Is Evergrande China’s Lehman moment?
Nick Payne, Head of Strategy, Global Emerging Markets Focus, assesses the latest developments in the Evergrande saga.
Troubled Chinese real estate company Evergrande has been dominating headlines. Some even fear China may be approaching a ‘Lehman’ moment. In September 2008 the uncontrolled bankruptcy of investment bank Lehman Brothers was the nadir of the US subprime mortgage crisis and ignited the Global Financial Crisis. In September 2021, the Evergrande Group, China’s second-largest property developer, is at risk of being unable to pay its debts. While the parallels may appeal to headline writers, they may also cloud sober analysis.
Property is highly important to the Chinese economy, accounting for about 70% of asset wealth compared with only 35% in the US. Chinese savers have fewer places to put their money than in the West. The importance of property ensures the Chinese government will do its utmost to head off systematic risk.
For several years, the Chinese government has been very concerned about the level of debt leverage among property developers. Its ‘three red lines policy’ is designed to keep property developers’ debts down: they must keep their liabilities below 70% of their assets, their net debt below 100% of their equity, and their cash higher than their short-term debts. Companies trespassing beyond those three red lines face penalties and would have difficulty raising further finance. Evergrande fails two of those red lines. Most Chinese property developers fail none.
The three red lines policy has had an effect. Average gearing among property developers in China has fallen from a peak of 92% in the first half of 2019 to about 64% in the first half of 2021. The property market in China is still growing both in terms of volumes of transactions and in terms of prices. Indeed, Chinese property prices have risen by about 6% year to date.
The problems faced by Evergrande are not new. They may have grabbed headlines recently, but they date back several years. Much of Evergrande’s difficulties appear to be of its own making. The company has had ample time and opportunity to sell a large book of non-core assets, in our view, or to slow its growth rate but has seemingly been unable or unwilling to do so. While its future remains hard to predict, one outcome could be that it will be carved up in a controlled restructuring.
Whatever the fate of Evergrande, for this to be a truly ‘Lehman’ moment, any fall would have to be uncontrolled, triggering a domino-like series of after-effects. Having studied the Chinese economy for many years, ‘uncontrolled’ is not the first word that would spring to mind in describing it.
Just as the US Federal Reserve is very concerned to avoid instability in the US stock market, so the Chinese government is at least as concerned to avoid instability in the property market, and to avoid lack of confidence and the consequent effect on Chinese peoples’ wealth, so much of which is invested in real estate.
UK: Transitory shocks, or structural change?
Matt Cable, Fund Manager, UK Small & Mid Cap, discusses the thriving UK IPO market and the transitory vs sustained inflation debate.
It’s been the busiest year for UK IPOs since 2014, with 77 IPOs year to date. It’s great to have many new businesses to look at, and of the 48 companies with above £50m in market cap at the time of listing, our team has participated in more than 10, having looked closely into around 30 offerings. The UK IPO pipeline for the rest of the year continues to look busy, and this trend is expected to continue into 2022.
The range of outcomes for IPOs can be quite wide. This gives more scope for fundamental-focused investors like us to offer a potential edge, as we can look to add value through companies that are not available on tracked benchmarks.
I always find the later part of the IPO cycle particularly interesting. Firstly, it’s when you start to see some of the more lower quality companies deciding to list, particularly those that are ‘lookalikes’ of other companies that have performed particularly well. Secondly, you start to see some investor fatigue, both in terms of less capital being available, but also in terms of some investors becoming less interested. Therefore, it can become a bit of a buyers’ market – as long as you are discerning, and you avoid the lower quality assets, there is the potential to find interesting opportunities at great prices.
Elsewhere, another hot topic in the UK market right now is about the outlook for inflation and rates. The debate really comes down to whether these effects are likely to be transitory, or if they’ll be more sustained.
Until recently, the general narrative was that we were likely to see a spike in inflation, but a transitory one, partly due to the base effect, given such a weak period at the peak of the pandemic. There were also expectations for short-term disruption due to freight costs, input cost inflation, and the transition into the Brexit world.
However, this narrative has now changed, particularly in the last week or so, as it’s become more apparent that some of these trends may persist. It’s looking more likely that we might see some structural changes to supply chains in the global economy, as businesses change their approaches to managing supply chains, with less focus on the lowest costs, and greater focus on resilience. From a Brexit perspective, we are also waiting to see how UK government policy will evolve.
The most recent, and high-profile, example has been the shortage of HGV drivers. If the government is genuinely looking to, through a market mechanism, push up wages and improve working conditions for lorry drivers, this would obviously result in cost increases for transport, which would also be structural. There’s a second-order effect too – if these things start to be perceived as structural, it becomes quite self-fulfilling.
While it’s difficult to know for certain whether some of these changes will be embedded structurally, rather than being transitory, as always, we remain mindful of how any developments might impact our portfolios.
The value of active minds: independent thinking
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