What is China Evergrande And What Should Investors Know?

Uncertainty on several fronts contributed to a broad fall in global stocks yesterday (20 September). 

Fears that Evergrande Group, one of China’s largest property developers, could default on hundreds of billions of debt sent Hong Kong’s benchmark Hang Seng Index 4% lower (the mainland Chinese market was closed on Monday for a public holiday). 

This weakness in China’s equity market spilled over to US stocks, where sentiment was already subdued. Investors were concerned about the historically volatile month of September, the US Federal Reserve’s meeting this week and the possibility of a government shutdown.

How did markets react?

Shares across the world tumbled on these investment risks. The MSCI ACWI global equity index slid 1.6% on Monday, its biggest decline in two months. On Wall Street, the S&P 500 dropped 1.7%, marking its worst day of trading since May. The index had fallen as much as 2.9% during the trading day, before paring back some losses in late afternoon trading.

As stocks sold off, safe haven assets rose, sending gold prices higher and the yield on the 10-year US Treasury note lower. Bond yield moves inversely to its price. 

High yield corporate bonds were however affected by Evergrande fears. The iShares iBoxx High Yield Corporate Bond (HYG), a widely watched ETF tracking high-yield bonds dipped around 0.4% in yesterday’s trading, marking its worst one-day decline in two months. 

What’s going on with Evergrande?

The Evergrande Group is one of China’s top three property developers. According to its website, it owns more than 1,300 real estate projects in over 280 cities in China. 

It’s also massively in debt. It owes roughly $300 billion, and a default could potentially destabilise China’s financial and property sectors. Should Evergrande collapse under its major debt burden, it could trigger turmoil across global markets too. 

Image credit: Bloomberg

Evergrande is due to pay $83.5 million in bond interest on Thursday. It has another $47.5 million payment due later this month. Failure to make those payments within 30 days of their due date would put Evergrande in default.

Earlier this month, FitchRatings downgraded Evergrande’s rating to CC from CCC+, indicating a probable chance of default. In a recent stock filing, Evergrande themselves noted that “there is no guarantee that the Group will be able to meet its financial obligations.”

What’s the risk?

Investors are worried that Evergrande’s failure to pay its debts will set off a chain reaction. There are as many as 1.6 million homeowners who have paid deposits and it’s not clear if Evergrande will complete construction on these properties.

China’s residential property market makes up about 20% of the country’s GDP. Evergrande’s woes could spillover to other property developers and cause significant turmoil in the Chinese housing market as property values suffer. 

A hit on housing could hurt China’s already slowing economy and that could bleed into other regional and global markets.

What’s going to happen now?

Evergrande bondholders will find out this week if the company is able to pay back its bonds. Company executives have been scrambling to find ways to repay its many debtors, suppliers and investors, such as by repaying investors in its wealth management products with real estate.

While many market experts see a government bailout as unlikely, some form of restructuring for Evergrande will likely take place. According to economic research consultancy Capital Economics, “the most likely endgame is now a managed restructuring in which other developers take over Evergrande’s uncompleted projects in exchange for a share of its land bank.”

Is this China’s Lehman moment? 

Although there are parallels between Evergrande’s troubles and the 2008 collapse of US investment bank Lehman Brothers, strategists see little chance for any systemic risk for the global economy.

“The conditions are simply not in place for even a large default to be China’s Lehman moment,” Barclays strategists said in a note on Monday. 

Chinese policymakers are well aware of the implications of an Evergrande collapse and have the appropriate policy tools and track record to manage any potential fallout from Evergrande’s default. 

Further headwinds to look out for

Although Evergrande is dominating headlines, not all of the volatility in stock markets is due to Evergrande fears. 

Investors are also focused on this week’s US Federal Reserve meeting for updates on the tapering timeline on its bond purchases as well as its board members’ long-term rates and economic projections. Partisan gridlock in the US Congress over the debt ceiling weighed on investor sentiment as well. 

Meanwhile, the Delta variant remains a global health threat as the colder months approach. The US COVID-19 vaccination rate currently sits at a stubbornly low 54.4%, which may impact further reopening of its economy. 

What should investors do?

While the pullback is certainly unsettling, it’s worth noting that downturns are part and parcel of investing. After the S&P 500’s 16% rally year-to-date, valuations may be overstretched and it’s not surprising to see some pullback in stocks. Some strategists have even called the sell-off a buying opportunity.

Although it may seem counterintuitive, the recent volatility isn’t a sign to exit the market completely. When you’re out of the market, your money isn’t exposed to the worst days of a correction. But this also means you’re missing out on the recovery days that should boost your returns over time.

During the 2008 global financial crisis, those who stayed invested in the S&P 500 recorded twice the returns of those who fled to cash and missed just three months of the recovery. 

Source: Syfe, CBOE

Market volatility does tend to be short lived. For long-term investors, the best course of action right now is to simply sit tight and do nothing.