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Bogeymen, blunders and black swans

The last few months has seen an escalation in equity market volatility. The delta variant, concerns about Fed tapering and China’s policy adventures have all compounded investor anxiety. Markets however are near all-time highs and most stocks are trading above their 200 day moving averages. The sideways price action over the period has lowered valuations as corporate profits have surged.

The Chinese property company Evergrande has become the focal point of market worry in recent days. Evergrande has more than $300 billion of debt outstanding and is facing a liquidity crisis. Evergrande is China’s second-largest property developer, with $110 billion in sales last year. The company’s shares have fallen more than 90% over the past year and its bonds trade at under 30 cents on the dollar. The company owes money to more than 128 banks as well as 70,000 retail investors through wealth management products.

The risk is that the company’s default could hurt other developers trying to refinance debt as well as countless retail investors. The Chinese government has so far failed to resolve the situation with a liquidity line which would help stem losses due to the forced selling of assets. Given the company’s woes were started by the government limiting leverage within the property sector, it is unreasonable that retail investors and creditors should bear such large losses.

While the Chinese banking system in not currently showing signs of stress (interbank lending rates haven’t spiked), there is reputational risk for Chinese authorities who have tried to open-up their domestic markets to foreign investors in recent years.

The bigger issue, we believe, is the authoritative tendencies of China’s current leader. Xi Jinping is trying to turn back time on China’s capitalist development and he will keep finding companies and sectors that he considers “unpatriotic”. Jack Ma, the founder of Alibaba’s sudden disappearance and the clampdown on everything from gaming to education is a clear show of intent. These actions are designed to cause shock and it was only a matter of time before a policy misstep caused a serious problem.

We have reviewed our holdings within the region in recent weeks and are pleased to see that fund managers have reduced risk by tilting away from affected sectors and through large underweights to Chinese equities. While a large default of any kind is likely to impact market sentiment, we believe the effects are likely to be short term with limited ramifications outside of China. International banks have very limited exposure to Chinese property firms and therefore are insulated from said risks.

We are positioned for a continued recovery in the world economy and are prepared for higher growth and inflation expectations, particularly in our bond exposures. We believe the high levels of policy support during the crisis have put the developed world in a strong position to recover faster than after the global financial crisis. We will continue to monitor and report back on concerns that could dislodge our positive stance.


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