The Knee-Jerk Lesson From This Week's Evergrande Story

Editors' Note: MarketMinder doesn't make individual security recommendations. The below merely represent a broader theme we wish to highlight.

Here is a tidbit so run-of-the-mill it seemingly shouldn’t merit mention: Stocks were flattish Friday and finished the week up 0.5% in price terms.^[i] Seems typical, even boring. But typical, boring weeks don’t start out with -1.7% routs and warnings that a too-big-to-fail Chinese property developer is about to default, allegedly sparking China’s “Lehman Moment” and sending shockwaves globally.^[ii] Indeed, the events so many feared actually came closer to happening—yet markets shrugged it off. In our view, this is the latest example of the dangers of reacting to negative headlines.

At the week’s outset, pundits globally argued the world was on the precipice and that a default by Evergrande—a massive Chinese property developer—would cause a mainland financial crisis, wrecking markets globally. Some saw pure financial risks, via developed-world banks’ potential exposure to Evergrande’s roughly $300 billion in debt. Others warned the company’s collapse would implode Chinese real estate markets, spurring the long-feared economic hard landing. When the company announced on Wednesday that it had reached an agreement to pay the roughly $36 million in interest owed to onshore investors in yuan-denominated bonds, the general reaction was, yah but just wait for that $84 million payment due to overseas investors on dollar-denominated bonds Thursday. Meanwhile, the central government indicated it had no plans to bail out the company and directed local governments to step in with targeted support for local businesses and homeowners only if absolutely necessary to prevent protests and other undesirable disorder.

Thursday’s deadline came and went without a peep from Evergrande, and overseas investors didn’t see a dime of that $84 million. Evergrande isn’t yet in default officially, as there is a 30-day grace period, but the bonds in question are trading as if default is a foregone conclusion. Meanwhile, Beijing signaled support for the millions of people who have bought unfinished homes from Evergrande, reportedly ordering local governments to provide cash for construction as needed while ensuring the company can’t divert the money to debt service. While there are no official policy pronouncements as of yet, it implies the government is focused on making residents whole while letting market forces play out for overseas investors. Time will tell how they treat domestic investors in the event Evergrande misses a local payment. There is precedent for making investors whole while letting companies suffer the consequences of default, as the government did when solar panel manufacturer Chaori Solar defaulted in 2014, but there is no consistent blueprint.

At any rate, we think it is fair to say that the chain of events pundits feared would happen actually happened: A missed bond payment and no official bailout. And yet, markets didn’t crater. After Monday’s rout, the S&P 500 was flattish Tuesday, up 1.0% Wednesday, another 1.2% on Thursday and finally 0.2% on Friday.^[iii] Yes, stocks just sort of sighed in response to the missed payment. We never advise reading much into short-term moves, but we do think that if this missed payment was the trigger for an economic collapse and financial crisis, stocks probably would have registered it.

Instead, we got a classic reaction to false fears: a selloff as negative headlines panicked everyone, followed by a quick recovery as people gradually realized the world wasn’t ending. The news coverage also became less apocalyptic as the week rolled on, with many pundits (rightly, in our view), pointing out that China’s financial system was too walled off from the rest of the world for troubles there to ripple globally even if Evergrande were a huge mainland negative after all. Cooler heads prevailed with time, as they often do.

Let this be a lesson: Reacting to fear and big short-term drops is always and everywhere an error, not least because markets are forward-looking and efficient. By the time Thursday’s missed payment made headline news, markets had already priced it in thanks to all of this week’s chatter. Surprises move markets, and after the early-week shouting and volatility, there was no surprise power left. We suspect markets are probably already looking past the 30-day grace period to the upcoming scheduled interest payments and pricing in the seemingly high likelihood of more missed payments. Without the surprise factor, this likely fades into the long-term backdrop, as such company-specific things usually do.

We also have a philosophical disagreement with all the coverage portraying Evergrande as a potential “Lehman Moment,” which we think has implications for investors. Using that phrasing implies Lehman Brothers itself was the fundamental trigger for the 2007 – 2009 global financial crisis and recession. But that isn’t really true. Lehman Brothers was one of several banks and investment banks forced to take huge capital hits when accounting rules in force at the time required all banks to write down the value of their comparable illiquid assets to the most recent sale price—even if they never intended to sell said assets, and even if they were still generating interest payments. So when funds sold mortgage-backed securities at firesale prices throughout 2008, taking big losses, it forced Lehman and the rest to take equivalent paper losses. When it failed, it wasn’t technically insolvent, as the value of its assets exceeded its liabilities. But it didn’t have the cash needed to meet the most pressing liabilities. Fed meeting transcripts show the Fed and Treasury then made a deliberate decision to force it into bankruptcy, shocking investors because it was such an about-face from how they had handled Bear Stearns, Fannie Mae and Freddie Mac. It was the inconsistent policy, in our view, and not the failure itself, that sent markets reeling in the aftermath. Not one investment bank’s failure.

While it remains to be seen exactly how the Evergrande saga will play out, we think there is a potential silver lining many overlook: the chance for the world to see a large company can fail in China without causing economic catastrophe. China has only recently begun allowing private firms to default, and Evergrande is the biggest test of that resolve. If the government lets it disintegrate and the economy doesn’t crash, that might help investors finally start moving past one of their longest-running fears.