Evergrande crisis is not entirely to blame for global market jitters
- The deepening liquidity crisis at China’s second-largest property developer is important only insofar as it feeds into a broader narrative around the slowdown in global growth and the risk of a major policy mistake
Pinpointing the catalyst for movements in asset prices across the world is not easy, particularly when there is a lot of uncertainty over the direction of markets. Even when sentiment is bearish, and investors expect a sharp sell-off, there is often disagreement over the precise trigger for falls in prices.
The link between the further declines in commodity prices, particularly industrial metals, and the plight of Evergrande was also clear. China consumes half the world’s steel, with the real estate sector alone accounting for approximately one-fifth of global demand.
What was less clear, however, was the selling pressure in markets where the channels of contagion from China are much weaker. There was little reason for the Russell 2000 index – a gauge of smaller stocks in the United States with less international exposure than the S&P 500 – to fall 2.5 per cent.
Nor did it make sense for an index of emerging market exchange traded funds that exclude China to lose more than the main gauge of Asia-Pacific stocks.
This suggests that, while the imminent prospect of an Evergrande default sparked Monday’s sell-off, markets were vulnerable to begin with, and are contending with a number of threats. The Evergrande crisis is important only insofar as it feeds into a broader narrative around the slowdown in global growth and the risk of a major policy mistake.
The key question is whether the highly leveraged developer poses a systemic risk, or whether its troubles constitute an idiosyncratic event limited to China’s property and financial sectors.
A full-blown crisis at a dominant company in a systemically important industry in the world’s second-largest economy will inevitably cause spillovers. The debate revolves around whether these effects are financial or economic in nature.
The initial reaction from emerging market corporate bond markets, a crucial gauge of sentiment, is revealing. Spreads on an index of emerging market corporate debt excluding Chinese issuers have barely moved over the past month, data from JPMorgan shows. A gauge of Asian corporate bonds excluding Chinese borrowers has also proved resilient.
The bigger risk is that deleveraging in the property sector, while avoiding a messy default, takes its toll on Chinese growth, exacerbating concerns about the disconnect between lofty valuations and mounting threats to the post-pandemic recovery.
Monday’s sharp sell-off came just when the global economy was showing increasing signs of slowing sharply, mainly because of the rapid spread of the Delta variant. Survey data published earlier this month revealed that global manufacturing and service sector activity slumped to a seven-month low last month, dragged down by contractions in output in Japan and China.
Yet, a gauge of global stocks is still only 3 per cent shy of its all-time high on September 6. The biggest risk in markets right now is not the fallout from the Evergrande crisis, it is the dangerously stretched valuations across many asset classes, particularly in the US where concerns about the virus and inflation have already knocked consumer confidence.
On Wednesday, the Fed presented updated forecasts pointing to a faster timeline for interest rate increases, and signalled it would begin scaling back its asset purchases in November. A more hawkish Fed in the face of a global slowdown increases the risk of a policy blunder.
Evergrande is a wake-up call for investors, not because they did not see the crisis coming, but because it is unfolding when markets are priced for perfection.
Nicholas Spiro is a partner at Lauressa Advisory