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Butterflies Flapping Their Wings

We remember the great events of history, but we seldom remember the path it took to get to them.  The convoluted sequence of events and decisions that have led to memorable, sometimes cataclysmic, outcomes are muddied by the effects of time and the bias of hindsight.  This is especially true of watershed moments in the financial markets, where rarely can one single decision be attributed to the cause of major financial consequences.  The markets are a chaotic system that tend toward stability, but occasionally become frightfully unbalanced.

It was in describing “chaos theory” in 1963 that mathematician and meteorologist Ed Lorenz described how very small changes in weather forecasting inputs could lead to surprisingly large changes in outcomes. In a subsequent paper, he asked, tongue in cheek, “Can the flap of a butterfly’s wings in Brazil cause a tornado in Texas?”  This has become part of the English lexicon now known as the “butterfly effect,” the idea that small things can have non-linear impacts on a complex system.

Today, we believe the most prominent butterfly for investors is the Chinese real estate market.  In particular, a company called Evergrande could be signaling changes to the financial world that may have broad consequences.  Evergrande popped into the headlines a few weeks ago, but given the short-term memory of today’s media outlets, was quickly forgotten in favor of covering billionaire’s space tourism follies.  It is a name we should remember, as it is likely to go down in the annals of financial history.

Evergrande is the second largest real estate developer in China, with projects ranging from apartments to vacation resorts.  They have about $300 billion in liabilities which are becoming increasingly difficult to meet.  That’s because Evergrande, along with many other Chinese real estate firms, has relied on Ponzi-style financing to complete projects.  Aside from traditional (junk bond) issuance, Evergrande also relied on large deposits from homebuyers and “wealth management products” (WMP, a sort of high-yield certificate of deposit) to fund its operations.  Bond holders, depositors, and WMP investors are now facing major losses because of Evergrande’s inability to repay them.

We have long said that ever-expanding debt levels are unsustainable because, inevitably, someone wants their money back.  This was the cause of the mortgage implosion in 2008, the collapse of the junk bond market in the late 1980s, and the unravelling of Bernie Madoff’s fraud scheme.  Evergrande is no different.  Construction has ground to a halt on most of their projects, leaving workers unpaid.  WMP buyers are trying to recover their investments, but there are no funds to meet maturity obligations.  And apartment buyers are faced with the loss of their deposits for buildings which may never be completed.  So profound was the grief among ordinary families who looked on Evergrande as a sure thing they occupied the company’s headquarters in Shenzhen and held executives hostage in their offices.

Chinese premier Xi Jinping certainly owns some of the responsibility for Evergrande’s fate.  Xi has introduced a much stricter doctrine of communism in recent years, beginning with his 2018 abolition of presidential term limits.  Called “Xi Jinping Thought,” the doctrine is a blueprint for consolidating power at the top of the communist party and purging China of capitalist excesses.  This led to suppression of democracy and free speech in Hong Kong, leaving the Hong Kong media a shell of its former self due to Chinese censorship.  Afterwards came a general crackdown on billionaires, unequal distribution of wealth, and the stratifying effects of capitalism in general.

With this change of societal direction under Xi Thought may be coming a greater willingness, indeed a necessity, to squeeze out many of the effects of capitalism, namely over-leverage and over-speculation.

The Chinese authorities are walking a tightrope between managing the deflating real estate sector and widespread social unrest as millions see their savings disappear.  Since Xi Thought is focused on reducing inequality and boosting “common prosperity” it seems likely the middle class will be aided well before the Wall Street class.  It would not be surprising if the Chinese allowed a broad default among financial firms, especially foreign ones, while making the middle class whole, driving home the message that Xi Thought is the thinking of the future.

Stress in the real estate sector can be seen in Chinese high-yield (i.e. junk) bond markets.  From a low of around 8% mid-2021, yields have spiked to over 20% before settling back a bit.  Evergrande has been able to juggle its books and make some recent interest payments, thus avoiding default for now, but the handwriting seems to be on the wall.

Total sales among China’s 100 largest property developers plunged by 36% in September from a year earlier, according to the Wall Street Journal.  Sales by the 10 biggest developers, including Evergrande, collapsed by 44%.  By some estimates, real estate counts for about 30% of China’s economy.  This body blow cannot help but adversely impact Chinese demand at almost every level.

U.S. investors may feel these problems are a world away, but like a butterfly’s effect on the weather, the impact of China’s real estate recession may affect our financial markets in unexpected ways.

We believe there are three issues that Evergrande’s plight brings home to domestic investors.  The first is that problems for the current bull market are likely to be liquidity driven, rather than economically driven.  China is taking overt steps to reduce debt and leverage in its economy, as Xi sees surging debt as the toxic fruit of financial speculation and adulation of billionaires as a mockery of Marxism.  Numerous central banks have already started taking baby steps to combat inflation by raising interest rates.  The U.S. Federal Reserve has begun telegraphing its intent to reduce its money printing efforts beginning late 2021 as they come under increasing pressure to take steps to control inflation.  All this will reduce the amount of cash flowing to financial markets, constraining a major source of fuel for rising stock prices.  The symbolism of moving to tighter monetary policy will not be lost on investors, as it signals a reversal of an implied guarantee by the Fed that every correction will be met with a new gusher of money printing.

Second, we should look to our own real estate market for signs of potential trouble for the bull.  Based on the CoreLogic Case Shiller price index, single-family home prices increased 19% over the last twelve months, a record increase.  While this has elated home builders, home buyers have reached the point of discouragement due to high prices and cutthroat competition for the limited homes for sale.  The latest survey from Fannie Mae below shows home buyer sentiment plumbing recent lows (gray line), implying that we may be reaching peak prices for this real estate cycle.  And this does not account for the many half-full office buildings left empty due to covid contagion worries.

This mirrors the drop in consumer sentiment as measured by the University of Michigan, which came in at 71.4 and equal to the lows of the early stages of the pandemic.  It is highly unusual for consumer sentiment to be declining as the economy grows, but homebuying frustrations, supply chain shortages, rising inflation and the persistence of covid restrictions have combined to sour America’s mood.  If this trend continues, we should expect consumer spending habits to dampen economic growth in the coming winter.

Finally, we can’t ignore the high levels of debt within our borders.  Most pressing for investors is the record level of junk bond issuance and the high levels of margin debt helping prop up stock prices.

Junk bonds, of course, are issued by less creditworthy borrowers who must pay a premium yield to entice investors to buy their bonds.  That premium has all but disappeared due to the junk bond issuance bonanza fueled by the Fed’s implicit backstopping of corporate bonds, demand from the need to finance mergers and private equity deals, and yield-starved investors seeking income anywhere they can find it.

Being very sensitive to liquidity, that is, the amount of cash looking to be invested, the junk market serves as a fever chart reflecting the stress financial markets are feeling, with yields rising as stress increases.  Any contagion from the Chinese real estate debacle should manifest itself in higher junk bond yields.  

They potentially have a long way to go.  Junk bond yields today are only 4.3%, a record low, and seem blissfully complacent about developments in China.  However, they reached 14% during the 2000-01 period when the internet bubble collapsed, 21% in 2008 during the mortgage meltdown, and 9% when covid first hit the economy.  You can track these yields for free at the St. Louis Fed’s FRED database here:

Evergrande should be a wake-up call to all investors that risks, especially of leverage, are mounting at the same time inflation is rising and the Fed is preparing to cut back on stimulus.

When the name Evergrande burst into the headlines, pundits asked whether this was China’s “Lehman Moment,” referring to the bankruptcy of that storied firm in 2008.  Not many noted that almost a year before Lehman went bankrupt, the major brokerage Bear Stearns did.  Conventional wisdom among the Treasury and Wall Street brain trusts at the time called Bear Stearns an isolated incident and proclaimed the mortgage crisis “well contained.”  Yet the underappreciated effects of this “butterfly” continued to haunt investors for years afterwards.

Perhaps Evergrande is only the “Bear Stearns Moment,” with the Lehman Moment still ahead of us?