Transatlantic Panic: Evergrande & the Federal Reserve Meeting

*Written September 22nd

Two major events this week will prove to be pivotal to both investors’ short and long-term investment strategies. On the one hand, US investors wait in anticipation of the Federal Open Market Committee (FOMC) meeting for projections regarding upcoming US monetary policy. While on the other hand, investors are witnessing growing fears as the Evergrande Real Estate Group begins defaulting – causing a worldwide economic contagion. Global indexes such as the Hang Seng Index, the Stoxx 600 Index, and the S&P 500 Index slumped 3.7%, 1.7%, and 1.7% respectively do to these concerns.

Federal Reserve Meeting

The FOMC holds eight meetings annually in order to assess economic and financial conditions to determine the appropriate stance on monetary policy. This includes assessing its risks to long-term goals such as price stability and sustainable economic growth. On a quarterly basis the FOMC releases a Summary of Economic Projections (SEP) that includes indicators such as GDP, inflation, and unemployment for the upcoming years.

After the COVID-19 crisis hit the economy, the US government underwent the largest asset purchase plan in US history. As part of this plan, the government has been purchasing $80 billion worth of Treasury securities and $40 billion of mortgage-backed bonds each month. Those assets are later added on to the federal reserve’s balance sheet, which has risen to a staggering $8 trillion since the beginning of the pandemic.

Most of the speculation around the FOMC’s September 22nd-23rd meeting is in regards to tapering. Deciding when to begin the cumulative roll back of purchases and over a what period of time will have a notable affect on the stock market. For this reason, the Fed has treaded very carefully around this issue but many anticipate tapering to begin before the end of this year.

The Evergrande Panic

Meanwhile, panic has spread globally thanks to the Evergrande Real Estate Group – the second-largest real estate developer in China and a Fortune Global 500 member. Lately, Evergrande has been witnessing liquidity problems, which recently turned into an overall solvency crisis. The company’s troubles began when it racked up $300 billion in debt while attempting to facilitate expansion, but they compounded when it began offering its properties at a discount to promote cash flow. The company had a debt scare in 2020 which was narrowly averted but caused Evergrande to develop a plan for cutting back its $100 billion debt pile by mid-2023 though a series of asset sales and stock offerings.

The situation is looking very grim considering the company’s $300 billion debt. By the end of the year $669 million in coupon payments come due as well as $2 billion in outstanding bonds in March. By April another $1.45 billion will be owed. Already, Evergrande is expected to miss its bond payment of $83.5 million on September 22nd as well as others in this month.

In light of this mounting debt, its current state is being compared to Lehman Brothers fall during the 2008 financial crisis. It is sending similar shockwaves throughout the global financial market in much the same way as volatility hits some of the largest sectors such as oil and technology. Even cryptocurrencies such as Bitcoin, Ethereum, and dogecoin have been caught up in the selloff.

Fearing a spillover will affect companies exposed to Evergrande and the Chinese real estate market as a whole, panic has created a contagion in global markets. As the world waits to see whether Evergrande is too big to fail and how the PRC will react, the downslide of a major company in such a pivotal industry has already fed into the narrative of China’s slowing post-pandemic recovery. If this is the case, the worldwide economic recovery will undoubtedly slow as well.

However, not everyone agrees. Some economists argue that the fall of Evergrande is unlikely to have a substantial effect on the American economy because the company’s debt is mostly in the Chinese Yuan and not in US dollars or other major currencies. But the slowing of the world’s second largest economy and a major trading partner for most of the world, will have obvious affects across the globe. Given the PRC’s political structure, it is certainly possible that the government may choose to let Evergrande fail which would have undesirable effects for not just the Chinese economy but the world’s as well.

Effect On The Stock Market

If the American economy is not linked directly to Evergrande’s future then what is sending investors into a selling frenzy? As Art Hogan – Chief Strategist at National Securities- explained, “You’ve got a whole basket of things to be concerned about — throw this headline into the mix and that throws everything askew”.

It appears that the fear of FUD is inadvertently creating a great deal of FUD as fear of a possible contagion spreads a risk adverse sentiment amongst investors – leading to irrational de-risking. As a result, this crisis is spilling over into unrelated industries, which the US market and others are currently showing.

Domestically, investors are already weary of the current rate of inflation as worry increases that this is not only a transitory phase caused by the pandemic. This has fueled a trend towards higher quality stocks which investors see as more stable in times of uncertainty. Because larger companies are often much more resilient they can better maneuver rising cost environments. For the same reason, stocks with a track-record of maintaining healthy profit margins during times of crisis are also outperforming lower value stocks at the moment.

Fed Meeting Prospects

Now the question is how policymakers in the FOMC will react to the growing economic turmoil? Earlier predictions pointed to starting tapering by the end of the year as the need for economic stimulus was reduced. The Fed also promised to keep interest rates as low as possible into the next year but some economists have predicted tapering could be complete as early as mid-2022 with changes to interest rates soon following. In this case, some economists believe interest rates will remain close to zero until 2023.

However, with tense market conditions resulting from increased inflation and Evergrande motivated sell-offs, the FOMC is likely to tread lightly at this meeting. Inflation has risen above expected rates in the last couple of months, outpacing the increase in wages. Furthermore, the Delta variant has affected recovery and predictions of economic performance – restarting the debate over government stimulus and recovery plans.

What Investors Should Watch Out For

There are arguments on both sides regarding Evergrande’s impact on the US stock market. US, European, and even Asian stock markets have already started to rebound and stabilize, showing signs that this was only a reactionary fall and not a substantial one.

Tuesday saw improvement for Wall Street’s blue-chip stocks as the S&P 500 gained 0.8% after suffering a 1.9% drop on Monday. Nasdaq, Stoxx 600, and Hong Kong’s Hang Seng also managed to recover by 0.8%, 1.3%, and 0.5% respectively.

It seems more likely that the FOMC’s meeting will center around the possible short and long-term effects of the Delta variant. Considering these domestic challenges, interest rates will probably remain near zero going into 2022, and the government stimulus rollback will probably not commence until next year as well which is good news for investors still wary of tapering.

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