There are several headwinds, including weaker global growth, concerns about inflation, rising input costs, tight profit margins, the Fed’s policy shift, and, most 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 issue?

To begin with, it's good to give a little background:

•   The real estate sector has always been heavily regulated given the significant role it plays in the economy, and it 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 objective: China is prioritizing economic and social stability.
•   We believe that the current problems facing the sector are more specific to the company, exacerbated by tighter regulations. 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 defaults would be relatively “orderly” and would not trigger systemic risk. To contain spillover effects on the system, the central government is likely to ask local governments to inject capital or ask other developers to perform a “national service” by taking over assets from developers facing liquidity problems.
•   Several developers have faced liquidity problems during this cycle. However, even the largest companies at risk have total interest-bearing debt that accounts for 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 there are no public complaints and that confidence in the sector remains unaffected.

That said, while China could carefully manage any potential default or restructuring by 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. The absence of such action poses a significant downside risk to future growth.

•   In this regard, there is widespread market expectation that the Chinese government will announce measures to support the economy as a whole before the October 1 national holiday, which commemorates the formal proclamation of the establishment of the People's Republic of China. This is seen as a major challenge 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 real estate financing are very strict, covering loans to developers, land acquisition loans, trust funds and private equity funds, and mortgage loans. It is difficult not only to obtain funding for new projects but also to recover cash from completed projects. There should be some easing of 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 7- and 14-day reverse repurchase agreements to address concerns about the state of its real estate and credit markets.

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

In another significant development, the Fed strongly hinted that it will begin to taper its 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 a rate cut was eagerly anticipated, given the strong indications from previous statements. While there are certain conditions attached to the decision to gradually cut rates in November, Powell made it clear that it would take a major disappointment to derail them from their course.

But Powell went a step further, noting that “a gradual tapering process concluding in the middle of next year would likely 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 plays out, and barring any major inflationary surprises, the outlook continues to point toward a very gradual normalization that would keep financial conditions fairly accommodative, and despite concerns about the recent downward revision in economic data, we remain confident that strong growth is on the horizon and that economic activity is set to pick up again. We believe the recent slowdown is temporary and is driven primarily by the Delta variant.

We do not expect this wave of COVID-19 to permanently destroy demand, but rather to delay the reopening and economic normalization. In fact, a growing number of indicators point to a turning point for the Delta variant. As long 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 the slowdown in China will likely be offset soon by a policy shift. 

In this context, risky assets would continue to perform well, and bond yields appear to be bottoming out, which generally bodes well for cyclical value stocks.

A final thought. We see a lot of emphasis on high equity valuations, but there is less discussion of how unattractive base rates and corporate spreads are, with little room for them to narrow.

In this regard, we believe the correct approach is to continue overweighting equities relative to fixed income, where relative valuations continue to offer a substantial premium compared to historical levels; meanwhile, for fixed income, we recommend a conservative approach in terms of duration.

Investors should keep in mind that the Fed is moving forward because it has greater confidence in the economy and will continue to provide support. While higher bond yields reduce the relative appeal 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.