The bond slump of 2022 [PODCAST]
What are the historical parallels to past bond market drops and what are expectations going forward?
What are the historical parallels to past bond market drops and what are expectations going forward?
Thrivent Asset Management contributors to this report: Sharon Wang, Senior Equity Portfolio Manager; Jing Wang, Senior Equity Portfolio Manager; Nick Cai, Senior Equity Portfolio Manager; Yifang Cao, Director, Fundamental Equity Data Science
Real estate problems in China and some extraordinary actions taken by the Chinese government to reposition its economy are beginning to affect global capital markets while stoking volatility in the U.S. market.
The September/October time frame in the U.S. market has historically been the weakest period, on average – and 2021 has been no exception. There are many issues of concern for investors, including the surging delta variant, which is showing signs of impacting economic activity and possibly corporate profits, potential changes in personal and corporate tax rates (higher), potentially diminished monetary support from the Federal Reserve (Fed), and persistent supply chain issues which could diminish growth.
Questions over the direction of the Chinese economy have added to those concerns.
Emerging market returns, and especially Chinese market returns, have sharply diverged from the strong returns of the U.S. and European markets this year. The MSCI Emerging Market Index is down 2.5% year to date. China has been a major contributor to this poor performance, given that it constitutes about one third of the MSCI Emerging Market Index. The MSCI China Index, which had surged to start the year as “reflation” hopes prevailed, has now fallen into a disconcerting bear market, down over 17% year to date.
By comparison, the U.S. stock market has increased steadily throughout 2021, with the S&P 500® up more than 19% through late September. And, while we saw a post Labor Day pullback of 3 to 4% in U.S. equities, a monthly pullback in the range of 2 to 4% has been par for the course for the U.S. market throughout most of 2021.
For many years there has been skepticism regarding the real estate market in China. Huge amounts of capital, much of it borrowed, have been pumped into building out entire cities. Massive multi-family structures were built with the belief they would be occupied in short order as the country became more urbanized. Significant real estate debt problems are now surfacing in China, which echoes the real estate bubble that fueled the 2008 financial crisis in the U.S.
Evergrande, the real estate behemoth in China, with total debt of over $300 billion, is in crisis mode. To put this in perspective, the Lehman Brothers default, which is considered the catalyst that led to the market collapse in 2008, had total debt of roughly $600 billion. There are also other large Chinese real estate companies that may have similar problems. It appears that a restructuring of Evergrande and/or default may be imminent. However, it is unclear what a resolution to this debt problem will look like given the very different legal, regulatory, market, and political environment in China.
For now, it appears that the financial implications of China’s real estate problems will not reverberate throughout the entire global financial system. However, it will impact economic growth in China. And, given China’s size and influence as the world’s second largest economy, it may also affect economic growth and commodity markets elsewhere. Given the opaqueness of this problem and the uncertainty this causes for investors, it is likely that this problem will persist as a depressing element to equity market valuation in China, as well as other emerging markets.
These developments could lead to a downshift in Chinese growth – at least in the near term, if not longer. Although growth in China is still expected to be higher than developed countries, it may not be as robust as it had been in the past. That, in turn, could have an adverse effect on other parts of emerging markets that trade with China, as well as the developed world. And the consolidation of authority under President Xi Jinping, along with shoring up his “base” by addressing income inequality, could mean continued confrontation with the U.S. Over time, it may even increase the odds of an event, such as an attempt at retaking Taiwan or a mistake in the South China sea.
Economies around the world have shifted dramatically over the past 50 years, from being driven by labor, natural resources, and manufacturing, to now being driven by capital, data/information and services. These changing dynamics have contributed to significant disparities in income and wealth distribution around the world.
Environmental, social, and data ownership/security issues have also become key problems that governments feel compelled to address. Finally, a very small number of information-based corporations have amassed such economic influence that governments are closely scrutinizing them and considering regulations to constrain their power.
In the U.S., and for Western developed countries as a whole, these issues are addressed in what can be a messy, inconsistent, and slow democratic process. Regulation, government institutions and tax policy are the key tools that Western democracies use to address issues. The approach by Western democracies is incremental, iterative, and oftentimes contentious and inefficient. Although this approach can certainly hinder timely and optimal approaches to problems, it rarely involves direct insinuation of government intervention into corporate activities.
This is not the case in China, where its one-party Communist rule can be used in a vastly different manner than in the West.
China, led by its powerful President Xi, also feels the need to address income and wealth disparities, as well as a host of other social, financial and political challenges. In addition, it has a unique demographic problem of a rapidly aging population, following decades of its disastrous “one child” policy.
China’s minimal social safety net programs are not prepared for the dramatic increase in older citizens that will require support. Unlike Western democracies, China is responding to these challenges by insinuating its authoritarian power in the structure of the Chinese economy and markets. It has directly cracked down on large corporations and industries in an attempt to change their strategic direction such that all economic entities will contribute to “common prosperity” and “socialism with Chinese characteristics.”
This has meant re-directing corporate profits for broader social needs, changing financial market regulations, and trying to reshape industries, such as the large private tutoring and gaming industries, so that they align with the goals of the government/party.
Global investors were caught off guard by the swiftness, magnitude, and breadth of the actions that Chinese authorities took to alter the mission and strategies of very large Chinese companies and industries. There is concern that profits from many large public companies will be diverted from shareholders to aid in the funding of social programs. There is also concern over significant regulatory changes that could seriously impact the financial model of entire industries, such as the for-profit education and gaming sectors.
In addition to profit concerns, there is the potential that such heavy-handed polices regarding business and markets will have a very damaging effect on the innovative drive of Chinese entrepreneurs. This, too, will weigh on Chinese market valuations.
China has proven over centuries, if not millennia, that it can play “the long game.” The governing party is intent on preserving social stability and political control, even at the expense of near-term economic growth. Furthermore, President Xi seems intent on becoming one of China’s transformational rulers, similar to Chairman Mao. His nationalistic and populist moves are aimed at garnering widespread approval of the common citizen, while curtailing the influence of corporations and the ultra-wealthy class of Chinese citizens.
For many years, corporations and investors have viewed China, with its enormous population and manufacturing capacity, as an attractive opportunity. Investment dollars flowed into the country, significantly contributing to the rapid growth of the Chinese economy. However, investors are now questioning this China narrative and examining other details of the investing environment.
One disconcerting detail that investors are now focusing on is the question of what ownership in Chinese equities really means. Direct foreign investment in Chinese companies is prohibited by Chinese law. In response, corporations and investment banks have developed “work arounds” such as Variable Interest Entities (VIE), that provide investors with essentially indirect ownership of shares in Chinese companies. However, these “work around” structures are rather opaque and have no shareholders rights whatsoever. Another major issue is the question regarding the integrity of accounting and auditing standards applied to Chinese companies. The SEC is now examining this area as it tries to provide more information and clarity to corporate disclosures.
In summary, it appears all these developments are not transitory but are secular in nature. From a near term perspective, the Chinese central bank will provide liquidity to soften the impact of not only actions being taken to resolve the real estate debt crisis, but also the new initiatives being taken to promote Chinese “common prosperity.” However, they will have long-term effects not just on the Chinese economy and markets, but also on emerging markets overall given the heavy weighting of Chinese oriented securities in those indices.
Within Thrivent’s mixed asset funds, we remain underweight in emerging markets equities given decelerating growth in China, the government’s ongoing aggressive intervention across multiple sectors, and the country’s large weighting in emerging markets indices. More broadly, we are positioned modestly overweight in equities with a preference for domestic equities.
All information and representations herein are as of 09/28/2021, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.
Past performance is not necessarily indicative of future results.