The Post-Mortem on Evergrande and the Fed

Will Evergrande contagion impact your portfolio? … be wary of commodity trades for now … what the Fed’s statement means for the fourth quarter


It’s been a rollercoaster week for investors.

Monday and Tuesday brought panicked selling as the Chinese Evergrande debacle roiled markets. All three major indices dropped, with the Nasdaq leading the losses with a 2% haircut.

But come Wednesday afternoon following the Fed’s statement release, investors were back to “buying the dip,” as they’ve done ever since the March 2020 low.

As I write Friday afternoon, investors seem to be digesting all the news, with the markets flat to slightly down.

In today’s Digest, let’s look closer at both Evergrande and what we learned from the Fed with the help of our technical experts, John Jagerson and Wade Hansen, of Strategic Trader.

Though the market has largely brushed off Evergrande concerns, and no longer fears an unexpected announcement from the Fed, there are lingering issues investors should watch.

Today, let’s shine a light on them and see how our technical experts are sizing up the fourth quarter.

***The fallout of the Evergrande implosion

For newer Digest readers, Strategic Trader is InvestorPlace’s premier trading service. It combines options, insightful technical and fundamental analysis, and market history to trade the markets, whether they’re up, down, or sideways.

This week, we’ve seen all of these directions, beginning with “down” thanks to Monday’s news that Chinese real estate developer, Evergrande, was struggling to meet its debt payments.

Here are John and Wade with more details:

Evergrande is a massive Chinese property developer with subsidiaries in a variety of other businesses. Depending on the day, they have assets of $1.3 trillion and liabilities of $300 billion.

Despite its size, Evergrande has become over-extended and has been effectively insolvent for quite a while.

Evergrande’s stock has been imploding this year. Below, you can see it losing 80% of value and counting since we began 2021.

Evergrande's stock collapsing 80%+ so far in 2021

This issue here is the ripple effect of Evergrande’s demise. Yesterday, we learned that Beijing will be hesitant to bail out the giant developer.

From the Wall Street Journal:

Chinese authorities are asking local governments to prepare for the potential downfall of China Evergrande Group, according to officials familiar with the discussions, signaling a reluctance to bail out the debt-saddled property developer while bracing for any economic and social fallout from the company’s travails.

The officials characterized the actions being ordered as “getting ready for the possible storm,” saying that local-level government agencies and state-owned enterprises have been instructed to step in to handle the aftermath only at the last minute should Evergrande fail to manage its affairs in an orderly fashion.

They said that local governments have been tasked with preventing unrest and mitigating the ripple effect on home buyers and the broader economy, for example by limiting job losses—scenarios that have grown in likelihood as Evergrande’s situation has worsened.

***As bad as this sounds, John and Wade believe the wider issue is the impact this will have on Chinese interest rates

Back to the Strategic Trader update:

Without massive intervention, corporate borrowing in China is likely to remain expensive.

High yield debt is already back to COVID-19 crisis levels, and we don’t expect that to come down.

In the short-term that should drag on commodity prices because higher rates will slow demand in the Chinese economy.

John and Wade point out that this is already weighing on commodity stocks, so they’ll be avoiding commodity-related trades for the time-being in Strategic Trader.

We made this same point here in the Digest earlier this week. The battery metals trade, which we believe will be a massive winner this decade, is under pressure from Beijing’s efforts to tamp down commodity inflation in China.

Long-term, the Chinese government can’t keep a lid on commodity prices. But shorter-term, which is where John and Wade are focusing, yes, commodity stocks could be weak.

For shorter-term trades, keep your eye on this.

***If Evergrande does implode, will it bring down U.S. stocks?

Returning to the broader, macro picture, what’s the potential fallout if Evergrande goes belly-up?

Back to John and Wade:

Yes, Evergrande is massive and there are a lot of Chinese, European, and US banks that will suffer losses if they fully default on their debt. However, in our view, there is no way that the Chinese government will allow that to happen.

We agree that an Evergrande default would create some risk of contagion, but the Chinese government is managing a delicate balance. Evergrande’s troubles have reduced the price of housing as real estate speculators have been burned, which is good for them. However, broader financial instability would be unthinkable.

We expect the Chinese government to step into the market and “rescue” Evergrande before things get much worse. While we don’t think that will bring Chinese interest rates down, it should be plenty to avoid a meltdown. Intervention in September or early October appears most likely.

If we are correct about an Evergrande bailout, then the volatility hitting U.S. stocks that has been triggered by the Evergrande default should calm down in the short-term.

I’ll point out that the Wall Street Journal article quoted above reported that local Chinese officials were instructed not to step in and help until “the last minute.” To John and Wade’s point, such language does suggest that China won’t allow a complete melt-down.

***Switching gears, what about the Fed, tapering, and interest rate hikes?

On Wednesday, the Fed held its benchmark interest rate near zero, but indicated that hikes could be on the way sooner than some had expected.

Here’s John and Wade with more:

The committee kept things vague (Wednesday) by saying “a moderation in the pace of asset purchases may soon be warranted,”. The Fed keeps things very vague when they are pushing the timeline for a change out further into the future.

So, we feel that (Wednesday’s) statement adds confidence to the estimate that the Fed will resist a taper until late this year or once the hiring picture improves.

After the Fed’s announcement on Wednesday, stocks rallied. But John and Wade, who wrote their update on Wednesday afternoon, suggested caution:

Drawing conclusions from today’s market action will be difficult. Fed days are always volatile and are prone to price reversals.

It will likely take investors a day or two to settle down before we can get a good read on how the Fed’s forecast that tapering should begin “soon” and that some members of the committee expect that rates could start to rise in 2022 will affect sentiment. 

To John and Wade’s point, yesterday the buying continued, with all three major indices climbing. But as I write Friday, the markets are either flat or down.

***Wrapping up, weighing all these factors together, how do John and Wade size up today’s market, and where we’re headed in the fourth quarter?

Here they are with their bottom-line:

Despite the outstanding issues of the Fed’s announcement today and the Evergrande crisis in China, the pullback in the S&P 500 has remained within normal ranges for a bull market retracement.

Market volatility is always frustrating, but we expect investors to start pricing in another stellar earnings season in October; that should lead to a bounce in the major indexes in the short-term…

We remain optimistic that monetary policy will remain stable enough to support stock prices in the fourth quarter.

Have a good evening,

Jeff Remsburg

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