Monday Digest

Posted 26 July 2021

Overview: Are markets at last waking up to ‘living with’ the virus?
Last week was a bumpy one. Major equity markets sold off heavily around the world, before recovering most of those losses by the end of the week. Unfortunately, that market volatility has been matched by uncertainty in the underlying economy, as the spread of the virus continues to pose a threat to global activity. Only a few weeks ago, markets seemed convinced that rapid vaccination programmes would bring some stability and respite to the world. A global surge in the Delta variant has put things on hold. Virus concerns are still ever-present in decision-making, for governments, businesses, and individuals.

For us, the primary concern had been that in this context – when societies find their way to live with the virus – policymakers may end the intense monetary and fiscal support too soon, choking off the recovery, but central banks have been at pains to reassure of their dovish intentions. The US Federal Reserve (Fed) has been key in calming those market nerves, but support from the European Central Bank (ECB) has been equally important. Therefore, last Thursday’s ECB’s policy update was easily the event of the week. President Christine Lagarde offered clearer guidance (compared to previous updates) that interest rates will stay at current levels, or lower, until it sees progress in growth forecasts for the Eurozone. However, we would argue that media reports that the ECB is pursuing a “lower for longer” policy are therefore a little wide of the mark. If growth suddenly came in much stronger, the ECB is resolved to act quicker. Second, the change in forward guidance only concerns interest rates. There was no real discussion of the ECB’s other policy tools, and Lagarde was coy on what undershooting the target might mean for its various support schemes. Third, Lagarde underlined that the ECB Council will use its own judgement when assessing the need to change policy, which means there is no automatic data or forecast-driven policy reaction function. That is not particularly new, but it is telling that Lagarde thought it worth emphasising.

Central bank support is crucial for markets as economic expectations wane. In a further sign that the outlook is dampening, the US Dollar continued its strengthening against global currencies – usually a signal that investors are looking for safe haven assets. The summer holidays are upon us, and hopefully will mean peace, quiet, and lots of spending on leisure activities. Perhaps the US and EU central bank events in late August and September will be the next major focus. With thinner trading volumes expected, it would be nice not to have deal with anything significant for a few weeks yet.

China’s fortunes rebound as property crackdown escalates

Evergrande Group, a Shenzhen based developer that was the world’s most valuable real estate company in 2018, saw an almighty sell-off in its share price last week, tumbling to a four-year low on Tuesday. Authorities have had an eye on Evergrande, one of China’s top property developers for a while, especially on its leverage structure. This has now trickled into more concrete action. On Monday, authorities in Shaoyang (a ‘Tier 4’ city, some 500 miles north of Hong Kong) halted sales at two of Evergrande’s projects due to “a shortage of funds”, causing the company’s share price to tumble.

Evergrande share price recovered towards the end of the week, as it announced it had resolved the issue with the Shaoyang authorities, but persistent uncertainties remain. Evergrande’s business model reflects modern China: it uses client money paid upfront for future developments as collateral, leveraging that cash to fund expansion at breakneck speed. And in many ways, Evergrande is a symbol of China’s rapid economic ascent over the last few decades. Stellar growth in the world’s second-largest economy has been accompanied by mass urbanisation and some of the quickest and most intense property development ever seen. Evergrande has been a key beneficiary of this, specialising in upscale city apartments for China’s growing upper-middle class. The group even owns its own football team in Guangzhou, a further symbol of the country’s newfound riches.

But Chinese authorities have spoken of “making progress in installing risk control mechanisms in small- and medium-sized financial institutions with high risks”, and Evergrande fits that description. The Chinese government has been making efforts at reining-in excessive debt for years, and last summer decided to clamp down on highly leveraged property developers by bringing in balance sheet metrics known as “three red lines”. This move has led to prolonged fears over Evergrande’s ability to refinance its bloated debt pile which, at $88 billion, stands at an eye-watering 224% of its shareholder equity. A potential Evergrande collapse might be a problem for the banks, and for the wider Chinese economy, given how deeply it is woven into the wider corporate fabric.

However, China’s recent equity market has improved – even outperforming the Eurozone – despite the problems at Evergrande and the crackdown on Chinese tech, suggesting investors have become more confident this marks a turn in China’s medium-term economic outlook. At the same time, while developed world economies have come off the boil, we have seen several positive surprises in China’s economic data. Total social financing for June rebounded by quite a lot more than was expected, even considering the usual seasonal jump. While comparisons with last year still make the growth level relative to GDP (known as the credit impulse) look negative, the authorities appear to be allowing relative credit growth to resume in comparison to 2019 levels. This is backed up by central bank liquidity injections into the money market and lower short-term money market rates.

Over the longer term, the loosening of domestic investment restrictions should add to this positivity. Government clampdowns are a caveat to this, but we should expect those to be focused on China’s large and powerful private companies, while its small and medium-sized firms could thrive by comparison. Restructuring the Chinese economy could become a great secular growth story, but in the meantime, it may be wise to focus on the cyclical development. The first signs of an improved growth outlook come just as market optimism may be waning in the western world. From a broader viewpoint, this shows an interesting disconnect between China and the world’s other major economies – to the extent that Chinese assets could act as a tool for diversifying investments. For cyclical assets like emerging markets, this is a positive sign. Politics might make problems for big Chinese companies, but the overall outlook is good.