Evergrande outcome has more importance than markets are giving it

Outlook:  In the US, the news of note today is new home sales, forecast up a little more than Aug (708,0000) at 714,000 but likely to disappoint, according to Trading Economics, which sees only 710,000. This is still well under 972,000 in July of 2020 “as high prices due to rising material costs continue to weigh on buyers' affordability.”

Focus on central banks can increase now that Feds can speak again and the rest of the world is itchy.

Norges Bank raised rates yesterday, while Turkey cut them and suffered dire consequences. The Bank of England may be next, which makes the drop in sterling a little peculiar. In the US, whether the Fed follows the script and ends tapering by mid-year for a first hike in September depends on whether the conditions continue to improve or suffer a setback.

Forecasts of a setback are starting to emerge, based in part on the regional Fed surveys (Philly down, Kansas City down a little) and globally, disappointing PMI’s. The market was willing to give the Fed the benefit of the doubt for far longer than usual, but now disagreement with the Fed is appearing around the edges. It’s not a taper tantrum, but more like a tremor. Yes, rates rose on the newly hawkish Fed, but did they rise enough? We need to watch the evolution of the rate curve because any back-sliding will mean market players see lower growth and maybe even a recession next year. So far this is a fringey opinion but can gain followers if data disappoints, especially labor market data. 

We still have a mostly risk-on mood, although we probably shouldn’t and equities are starting to realize they are on thin ice. Selling dollars is increasingly risky, especially if we get more news out of China over the weekend (not to mention the German general election).

We still don’t have any information on Evergrande payment of the now-overdue debt, and only a whisper or two of what the Chinese is government is going to do. One story has it the government will break up the company in to four parts, but this doesn’t tell us anything about the default. In the WSJ “10 important things to know today,” the Evergrande collapse is a footnote, not a major entry. Bloomberg puts it first but the reports is about the PBOC having “pumped a net 460 billion yuan ($71 billion) of short-term cash into the banking system in the past five working days as policymakers seek to avoid contagion from China Evergrande Group’s problems. The indebted developer’s stock and bonds fell again, following a rally yesterday, as investors wait for any sign of a payment of the interest due yesterday.”

As noted yesterday, we were shocked by the absence of information when Evergrande was supposed to pay up. But everyone seemed to take it in stride, pointing out the 30-day grace period. The NYT reports “Fears faded somewhat as Chinese regulators reportedly instructed the embattled property developer to repay some of its debts and China’s central bank injected money into the country’s financial system. Evergrande’s stock jumped nearly 20 percent today, even as large holders said that they might dump their stakes and doubts swirled around an $83 million interest payment on a dollar bond due today.

“Market watchers are assessing the implications of a potential restructuring of Evergrande’s $300 billion in debts. A full-blown bailout is unlikely, analysts say, but Beijing has the means to limit the damage if the company fails. ‘We believe that Evergrande is an exceptional case that is unlikely to lead to a broader systemic crisis in the property sector,’ Houze Song of the Paulson Institute wrote in a recent report.

“International investors in Evergrande’s bonds are preparing for turmoil — and in some cases buying more. Evergrande’s debt is in the portfolios of many major investment firms, and some hedge funds have been adding more to their holdings as prices have tumbled. A group of bondholders has tapped restructuring advisers at Kirkland & Ellis and at Moelis. For its part, Evergrande has hired the firms Houlihan Lokey and Hong Kong Admiralty Harbour Capital….

“Beijing’s intentions are unclear, especially when it comes to prioritizing debt holders at home and abroad. In the bankruptcy of Dubai World, in which confidence in a country’s financial system was similarly wrapped up in a single company, the company managed to pay back its creditors. But Dubai is a big borrower that relies on international credit markets, quite unlike China, which has recently discouraged local companies from listing abroad, among related measures. Despite all the uncertainty, with prices on some of Evergrande’s offshore dollar bonds that mature within months trading below 30 cents on the dollar, bargain hunters with a big appetite for risk see a bet worth taking.”

Well, vultures were always a possibility although it seems a bit early. This makes the point, again, that economists view market data differently from bred-in-the-bone traders. Economists see an economy that made bad credit choices for decades, leading to catastrophic failure and loss, while traders see the opportunity to buy underpriced assets—sell on the way down and buy on the way back up.

Here's our view: the Evergrande outcome has more importance than markets are giving it. If China can reorganize the company and somehow avoid most losses for investors, the current nonchalance toward the case will be justified. But it seems unlikely no investor will go unpunished so now we have to ask which investors are going to get screwed? In the choice between Black Rock and the Chinese saver/worker, who will China choose to win and lose? Until we have answers, unease can grow and grow some more. China would do well to get this fixed long before the 30-day grace period ends.

Then there is the case of the emerging slowdown.  It’s not much so far, but not zero, and while re reject the idea of outright stagnation or recession, it’s a little weird to have hawkish central banks at the same time. Going forward, this will be the focus. Again, if the 10-year starts sliding down, watch out—the gloomsters are in the driving seat. We see risk-off on the near horizon and therefore a dollar recovery, and remember, end-September is historically friendly to the dollar.

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