The impending default or restructuring of Evergrande, China’s second-biggest property developer, dominated China’s news last week. Please see below article received from Legal and General yesterday afternoon, which discusses the effects of this on the broader market.
Localised, so far
Evergrande accounts for 6.5% of liabilities in China’s property sector, and its sales make up roughly 10% of all property transactions in the country. Evergrande could therefore pose a systemic risk, but so far stress in the financial sector has been localised. Interbank spreads are not elevated and the renminbi has held up well.
After a string of incidents that have given equity investors concerns about China – such as regulation of tech, education and casinos – its stock market has slipped behind international peers, but over a longer-term perspective it remains close to recent highs.
Evergrande’s problems could still affect the broader economy beyond the financial channel. People are no longer buying off-plan properties from the company; if this feeds through to Evergrande’s building activity, it could leave a noticeable impact on GDP. August property sales and starts were already in contractionary territory, and GDP is under pressure from Covid-19 outbreaks and lockdowns.
We believe the authorities have the levers to steady the ship, however, and will do so soon. This would likely involve a liquidity provision via a reserve requirement ratio (RRR) cut, fine-tuning of property financing policies, and measures to ensure Evergrande can continue its regular operations.
There is a manageable path forward, in our view, but China’s history of managing delicate situations in financial markets is not unblemished, so this remains a risk to watch in the weeks ahead.
Blockages but not stoppages
The release of the Federal Reserve’s Beige Book earlier this month led to discussion about the effects of supply-chain disruptions on corporate earnings. Last week’s Goldman Sachs US Industrials conference was an opportunity to hear directly from the companies in the middle of the supply-chain issues.
Five things caught our eye:
1. Overall, there was a very consistent message across companies. All are dealing with supply-chain challenges, but all are also talking about strong demand and a growing order backlog, which bodes well for 2022.
2. There is no uniform picture of the disruptions across individual companies and sub-sectors. Some are reporting supply-chain issues getting better than they were in the second quarter; others are seeing things deteriorate. It really seems to depend on your very specific sub-sector.
3. Pricing-power optimism is high. That matches the strong pricing-power sentiment evident in other data sources, and suggests most companies think they can pass on higher input costs if needed.
4. Companies did not take the opportunity to guide lower or to issue a profit warning, so they seem confident they can hit third-quarter numbers despite supply-chain issues.
5. There was a muted market reaction to all the supply-chain commentary. Most stocks were down over the week, but that’s not materially different from the wider market. The comments didn’t shock investors, so expectations for the third quarter appear to have largely adjusted.
It’s too early to sound the all-clear on that front, as there are clear blockages, but it seems there are no economy-wide stoppages, which we believe makes for a good start to the traditional ‘profit warning’ season.
Currency market at a standstill
One of our currency traders told us last week that she has been seeing the same spot levels in developed currency markets for months now. It’s not that we love volatility, but there is a lack of action in the currency space. Idea generation is easier when prices are on the move as momentum traders will enforce the trend up to the point where positioning and sentiment become stretched, and a contrarian approach starts to look more promising.
We know volatility is low across financial markets, reflected in the realised volatility of assets and implied volatility in option markets having dropped sharply since the pandemic peak in March last year. But where equity volatility (e.g. the VIX index) and bond volatility (e.g. the MOVE index) have recently moved more sideways, currency volatility in developed markets continues to grind lower (e.g. the CVIX index).
The impact on prices of this low-volatility environment is quite different too. It’s a boon to equity markets, with one market after another reaching new all-time highs; a blessing for credit issuers keeping spreads historically tight; and a godsend to bondholders, with longer-end yields reversing much of the sharp increase from earlier this year despite high inflation prints. Stable spreads and yields may sound dull, but they allow fixed-income investors to continue earning that credit spread and capture the rolldown of longer-dated bonds.
In currencies, things are different. Carry is almost non-existent with interest-rate differentials at a historical bottom, while spot prices have stopped moving. To quantify our trader’s observation, we calculated the average distance between today’s spot price and the six-month trailing average across all 45 developed crosses. That average is just 1%, close to its lowest point over 20 years, which illustrates that developed currency markets are stuck.
We don’t have many active currency positions open and don’t take much risk in this asset class at the moment. It’s tempting to chase smaller and smaller movements, but in our view it wouldn’t be good portfolio management and so we prefer to be patient and wait for bigger opportunities to come.
We will continue to publish relevant content and news as we head into Autumn in the UK.