The debt problems at China Evergrande Group, a large Chinese real estate developer, were the ostensible trigger for a cumulative five percent pullback from all-time highs during Monday’s trading session. A late day rally of slightly more than one percent from its intraday lows brought the S&P 500 decline to 1.70% for the day. On a closing basis, the S&P finished 3.95% below its closing high of 4,536.95 reached on September 6th. Cyclical sectors such as energy, consumer discretionary and financial services led the S&P 500 lower on Monday while safer ones such as utilities and real estate experienced the smaller declines.
Evergrande is one of the largest Chinese real estate players. It has debt around $300 billion, owes various vendors billions, and has many projects in various stages of development. The company appears to be bankrupt, and the only question is how much debt it defaults on and how it restructures. Neither us nor other market participants know how this will play out. The answer is dependent on the Communist Party and President Xi. Investor concerns include the possibility of contagion in China if defaults ripple across the economy and a potential economic slowdown which could dampen the current economic recovery. We believe that economic stability is one of the primary concerns of China’s Communist Party and so while there will be losses they will likely be contained. More importantly for domestic investors, we do not think this will move around the world a la Lehman Brothers. U.S. credit markets have remained fairly composed with credit spreads near recent lows. This was not the case in 2008 right before Lehman Brothers defaulted. Credit markets at that time were warning of an impending slowdown for global economies and a steeper decline in equity markets.
We do not want to diminish the Evergrande story. It is an important event that must be monitored. On the other hand, a market pause was needed and welcomed. The S&P 500 is up a little over sixteen percent through Monday’s close and this pullback will remove some of the froth from equity markets. If it wasn’t Evergrande, something else would have triggered it. Now that a pullback has happened, we feel it is time to selectively move back into stocks for those at less than full equity exposure.
We believe markets are likely to remain choppy into earnings. This is around the time of the quarter when corporations are not allowed to buy back their own stock. Thus, a key source of equity demand will be temporarily removed. Nevertheless, with interest rates this low and earnings growth robust, the S&P 500 is probably close to a bottom. While now is not the time to place large bets, it is also not the time to take a lot of money off the table.