This week, markets turned volatile due to contagion fears from the real estate developers crisis in China.
In recent weeks, the insolvency of Evergrande, one of the leading Chinese real estate developers, has become increasingly clear. For years, the sectors business model was based on the combination of high financial leverage and rising house prices. When the Chinese government decided to (suddenly) limit the leverage of the sector and price growth, real estate developers came under financial stress, especially Evergrande, one of the most indebted – with around $300bn debt. Recent government impositions on the banking sector, aimed at limiting exposure to Evergrande and curbing credit through higher mortgage rates, have effectively forced the company to default.
Stress quickly spread to the whole sector. The restrictions imposed by the regulator have extended to other highly leveraged developers, and the collapse in bond prices is making it difficult to roll over maturing debt. Within the sector, it is likely we will see more companies default. However, the market is already pricing in a broad stress scenario, with even the highest rated issuers (BB) are now offering $ yields above 10%.
Financial risk is likely to be limited. As shown in a JP Morgan study, loans to Evergrande account for 0.2% of total banks loans, and the entire sector accounts for 7%. In addition, Chinese policymakers have ample room to support the banking sector (via a high capacity to extend liquidity and a high level of reserves). Finally, exposure to the sector by large US and European banks is limited. Some funds have a more significant exposure but also a higher capacity to handle volatility.
Economic risk is potentially higher, as the sector represents about 15% of China’s GDP. So, if stress were to spread to other companies in the sector, the risk of a slowdown would be tangible, with strong consequences for the global economy. A deep slowdown, however, would quickly find a reaction from the Chinese authorities. Over the summer, the PBOC began expanding monetary policy at the first signs of a slowdown in the data. Fiscal and monetary space in China is greater than in major advanced countries, and a reaction to support the economy may come soon.
The market began to correct this week, but valuation levels are far from attractive, especially in credit. The major global indices corrected 2-3%, but starting from the highs of the last 12 months. Credit widened about 10bp, and lower quality issuers lost between 1-2 points. European and U.S. equity continue to trade at 21 and 16 times earnings, respectively, 20-30% above historical averages. American and European equities trade at the lowest spread in five years. Valuations therefore remain anything but attractive, with the exception of the Chinese market, the epicenter of the problem.
The risk of systemic contagion therefore remains low, but volatility has not yet generated an interesting entry point on the main asset classes. We therefore maintain a cautious positioning and are ready to take advantage of the opportunities that the market should offer.