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The China Evergrande Problem

China Evergrande Problem
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I wanted to write a quick letter sharing my thoughts regarding today’s market sell-off. Worries about spreading troubles from China’s property market have crept across all risk asset classes, and we have seen impressive drawdowns today. China Evergrande Group, the focus of this concern, has the most considerable debt burden of any public traded real estate management or development company in the world ($300B).

The company is in severe financial trouble, and the potential fallout has investors remembering the Lehman Brothers debacle in 2008. I do not know if it is fair to compare Evergrande to Lehman as the US consumer is stronger today than it was then, but the comparison still has some merit. 

Evergrande rode the Chinese property boom and has urbanized large swaths of the country. The company took on a ton of debt to finance these activities, getting ahead of itself. In recent years, the company has faced lawsuits from homebuyers who are still waiting to complete apartments they partially paid for. There are nearly 800 projects across China that are unfinished. Additionally, suppliers and creditors have claimed hundreds of billions of dollars in outstanding bills.

Not surprisingly, Evergrande stock has plummeted, and its bonds are trading around 25% of its par value, indicating a high probability that Evergrande will face bankruptcy soon. 

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China Evergrande Stock plummets

Investors are wondering if its potential default will spread contagion to other similar companies. They are also wondering whether or not China will step in to bail out Evergrande to help stem the flow of contagion.

So far, I have read conflicting reports on whether China intends to step in to assist. On the one hand, China would be foolish not to step in as contagion can wreak havoc on their markets. Beijing will be tempted to say no, but leaving millions of homeowners, suppliers, and investors unhappy could cause severe damage. Beijing has stepped in to shore up other large companies in the past. 

However, China has begun its campaign against western-style capitalism. The Wall Street Journal recently reported that President Xi is trying forcefully to get China back to the vision of Mao Zedong. The latter saw capitalism as a transitory phase on the road to socialism. As a result, China has more recently shown a greater willingness to let companies fail to reign in China’s unsustainable debt. If they intend to stay the course, Evergrande’s equity and bondholders may be forced to pay the price. 

Or, a third option might present itself – China might decide to step in to restructure at least some of its debt while letting other obligations be managed as best they can be. 

Either way, this mini-crisis will pass, and the markets will rebound, as they always do. I believe China will ultimately decide to step in and help mitigate the fallout. 

Also, keep in mind that intra-year drawdowns are typical. It is easy to forget that market volatility is normal and should be expected. In fact, market volatility is the price we pay as investors for our market returns. In 21 of the last 41 calendar years—more than half of the time—the S&P 500 saw a double-digit pullback within the year. Drawdowns are normal and should be expected.

Drawdowns are normal

This more recent drawdown represents more of a buying opportunity more than anything. If you have cash on the sideline, now would be a great time to consider deploying it. Of course, if you have any questions or concerns, please do not hesitate to contact us. We are more than happy to assist.

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