Anatomy of a Selloff

Stocks began this week in freefall, ending down 1.7% on Monday, though off deeper lows on the day.  The prime culprit to the selloff was the liquidity woes of Evergrande, a large Chinese property development company.

Evergrande is one of China’s largest property developers, with some 1,300 projects across more than 280 Chinese cities.  Moreover, they have made investments in operations that cross into other unrelated industries, including wealth management, electric vehicles, media production, a soccer club, and a mineral water company.

Evergrande funded its growth through the aggressive issuance of debt.  It is the world’s most indebted property developer, with over $300 billion in liabilities.  Its cash on hand, by contrast, is a relatively paltry $15 billion, and the company is facing a series of near-term debt service payment obligations.

A classic financial truth is that, in tough times, excessive debt causes exceptional risks to the borrower.  The cash crunch at Evergrande coincides with a general slowdown in China’s property market, exacerbated no doubt by the Covid-19 pandemic, but also hindered by tougher lending standards set forth by the Chinese administration in an effort to cool their property boom.

Having learned of Evergrande’s financial stress, investors were quick to de-risk.  Memories of the 2008-09 financial crisis remain fresh, even thirteen years later, and fears that Evergrande’s problems could provoke a financial contagion prompted a fast selloff in world stock markets.

It remains to be seen whether Evergrande ultimately fails.  The company announced that it had made a required interest payment due today.  Another debt payment is due Thursday, and yet another looms next week.  Should Evergrande fail to make payments on its debts, the company’s lenders – including some of China’s largest banks – will come under further pressure.  Resolving the Evergrande situation will be a sizable and generally unpleasant undertaking for the Chinese financial sector, and the Chinese government.

US and global stock markets have been remarkably resilient this year, hitting record highs on several occasions.  These gains have come despite a lengthy list of investor worries:  the impact of the covid delta variant, slowing economic growth, inflation, supply chain chaos, a growing political standoff in the US over the debt ceiling, and the potential for central banks to begin withdrawing stimulus measures.  Most of these risks are well-known to investors, which has allowed them time to adjust and adapt their market expectations.

Then came Evergrande and its situation, one largely unknown to the majority of investors.  Given the uncertainty surrounding the company’s debt obligations and its ability to pay, and resulting impacts on the global financial system, investors took a “sell first, and ask questions later” approach to the issue.  Though the matter is far from resolved, in only a few days Evergrande is moving from the column of unknown (or unanticipated) risk to one of known risk, similar to the other risk factors we note above.  Investors are handicapping the new risk, as they have done for all the others.  The early collective verdict is the Evergrande matter is a localized problem, largely contained to the company and its lenders, the Chinese economy, and ultimately to the Chinese financial system, but not the global system more broadly.  We tend to agree with the assessment, only adding that a property recession in China could hit some US stocks with supply-side exposure to the sector.

Is there a lesson to draw from Evergrande?  We think so… as we noted, the list of reasons the market could sell off is not a short one, and encompasses some pretty weighty issues.  Market drawdowns are an entirely normal feature of the stock market. Over time, they are a constructive force for stocks and stock prices, and help to keep risks contained and markets in balance.  Selloffs can range from a mild few percent (a frequent occurrence) to a deeper correction (an annual or so occurrence) to, occasionally, something more significant.  But in general, selloffs provide the mechanism for markets to cleanse themselves of excesses, for investors to regroup, and for risks to be properly identified and priced.

There may, and likely will, be more market-moving news from Evergrande.  As we do, the Ascent team will monitor impacts and chart our strategy with the interests of our clients first, always.

Respectfully submitted,

Scott C. McCartney, CFA

Partner & Chief Investment Officer

Mark Moshier, CPA

Partner

Brad Kowalczyk, J.D., LL.M

Partner