The potential that Evergrande—one of China’s largest real-estate developers—may soon default on its debt is raising concerns among investors and the markets. The ongoing cat-and-mouse game between Evergrande and Chinese authorities, as well as the rapid deterioration in the prices of Evergrande-related securities during the past couple quarters, has prompted questions about a potential broader contagion within and outside China markets.
There is certainly always a fear of skeletons in the closet in these situations—into which we won’t claim to have any greater visibility than most. But that does not preclude a desire to better understand the context around the situation as it plays out, even though we don’t carry any direct exposure to Evergrande, because it might affect near- or intermediate-term positioning—especially as it concerns taking advantage of widening potentially fundamentally attractive opportunities.
Chinese Authorities Tempering Market Expectations
There have been several of these funding “standoffs” during the course of the past few years as China has tried to reduce the market’s expectation for an implicit guarantee, and generally temper the vigor with which debt was created over the prior decade. Each time China has pressed a little more in this regard. Appreciating that Evergrande is admittedly a bigger entity, however, its financial liabilities are still modest in the context of the entire system, in our view.
The market doesn’t appear to be underestimating risks for Evergrande.
The market doesn’t appear to be underestimating risks for Evergrande. After all, Evergrande assets have been selling down for the past couple of quarters at this point and are currently off by about 80%.
Further, in broader equity markets, Evergrande represents less than two basis points of the standard indices. In debt markets, Evergrande liabilities represents a larger slice of the high-yield space, but this refers to mere basis points of total onshore debt.
The market seems to be expecting default/restructure for at least a couple months. Evergrande has telegraphed that it will probably miss near-term interest payments to banks in September, but how debt that matures later in 2022 and beyond gets restructured is the question. We believe it will most likely be, some mix of forced asset sales, delayed projects, and state/bank support will contribute to the resolution.
So, the salient concern from our macro perspective becomes that of contagion. Contagion where?
Within China, the near-term contagion risk is most pronounced for some associated credits and geared most likely, at least in the short term, to housing and broader real-estate sector development. While that concern is negative for economic growth, it also may serve to temper the medium-term hit to real-estate prices as supply is reduced. The policy uncertainty with Evergrande and real estate is yet another risk that is now likely weighing on markets.
The recent backdrop of elevated economic growth in China appears to have created an environment in which the government has felt comfortable implementing stricter regulatory policies (and shown less willingness to support entities that have run into trouble). Markets have—somewhat understandably—generally had a negative reaction to this approach.
Despite very bearish conventional wisdom and recent conservative positioning in our portfolios, we are now beginning to consider increasing exposure to these widening opportunities.
While we believe this approach by the Chinese authorities is likely to continue in the near-term (specifically, as it concerns Evergrande, tempering market expectations of support or an outright bailout), it will become more difficult to do so as the environment returns to one of more normal growth and with the manifestation of a new political cycle about a year from now. The Chinese authorities, of course, do have an incentive (and the power) to reverse course on their recent patterns much sooner than a more normalized economic growth number or the 2022 election cycle should they feel that contagion is manifesting within its markets.
As a result, we believe that near-term contagion across emerging and/or Asian economies outside of China is a low probability. Should we see examples of contagion within China, however, we will move quickly to reassess the possibility that it spreads outside of China.
Potential Investment Implications
Therefore, despite very bearish conventional wisdom and recent conservative positioning in our portfolios, we are now beginning to consider increasing exposure to these widening opportunities.
With little to no exposure to broad Chinese equities for most of 2021, we have recently shifted some long exposure from local smaller-capitalization A-shares to a broader index exposure. We are positioned in line with our long-term equity valuation signals in China, while remaining below our long-term valuation signals in Hong Kong, and are evaluating increasing exposure to both from here.
Aaron Balsam, CFA, is a senior analyst on William Blair’s Dynamic Allocation Strategies team.
John Simmons, CFA, is a senior investment strategist on William Blair’s Dynamic Allocation Strategies team.