There are several headwinds perceived in weaker global growth, concerns about inflation, rising input costs, maximum profit margins, the Fed's policy shift, and recently concerns about China's credit markets.

But let's take it one step at a time.

How concerned should investors be about the Evergrande problem?

To begin with, it is good to give a little background information:

•   The real estate sector has always been highly regulated given the major role it plays in the economy and has experienced multiple cycles driven by ​​by periodic regulatory adjustments. However, regulations have evolved over the past two years, shifting from land auctions to balance sheet management to reduce macroeconomic risks. This is very much in line with a broader goal of China prioritizing economic and social stability.
•   We believe that the current problems facing the sector are more specific to the company, exacerbated by regulatory tightening. The government is clearly trying to force state-owned enterprises to be more careful in their risk management, so defaults may be allowed. That said, we believe these would be relatively “orderly” without triggering systemic risk. To contain spillover effects to the system, the central government is likely to ask local governments to inject capital or ask other developers to perform “national service” by taking assets from developers facing liquidity problems.
•   Several developers have faced liquidity problems in this cycle. However, even the largest companies at risk have total interest-bearing debt that is less than 0.5% of total corporate debt in the system, and most of the debt (especially bank loans) is secured by real estate assets. Currently, the government is prioritizing the smooth delivery of apartments that have already been sold to ensure that there are no public complaints and that confidence in the sector is not affected.

However, although China could carefully manage any potential default or restructuring of Evergrande to protect the financial and real estate markets, it may need to do more. Economic data is already weak, and a clear message from the government is needed to shore up confidence and stem the domino effect. Failure to act poses a significant downside risk to growth going forward.

•   In this regard, there is widespread market expectation that the Chinese government will announce measures to support the economy in general before the October 1 national holiday, which commemorates the formal proclamation of the establishment of the People's Republic of China. This is considered a major issue for Xi Jinping, and therefore the government is unlikely to tolerate any risk of chaos or turmoil in the economy ahead of this celebration. Current policies on property financing are very strict, in terms of loans to developers, loans for land acquisition, trust/private equity funds, and mortgage loans. Not only is it difficult to obtain funds for new projects, but also to recover cash from completed projects. There should be some relaxation in mortgage lending before the end of the year, otherwise the real estate sector could face more systemic risks.
•   Finally, the People's Bank of China has continued to inject short-term liquidity into the banking system through seven- and 14-day reverse repurchase agreements to manage concerns about the state of its real estate and credit markets.

In summary, we do not believe that the sector faces systemic risks; overleveraged developers will gradually sell their assets with the support of central and local government when necessary.

In another significant milestone, the Fed strongly hinted that it will begin to reduce asset purchases after the next FOMC meeting in early November. This week's post-meeting statement indicated that if economic progress "continues broadly as expected," then a slowdown in the pace of purchases "could soon be warranted."

The signal of reduction was eagerly awaited, given the strong indications in previous statements. Although there are certain conditions attached to the November decision to gradually reduce purchases, Powell made it clear that it would take a major disappointment to divert them from their course.

But Powell went a step further by noting that "a gradual reduction process concluding in the middle of next year is likely to be appropriate." This implies a reduction per meeting in the monthly purchase pace of $10 billion for Treasury bonds and $5 billion for MBS.

Regardless of how the story ultimately ends, and barring any major inflationary surprises, things continue to point to a very gradual normalization that would keep financial conditions fairly accommodative, and despite concerns about the recent downturn in economic data, we remain confident that strong growth is ahead and activity is set to accelerate again. We believe the recent slowdown is temporary and is mainly driven by the delta wave.

We do not expect permanent destruction of demand from this wave of Covid, but rather a delay in reopening and economic normalization. In fact, a growing number of indicators point to a turning point in the Delta variant. As Covid continues to subside, strong momentum should continue into 2022 as companies begin to rebuild depleted inventories and increase capital spending. Central bank policies should remain growth-oriented, and even China's slowdown is likely to be offset soon by a policy shift. 

In this context, risk assets should continue to perform well, and bond yields appear to be finding a floor, which is generally a good sign for cyclical value leadership.

A final thought. We see a lot of emphasis on high equity valuations, but less is said about the unattractive nature of base rates and corporate spreads, with little room for compression.

In this regard, we believe that the correct approach is to continue overweighting equities over fixed income, where relative valuations continue to offer a generous premium for their history, while for fixed income we recommend a conservative approach in terms of duration.

Investors should note that the Fed is moving forward because it has more confidence in the economy and will continue to provide support. While higher bond yields reduce the relative attractiveness of stocks, a gradual rise in bond yields should be more than offset by the positive impact of rising corporate earnings as economies return to normal.. Therefore, the Fed's tapering should be viewed as the gradual withdrawal of an emergency support measure as conditions normalize.