Why are equities ignoring the signs out of China? Why are equities ignoring the signs out of China? Why are equities ignoring the signs out of China?

Why are equities ignoring the signs out of China?

Equities 7 minutes to read
Peter Garnry

Chief Investment Strategist

Summary:  Global equities are in their second longest rally with a drawdown of 5% or less since 1999 and this is despite record high equity valuations, an economic slowdown due to the Delta variant, power shortages in Europe and China, and recently a group of Chinese real estate developers are under growing pressure. All these factors should have risk alarms sounding but equities remain cool and calm.

There are many dynamics at play this year in China. The country’s housing market has for years been highlighted as overleveraged and a key risk for China without ever turning into a crisis. In recent months China’s biggest real estate developer China Evergrande Group has spiraled into a liquidity crisis declining 91% from the peak in July 2020. For now equity markets outside China are calm indicating, under the assumption that markets are efficient, that investors believe this is not a systemic risk for the global financial system.

Source: Saxo Group

Evergrande, which local bonds were suspended today, has effectively gone into a restructuring phase which will cost shareholders and bondholders, but the Chinese government will try to limit the negative effects on the banking industry and the people that are waiting for their homes to be built. However, the stakes are increasing as risk aversion increases in the industry and already now there are signs that other real estate developers are experiencing some increased pressure. The table below shows some of the largest Chinese real estate developers with a combined market value of $131bn and $291bn in short- and long-term interest bearing debt, but total liabilities of $1.06trn. For comparison Lehman Brothers had $613bn in debt when it filed for bankruptcy.

The Chinese government has the ressources to soften the impact from the ongoing issues in the housing market and in fact the situation can be showcased as exactly why a new policy trajectory is needed. China Vanke said in July that the glory days of property development are over, so the industry has seen the writing on the wall. Under the new policy trajectory of China we know the emphasis is on ‘Common Prosperity’, self-reliance, and the environment, which means that investments will be redirected into semiconductors, renewable energy, and other key technologies. Back in August, we recommended investors to stay away from the Chinese technology companies within social media content and gaming, and instead focusing on consumer oriented companies. This is still our view.

Supply side issues are growing

Iron ore prices have lately been under severe pressure and as more prices of the puzzle are revealed it is now clear that part of the reason is maybe Chinese factories including steelmakers shutting down production due to power shortages. The world is currently facing an ‘energy shock’ with Europe experiencing dramatic increases in electricity and energy prices. Liquified natural gas is in high demand from China and Japan, while Europe is also scrambling to get supplies as Europe has been hit by a perfect storm of lower than normal electricity production from renewable energy sources. At the same time coal prices are soaring as well adding further pressure to Chinese producers which in turn could keep the inflationary pressures running globally.

For now equities are staying calm, but the growing evidence of dissonance in the global economy and equity markets cannot be ignored for too long. The dominos are in motion now and it is just a matter of time before we get a healthy correction in equities reflecting the growing issues in our global economy.

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