CIO Office Monthly - September 2021

In short:

  • Evergrande missed offshore bond interest payment, another is due this week.
  • Fed sets the stage for November taper and rate hikes are on the horizon.
  • A global energy crunch is contributing to higher bond yields.

The key story driving markets this month was the fate of the world’s most indebted property developer, Evergrande. With land sales to homebuilders accounting for more than 50% of Chinese local government revenues and housing representing more than 70% of household wealth in the country – the potential impact of a collapse in this sector could have global implications. Fears of a broader contagion outside of China’s property sector led to investors taking risk off the table during the month. Some of these concerns have begun to recede as investors banked on Beijing intervening to limit the damage.

Global Risk Market ReturnsSource: Bloomberg

Intervention is justified, as it could be argued that the company’s troubles are the result of a CCP-initiated policy change to encourage deleveraging. To improve the financial health of its real estate sector, the Chinese government introduced the “three red lines” policy in 2020 – forcing developers to meet strict debt level requirements. While not extreme by global measures, much of the BB, B and CCC rated developer’s debt did not pass these requirements as recently as last year. Policy reform in the sector was necessary to prevent a systemic crisis with the potential to derail the whole financial system. Whilst property prices were rising, developers aggressively overpaid for land from local governments – transferring risk to customers and their mortgage lenders. Capital was also being misallocated away from more innovative and productive industries, creating a structural problem that the CCP needed to solve. As growth began to slow and demand for houses waned, this unsustainable combination of leverage and misaligned incentives began to show its cracks. 

Last week, Evergrande missed a payment due on bonds held by offshore investors. The company has a 30-day grace period before any failure to pay officially results in a default. It faces an additional payment on a 2024 bond due this Wednesday. Investors will be keenly watching to see if there is any broader impact on the Chinese financial sector in the weeks ahead, and for any further temporary policy responses such as the liquidity injection seen last week.

The crisis will most likely be resolved through asset sales. Troubled developers will need to liquidate unfinished or underperforming assets – selling them to developers with stronger balance sheets and to State Owned Enterprises. The state will need to step in to compensate employees, suppliers and homebuyers.

Global Economic Data Highlights

Global Macroeconomic Data

Source: Bloomberg

The Federal Reserve meeting last week set the stage for a November announcement on the timeline of tapering its asset purchase program. Fed Chair Powell revealed that the Federal Open Market Committee supports a “gradual” taper with the intention of withdrawing the stimulus completely by the second half of next year. In addition, there was a significant shift in the projections for interest rate increases expected by Fed officials. Half of the 18-person committee now expect a Federal Funds Rate increase in 2022. Equity markets reacted favourably to the announcement, with the S&P 500 closing higher on the day.

Following the meeting, and a similar announcement by the Bank of England, yields on global bonds have risen sharply. Nominal yields can be derived from real yields and inflation expectations. The latter have been stable since the first quarter of this year. Since the Fed announcement, the future path of short-term interest rates is more uncertain, and investors demand a premium to own long-term bonds rather than to roll-over short-term deposits. This “term-premium” is a major contributor for higher bond yields in recent weeks.

In addition, an energy crunch sweeping across Europe and China is driving up oil and natural gas prices. Inflation expectations are rising in the US, Europe and notably the UK. Sovereign bond yields are being driven up accordingly. As a result, we could see a repeat of the first half of this year, where value/cyclicals begin to outperform growth for a sustained period.