A grim economic outlook?
Vikram Aggarwal, Fund Manager, Fixed Income, analyses what the deteriorating economic outlook means for the overall market environment.
We started the week with quite a pronounced weakness in risk assets and outperformance of safe-haven assets. The main driver was the news surrounding Chinese real estate company Evergrande. The company has about $300 billion of liabilities, or 2% of China’s GDP, a significant number. This is a mixture of bank debt, corporate bonds, and onshore commercial liabilities.
Whether this triggers a systemic crisis and whether this is a ‘Lehman moment’ is still debatable. The Evergrande bond curve suggests that the market was expecting distress or some sort of default or restructuring soon.
The unfolding crisis will have a profound impact on the economic outlook for China. It’s less likely that Chinese consumers are now going to spend aggressively. Precautionary savings are likely to increase, and this ultimately means quite a grim economic outlook for China.
Secondly, what’s driving broader risk off is the deteriorating economic situation in developed markets. Economic data suggests we are in a stagflationary environment. A good way of observing this is by looking at the divergence between the economic surprise indices. If you look at the Citi Economic Surprise Index for the US, it is deeply in the negative territory, whereas the Inflation Surprise Index is in positive territory and the highest it has been for a long time.
What we are witnessing now is not ‘good inflation’, as it is caused by supply side issues. This ultimately leads to demand destruction. So, from an economic growth outlook perspective, this is quite negative.
Whether we stay in this stagflationary environment is debatable, but our team’s view is that the world we are moving between stagflation and deflation. Both of those environments are very negative for risk assets, but very supportive for the US dollar and longer-dated government bond yields as economic growth prospects deteriorate.
Evergrande: a difference of opinion
Ross Teverson, Head of Strategy, Global Emerging Markets, discusses the differing opinions of local and foreign investors about Evergrande, and explains why he remains cautious about the Chinese property sector overall.
There’s a real split of opinion about Evergrande between local investors in China and foreign investors. In general, from a local perspective, Evergrande’s debt crisis is not viewed as a systemic issue, for several reasons. The developer only accounts for around 3% of the Chinese property market, and the Chinese government has shown it can deal with big bankruptcies in recent years. Evergrande has far more exposure to some of the lower-tier cities, where there isn’t a supply constraint to support pricing; in contrast, for other developers in China that focus on cities like Beijing and Shanghai, there is greater confidence that property prices will ultimately be supported there due to supply constraints. Furthermore, while Evergrande has been slower to deleverage, many other developers have been better at meeting the government’s three red lines in terms of property sector regulation.
In contrast, the view among foreign investors is generally more negative, partly due to the sheer size of Evergrande’s liabilities, at over $300bn. There is far greater scepticism from these investors that the Chinese government can engineer a controlled slowing of the property sector.
Of course, it’s very difficult to know at this stage how it will play out. Over the past week we’ve seen some systemic risk getting priced into equity markets. Part of the reason for the de-rating of equities is the lack of clarity from the Chinese government. While most investors would like the government to lay out its plans for Evergrande, it needs to reduce moral hazard in the property sector and as a result I don’t expect it’ll be in a hurry to provide complete reassurance to the market.
I believe the base case is that pre-sold apartments will be delivered for those who have bought them – the government cannot afford for that not to happen – and Evergrande will likely get broken up and sold off in a controlled manner. Yet even in that scenario with the government controlling the process, we cannot get away from the fact that property has been a huge part of the Chinese growth story, at around 25% of GDP (directly and indirectly), and it simply cannot be as big a driver of growth now as it has been in the past.
Ed Meier, Fund Manager, UK All Cap, examines the factors behind the current energy crisis and how this might affect UK companies.
UK power prices have spent the last 10 years bouncing along between £30 and £40 per megawatt hour. However, the current energy crisis has caused prices to rise over 200% to £170 per megawatt hour. What has caused the current energy crisis, and what does this mean for UK companies going into winter?
The first thing to note is that the energy market in the UK has been brittle for some time. It just takes a few adverse events to occur to start a chain reaction leading to situations such as the current crisis in which we now find ourselves. One of the main factors behind this is the transition away from coal power. As coal power has come off the grid, gas has become a much larger part of our national energy consumption. This means that energy companies have become more sensitive to price movements in gas – a situation exacerbated by unseasonably low wind (which has replaced much of that coal generation).
The price of gas itself has been driven up by a confluence of factors such as a cold winter which caused a peak in demand in Asia. This has meant that LNG shipments which would have normally gone to the European market have instead gone to Asia. This, combined with production disruption in Norway, has led to natural gas storage levels touching 10-year lows as we prepare for winter.
So – what can help alleviate the current crisis? One natural way in which the crisis will be eased is if there is a mild winter, which would mitigate the demand for natural gas and allow storage levels to normalise. Another possible solution to the current crisis could be the Nord Stream 2 pipeline which transports gas from the world’s largest reserves in Russia to the EU. While this has been built, it is still waiting for German certification. However, it is important to remember that once certified it will take a while for production to ramp up to a level large enough to make a significant difference.
If none of this happens then natural gas must move out of “merit order” – that is become so expensive that the less efficient plants do not operate. Whilst we can already see this with news of fertilizer plants closing it also requires replacement electricity in most cases and this will be provided by coal in the first instance. Coal though – which is not environmentally friendly – has had little investment for the last few years so is itself somewhat scarce further driving the price of energy that much higher.
What does all this mean going forwards? Looking ahead into winter, I believe that companies with thin operating margins but reasonably sized utility bills could be in for a painful surprise and will have their resilience tested. On the other hand, companies that can provide flexibility to the UK’s energy needs will likely be winners in this environment.
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