With recent U.S. economic strength making recession appear to be a distant risk, investors are paying closer attention to China’s deepening woes. Once-mighty Chinese property developer Evergrande’s filing for bankruptcy protection in the U.S., though long expected, fueled concerns as Chinese stocks continued their recent plunge.
Hong Kong’s Hang Seng index fell 2.1% on Friday. Losses since January now eclipse the 20% bear market threshold.
China was expected to lead a global growth spurt after ditching its zero-Covid policy late last year. Yet it’s now obvious that the world’s No. 2 economy’s problems go much deeper than Covid.
China’s Debt Reckoning
“So many things are going wrong in the Chinese economy at the same time, but of course it is not coincidence at all,” Carnegie Endowment senior fellow Michael Pettis tweeted. “This is how systemic imbalances work themselves out.”
Pettis is among economists who have long warned that China’s economic model, built on exports, debt-funded infrastructure and property wealth, was bound to hit a wall. Now it seems that we’re reaching that point, and the fallout could be ugly. Earlier this week, JPMorgan Chase said it now expects 10% of high-yield corporate debt in Asia to default this year, up from an earlier forecast of 4%. That’s the base case, not a worst-case scenario.
While Beijing could cushion the blow with stimulus — especially if it were directed to consumers in a break from the past — a prolonged slowdown in China could take a bite out of S&P 500 earnings, particularly for commodities producers. But China’s woes could have a disinflationary impact worldwide at a pivotal moment for monetary policy.
The real concern for U.S.-focused investors would be if a plunge in China’s currency infected global financial markets. But that’s seen as unlikely due to tighter capital controls imposed in the wake of China’s last major yuan rout in 2015 and 2016.
China’s Slow-Motion Debt Crisis
For the last five years, Beijing has been trying to curb the risk of financial crisis without giving up its GDP growth target of 5% or more. But it’s running out of options.
Evergrande defaulted on its $340 billion in debt back in 2021 after Beijing set “three red lines” limiting leverage for property developers in 2020.
Regulators have since loosened that framework, but faith in China’s property sector remains at a low point, with zero-Covid policies possibly exacerbating the damage to consumers’ psyche.
‘Lehman Moment’ Coming?
Christopher Wood, global head of equity strategy at Jefferies, wrote this week that the total level of outstanding mortgages in China has started to decline outright amid prepayments, with households paying more than is due. “This reflects the increased risk-aversion on the part of households,” he wrote.
Evergrande’s latest filing in the U.S. aims to gain approval for a debt-restructuring plan unveiled earlier this year. However, ongoing weakness in China’s property market continues to claim more victims. Earlier this month, Country Garden, among China’s largest developers, missed bond payments totaling $22.5 million. It has liabilities approaching $200 billion, according to Bloomberg.
Households got accustomed to high savings rates via investment trusts that depend on returns from real-estate holdings in their portfolios. Yet such savings vehicles appear increasingly unsafe. Earlier this month, clients of Zhongrong International Trust said it delayed payments on maturing wealth products. Bloomberg reported that Zhongrong invested heavily in unfinished real estate projects in 2022, expecting a payday when they were completed. That strategy has struggled as property sales hit the lowest level in more than a decade.
“The risk of a real Lehman moment in China is rising,” Wood wrote, if property sales continue to decline.
Meanwhile, foreign direct investment in China fell to $4.9 billion in the second quarter. That’s down 87% from a year earlier and the lowest level since 1998. That’s likely related to the deep rift between the U.S. and Beijing, which has worsened since the start of Russia’s war over Ukraine and the U.S. imposed strict export controls.
S&P 500 Impact
China’s woes may cause some ripples for S&P 500 companies. Tesla (TSLA) announced further price cuts in China this week, possibly responding to signs of EV market softness. Freeport-McMoRan (FCX) slumped below its 200-day line on Friday, with copper prices having fallen about 7.5% since the end of July. Crude oil, which rallied past $84 a barrel last week, has eased back to $81.25. Lithium giant Albemarle (ALB) has tumbled near a two-year low as lithium spot prices have fallen 22% this month.
“Growth in China has disappointed, but not sufficiently to change the global picture,” Solita Marcelli, chief investment officer in the Americas for UBS Global Wealth Management, wrote in a Friday note. “And weakness in China may even help reduce inflation in developed markets.”
The upshot: UBS has become a bit more constructive on equities, though with a neutral view overall. The firm has a 4,500 S&P 500 target this year and 4,700 for June 2024.
Investment strategist Ed Yardeni goes a step further: “China’s recession and deflation are reducing the risks that the U.S. must fall into a recession to bring down inflation!”
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