate about whether or not this would be a “Lehman moment” for China dominated. Even the unflappable S&P 500 briefly broke through its 100-day moving average for the first time since October 2020.  

By Thursday afternoon, it seemed clear that the “no” side of the debate was winning. Most major markets had fully reversed their moves from Monday, with assets sensitive to Chinese growth, such as Brazilian equities and iron ore, leading the way. The S&P 500 headed into Friday less than 2% from all-time highs.

We think the market is probably right not to fret too much over Evergrande. Chinese credit spreads in sectors other than real estate have been well contained, Western banks have extremely limited exposure to Evergrande itself, the Chinese currency has been stable, and, as we mentioned before, Evergrande bond holders have more or less priced in default and restructuring already. But while Evergrande is unlikely to trigger much of a financial market crisis, it does seem more likely that the global economy will face a continued headwind from the Chinese property sector into 2022. The expansion should be able to power through the weakness, but it probably will put some additional downward pressure on sovereign bond yields and cyclical equity sectors such as industrials and materials, unless Chinese policymakers choose to stimulate the economy more aggressively.

That brings us to our second main character, which will also play an important role for markets in 2022. On Wednesday, the Federal Open Market Committee (FOMC) all but confirmed it would begin to taper its asset purchase program in December and complete the process by the middle of next year. That opens the door to the possibility of a rate hike at the end of 2022, and half of the FOMC participants already think it is heading toward that outcome.

We still think the eventual rate-hiking cycle is more likely to start in 2023. There are early signs that the supply-driven inflation surge is losing steam, and there is still a long way to go to a 4% (or lower) unemployment rate. A softer inflation backdrop, which we are expecting, should give the Fed the leeway to not rush for the exit while the labor market continues to make a full recovery back to pre-pandemic trend.

One thing seems to be becoming clearer to investors though: Flexible Average Inflation Targeting (FAIT)—the Fed’s new framework that is meant to allow for inflation overshoots to ensure maximum employment—doesn’t seem to be all that different from the old way of doing things (where preemptive tightening to prevent inflation was more or less the norm). One way to see that is in the difference between 5-year and 30-year Treasury rates.

Roughly speaking, when 30-year yields are much higher than 5-year yields (making the curve steeper), the market believes the economy will be able to run with a meaningful inflation overshoot and maximum employment. Right now, that curve is flatter than it was when the Fed first announced the new framework in the late summer of 2020. We will find out more about what FAIT really means as the labor market gets closer and closer to maximum employment, but right now a lot of the enthusiasm that existed at the beginning of this year has evaporated, not only because of the Fed, but also because of the Delta variant and the aforementioned weakening growth backdrop in China.

What does it all mean for you? We aren’t questioning the durability of this expansion. We think it is very likely to continue through 2022. However, the shifts both in China and within the FOMC argue for a slightly less vibrant economic backdrop than would be possible otherwise. We are comfortable with our overweight of stocks relative to bonds, but a focus on quality and balance between cyclical and growth sectors is increasingly important. We think the path of least resistance for interest rates is higher (10-year yields ended trading Thursday at the highest level since mid-July), but it will take more than just the Fed to make it happen. The continued reconciliation and infrastructure bill negotiations in Washington are the most impactful potential catalysts from here. For more details on that, plus a more in-depth discussion on China and the other questions facing markets, we encourage you to watch our webcast, and to reach out to your J.P. Morgan team to discuss how these issues may impact your plan.

1. If you want to learn more about Evergrande, and how deeply embedded it is in the Chinese economy and financial markets, we highly recommend the Odd Lots podcast episode from Joe Weisenthal and Tracy Alloway. 

 

All market and economic data as of September 2021 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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All companies referenced are shown for illustrative purposes only, and are not intended as a recommendation or endorsement by J.P. Morgan in this context.

All market and economic data as of September 2021 and sourced from Bloomberg and FactSet unless otherwise stated.

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