Monday digest

Posted 27 September 2021

Overview: wall of worry time?
‘Chaos’ can sometimes feel like an overused word in modern times, but it certainly felt apt last week, as the UK was buffeted on multiple fronts. Globally, the news flow was not much better, with economic data confirming slowing rates of growth and the imminent demise of China’s largest property developer causing journalists to cast their minds back to the Global Financial Crisis. If that was not disturbing enough, the US Federal Reserve (Fed) announced it will likely begin tapering its COVID-induced asset purchase programme (QE) before the end of the year and then rapidly drive down future purchases to zero by the middle of 2022.

Yet against this unnerving backdrop investors may have been surprised at how relatively unfazed stock prices (and capital markets more broadly) traded over the week. After falling sharply last Monday, stock markets recovered over the course of the week and ended the week moving skittishly sideways. Almost more important for investment managers was the stability in bond markets. Given the excited talk of a looming global credit market meltdown, and then central bank policy error, there was precious little movement in credit spreads or the yield curve.

Back to the UK, with headlines dominated by utility companies going under, steep rises in winter heating costs, gaps on supermarket shelves and petrol stations running out of fuel, it was easy to miss the Bank of England signalling it may raise rates as early as December of this year. Given current upward price pressures are predominantly the result of labour shortages and regulatory failings in the energy sector, the fact the Bank said it would continue its programme of extraordinary monetary easing – while at the same time tightening through an interest rate rise – has us wondering whether this is a ‘warning shot’ towards a government which has the levers for remedial actions at its disposal.

At the time of writing, after yesterday’s German general election, it will remain unclear which parties emerge as coalition participants, after the result left various coalition constellations possible. However, what is quite possibly behind this morning’s positive market reaction is that the German electorate moved back towards the centre and while voting for some change, also voted with Olaf Scholz and the SPD for a continuation of Merkel’s political style of few real surprises but lots of stability. From that perspective and if the last 70 years are anything to go by, regardless of what shape the coalition ultimately takes, we do not expect this short-term uncertainty will lead to any longer-term destabilising effects. 

Why Evergrande’s fall doesn’t feel like a ‘Lehman’s moment’
Evergrande’s ‘riches to rags’ story seems to be reaching its final chapter. What was once the world’s most valuable property company is on the brink of bankruptcy and serving as a cautionary tale about China’s bloated credit bubble. The firm’s huge debt pile – and its large share of the Chinese property market – have led to widespread fears of financial contagion. Fortunately, the Lehman comparison is far-fetched. Evergrande’s assets and liabilities are far simpler and more tangible: most of its debt is in bank loans and bonds, and it appears to be less wrapped up and layered in structured products. The Chinese government will not want to let the crisis get out of hand, but the key element is to contain contagion, while being mindful of moral hazard. Debt cancellations – particularly for foreign investors – are likely. This could lead to further defaults from US dollar bond issuers, which would be a sign of systemic risk. Aside from the knock-on impact on investment, disruptions to the property sector will be a dampener on Chinese growth, all while the country still struggles to recover from the pandemic.

Bailing out creditors too generously may set a bad example for similarly troubled companies, while being too firm leads to unnecessary social costs. The real risk in our view is that Chinese authorities, eagerly sticking to President Xi’s common prosperity goal, overplay their hand on the moral hazard component. While the state is clearly extremely concerned about debt and long-term stability, it is also worried about rapidly rising property prices and waning affordability. Letting Evergrande fail might help the former, but it is likely to exacerbate the latter, as the remaining developers refinancing will become more expensive as a result. Indeed, for all the talk of property oversupply, rising prices – particularly in the major cities – suggests the opposite problem.

These considerations lead us to two conclusions. First, whatever default Evergrande undergoes is likely to be orderly, with the PBoC injecting cash to ease wider liquidity problems. Second, and more generally, we suspect the negative growth effects will lead to greater fiscal and monetary stimulus further down the line to counter the effect. Beijing has been cautious throughout the pandemic recovery, trying not to fan the credit flames any further, but doing so now could create extreme economic pain – something the Communist Party is usually desperate to avoid. Markets will surely go through their ups and downs in assessing the Evergrande fallout. In the short term, answers to many questions may only come forward sparingly, especially as the first week of October is a national holiday in China, during which markets will be closed and authorities will be much less likely to intervene. It therefore makes sense not read too much into any short-term moves. Ultimately, the Communist Party will not let Evergrande spoil things for much longer.

US debt ceiling – an unwelcome evergreen
Political brinkmanship can be unpleasant to behold, for investors and indeed the public – but in the US, it is woven into the political fabric. Last Tuesday, Democratic lawmakers in the House of Representatives passed a bill to extend the debt ceiling limit until the end of next year. The legislation will have a much harder time in the Senate though, where at least ten Republicans would need to back it for the bill to pass under normal measures. In the House, almost all Republicans voted against the budget policy, a sign that virtually no one is prepared to break party lines. Without raising the ceiling, the US Treasury will be unable to meet its obligations and another government shutdown is likely.

Lawmakers are aware that stopping payments to federal employees and defaulting on Treasury debt has been viewed by the electorate as an incredible act of self-sabotage. Democrats are hoping that, as usual, this will be enough to force Republicans to back down. This time could be different though. In the background are President Biden’s ambitious fiscal plans, which include a proposed USD 3.5 trillion in extra social spending, measures to combat climate change and a slew of tax increases. Republicans are wholly against these plans and worry that buckling on the debt ceiling would imply their tacit consent. Republicans are not the only ones with reservations either. Centrist Democrats in the House and Senate are reluctant to back the new tax and spend measures in their current form, demanding a smaller package with more modest tax increases. Moderates are also pushing for a separation of Biden’s proposed plans on infrastructure and social care spending – something the left wing of the party has been opposed to, although this position seems to be softening.

The more fiscally-conservative Democrats will likely be confident they can achieve compromise, given the pushback from Republicans – and the looming threat that the latter could gain control of the House in next year’s midterm elections. Some analysts estimate that compromise could push the total spending down as low as USD 1.5 trillion, which would be paid for over the long-term through modest tax increases. However, we suspect centrist Democrats might be overestimating their negotiating position. While Republicans are traditionally against budget deficits, they have shown over the last few years that their main concern is taxation. Fully costed plans mean higher taxes in the long term. At the same time, many Republican-controlled states are likely to be big beneficiaries of increased spending, whether through infrastructure (and other) investment, or much-needed disaster relief. This means we could see a peculiar situation in the next few weeks, with Republicans pushing for an increase in the budget deficit, while right-wing Democrats push for more modest and costed plans. Progressive Democrats would likely be on board with the former proposal and, given Biden’s preference for bipartisanship, that could be the route his party opts for.

That would mean increased fiscal spending, with less of a hike in short-term taxes than initially thought. Judging by the recent mood in capital markets, investors now seem to expect that  scenario. It would certainly be a positive for long-term growth. Debt ceiling debates are likely just a negotiating tactic in this wider discussion. The only problem is whether brinkmanship could spoil market sentiment in the meantime. We think that is unlikely, but it is a risk.

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