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The world’s attention has zeroed in on private-sector property developer Evergrande Group, and worldwide financial markets are roiled over the firm's potential to miss interest payments or outright default. The question is, is this a problem for China, or is there risk for greater market contagion, with waves potentially crossing the Pacific Ocean to crash on US shores?
Reporting indicates that in dollar terms, this is a large problem. The Wall Street Journal reports that Evergrande has roughly $88 billion in outstanding debt, with nearly half of that due in the next year. This total debt load is reported to be the highest of any development group in the world. To call this a nothingburger would be overly cavalier.
I think the situation is even more compelling given that it is occurring in the midst of a slowdown underway within the Chinese economy. Generally, as economies slow and transition to the back side of the business cycle, systemic stress builds and vulnerability to volatile events such as this one increases. In fact, I detailed some of the concerning data points for China all the way back in my early-July TrendsTalk. Back then, China was already exhibiting signs of a slowdown across most of its prominent indicators. Those indicators have further soured in the two-and-a-half months since. Below is a summary of concerning data points that go beyond the current Evergrande headline:
- On a year-over-year basis, China Industrial Production tentatively transitioned to Phase C, Slowing Growth, as of August 2021 data, a quarter earlier than ITR was projecting.
- Negative checking points from even sharper deceleration in the monthly and quarterly data for Production indicate that this transition is likely to hold.
- The China Leading Indicator is in steep cyclical decline, indicating more economic malaise to come moving forward.
- China Power Generation is decelerating, and China Railway Freight Carried volume has moved into contraction on a quarter-over-quarter basis, confirming the anemic showing in the headline Industrial Production figures.
- On the development side, both China Residential and China Nonresidential Floor Space have fallen into recession, trends that are likely to worsen given the Evergrande implosion.
With the benefit of this broader assessment of the fundamentals, we can see that things are about to get worse in China this fall, making the Evergrande situation – arriving as China heads into a more vulnerable stage of the business cycle – that much more concerning. Given that much of China’s economic growth is predicated upon domestic development and construction, one wonders if this could mark a shift in China’s reliance on relentless commercial and infrastructure projects to drive growth. It's a question worth pondering, but it's probably too early to answer at this point.
For us, the more pertinent question is, will this leak into non-Chinese markets and make for a stressful autumn for our portfolios? In our August ITR Trends Report™ executive summary, ITR Economics CEO and Chief Economist Brian Beaulieu highlighted that the US stock market had begun weakening on a rate-of-change basis and assigned a high probability of a stock market correction this fall; this was even before the Evergrande risk showed up on our dashboard. So, this additional noise could be the catalyst event that ultimately takes the blame for something ITR already thought was probable based on fundamentals – lofty valuations and preexisting leading indicator decline – from over a month ago. However, calling for a full bear market in the US at this point feels premature. China has a non-traditional banking system, and Beijing can force a bailout if necessary and drive damage control. Given the weakening of the country's economic fundamentals (detailed above), letting a default play out organically could be playing with fire at this stage in the business cycle; instead, we will likely see more pain before this situation resolves itself. With or without an Evergrande failure, the Chinese economy will be experiencing a pronounced slowing in economic growth. Readers should adjust their expectations accordingly when working with or in China in any capacity.