China Woes Drive Stocks to Biggest Drop Since May

by Jeffey Kleintop, Michelle Gibley, and Kevin Gordon, Charles Schwab & Company Ltd.

Stocks sagged Monday as investors eyed multiple concerns, including the worsening debt woes of Chinese property giant Evergrande, an ongoing battle in Washington over infrastructure spending and the debt ceiling, and uncertainty over when the Federal Reserve will begin to remove economic supports.

The S&P 500 closed down 1.7%, its largest drop since May. Traditionally defensive sectors Utilities and Real Estate were relative outperformers (declining 0.2% and 0.6%, respectively), while Energy was the greatest underperformer, falling 3%.

Evergrande problems could spread outside China

The consequences of a restructuring or default of China Evergrande Group this week are likely to be largely be confined within China, but global investors could see some effects. We believe the impact outside China is more likely to be a ripple than a “Lehman-Brothers-type” moment that destabilizes global markets, as happened when the financial services firm Lehman declared bankruptcy in September 2008. Some thoughts:

  • China Evergrande Group is the world’s most indebted property developer, with 1,300 properties in 280 cities and has expanded into investments outside of construction, including property management, electric vehicles, internet and media production, a soccer team and more.
  • The wheels were set in motion in August 2020, when China began a strict deleveraging campaign for property developers, called the “three red lines,” to help control home prices by reducing credit to the property sector and to ensure a more stable financial system. China Evergrande Group was one of several companies in violation of all three red lines, making Evergrande ineligible for new loans to keep funding development, therefore needing to sell assets as a source of cash. Asset sales have come up short and the company’s heavy reliance on rolling over short-term debt meant it has had difficulty meeting its debt obligations.
  • Many stakeholders will create a tightrope for regulators. Evergrande’s stakeholders include homebuyers, retail investors, banks, and foreign investors, employees and companies that feed into the property development supply chain. Homebuyers often pay cash upfront for properties delivered years later, and Evergrande is reported to have 1.4 million unfinished apartments, according to Capital Economics. Evergrande counts 200,000 employees and 3.8 million indirect jobs per year. Investors have sold the stocks of other property developers due to the potential for a decline in home prices if fire sales are undertaken and/or Evergrande’s peers have difficulty accessing capital markets. The Chinese government may need to walk a tightrope of allowing some stakeholders to suffer losses and avoid the specter of implicit debt guarantees, while also stepping in to keep Evergrande’s problems from affecting the broader market.
  • We aren’t seeing a credit crunch spread to the entire Chinese financial system. While Chinese high-yield indexes are selling off, pushing yields higher, a closer examination shows divergences. As you can see in the chart below, Bank of Communication has reflected little impact, while real estate developer Kaisa Group has sold off. Both bonds represent the largest positions in the Bloomberg China High Yield Index.

Bank of Communications has remained steady, while real estate developer Kaisa Group has sold off

Source: Bloomberg, as of 9/20/2021. Past performance is no guarantee of future results.

  • Could Evergrande’s troubles reverberate to the rest of the world? While there could be effects outside China, particularly to construction-related commodities and equipment and foreign firms holding its debt, Evergrande represents a small portion of the overall global debt market.
  • We don’t believe this will be a “Lehman moment” for China. The failure of Lehman Brothers was a result of excessive risks taken in the subprime mortgage market by Lehman and many other banks. A crisis of confidence in the banking system resulted in the need for governments to infuse banks with cash to avoid a liquidity crunch. In China’s case, it has some unique characteristics of its financial system that reduce the threat of a crisis: The Chinese government controls both sides of the banking system (lenders and borrowers). The largest borrowers are state-owned enterprises, and China’s reliance on internal sources of funding makes it more resilient. China’s vast domestic capital means it is not very vulnerable to a sudden withdrawal of capital by foreigners that would shock the economy into a recession. On the lender side, the government holds sizable stakes in the large, systemically important banks and could recapitalize them in the event of a crisis. Additionally, Chinese banks don't appear to have used leverage and derivatives to the extent Western banks did in the years leading up to the global financial crisis in 2008.
  • We are watching home prices as a potential channel for contagion to China’s overall economy. There is the potential for headwinds to China’s domestic economic growth if Evergrande’s problems become a bigger property sector issue and result in the offloading of properties at fire-sale prices and if consumers, businesses and banks retreat due to lower confidence, which in turn could slow global growth.

While the primary impact of Evergrande’s problems is likely to be felt within China, its fortunes are of interest to global investors due to the impact on emerging market bond funds, commodities and equipment related stocks. Additionally, China’s economic growth could take a hit and hurt demand for companies globally, but downside risks to growth could prompt Chinese policymakers to add stimulus and result in a rebound for Chinese stocks, with the MSCI China Index off nearly 30% from the 2021 high.

U.S. stock markets face other concerns

Evergrande was not the only concern weighing on markets on Monday. Other issues include:

  • The debt ceiling: Treasury began taking “extraordinary measures” on July 30 to ensure the U.S. does not default on its debts. But those measures are likely to run out sometime in October. Congress will have to raise or suspend the debt limit by then—but there’s no clear political path to do so. Uncertainty over when and how Congress will act is likely to result in market volatility, as it has in past debt-ceiling battles. Meanwhile, lawmakers are scrambling to fill in the details on a $3.5 trillion spending bill, including which tax increases to include.
  • Potential reduction of monetary support: The Federal Reserve is likely to taper the pace of its bond purchases this year, removing some of the support that the central bank has lent the economy since the beginning of the COVID-19 pandemic in March 2020. That doesn’t mean the Fed will begin raising short-term interest rates, but it would be the beginning of a slow withdrawal. The Federal Open Market Committee, the Fed’s policymaking arm, meets this week, and may provide more clues about its intentions after the meeting ends on Wednesday.

The S&P 500 index has continued to recover from minor dips throughout the year, but market breadth has deteriorated, with fewer stocks reaching new highs. Seventy-two percent of members in the S&P 500 were trading above their 200-day moving average as of September 17—down from this year’s peak of 97% in April. Even before Monday’s weakness, as of Friday (September 17th), 86% of stocks within the index had experienced at least a 10% correction at some point this year, and the average stock was off its year-to-date high by more than 10%.

Meanwhile, investors have shifted toward defensive sectors, such as Real Estate, signaling concern about the potential for a slowdown in economic growth. Estimates for third-quarter gross domestic product (GDP) have been revised down on inventory pressures that have taken longer than expected to ease, along with a pullback in consumption due to the spread of the COVID-19 delta variant.


Heather O’Leary, Research Analyst-Global Investment Strategy, contributed to this report.

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