Most people, when they think of a crisis, picture something with possibly catastrophic consequences and something that happens suddenly. Economic crises, however, don’t usually come upon us all in a rush. They tend to be more like a slow motion train wreck, something we can watch unfold and eventually arrive at a conclusion that when we look back, looks to have been inevitable. But it isn’t inevitable at all, actually. If the right people see the problem unfolding and act appropriately, economic crises can often be avoided.
That is what all investors around the world hope is happening right now in China.
The real estate “crisis” there is certainly playing out in slow motion. With hindsight, it is clear that there have been problems in the Chinese real estate market for some time. Highly leveraged companies building far more properties than there could ever be demand for can only end one way, but a belief that the government would come in to bail everyone out allowed the situation to continue without almost no one inside or outside of China sounding too many alarm bells.
This week, that state of affairs potentially changed when real estate giant Evergrande was finally declared insolvent by a court in Hong Kong.
The Evergrande story is a perfect example of a slow motion crisis unfolding. They were China’s biggest real estate developer but hit cash flow problems a couple of years ago, leading to a default on their debt in 2021. A similar Western company that defaulted on a bond payment would almost certainly have gone under in a shorter time than Evergrande, but the persistent belief that the Chinese Communist Party (CCP) would not risk the collateral damage that could come with an Evergrande meltdown allowed them to continue doing business.
That help never materialized, and Evergrande was allowed to meet its fate this week.
One can never know for sure why that sort of thing can happen in China. There is a history there of the government making decisions about individual companies based on factors other than economic policy or market forces. That may be a personal quarrel or a family connection, or it may be a perception of a company or its CEO as being insufficiently enthusiastic about the CCP and its political agenda. In this case, though, this looks more like a purely economic decision. If that's the case, it is more worrying for investors both inside and outside China than a decision based on politics or a personal vendetta, at least in the short-term.
It represents a shift in policy towards a purely capitalistic approach, where a company that makes bad decisions pays the price for them. No company is seen as protected, no matter their size or systemic importance. In the long run, those of us who believe in a capitalist system would, of course, regard that as healthy. History certainly shows that the market is the most efficient way to allocate capital. But, in the short-term, it will call into question the viability of quite a few other Chinese businesses, resulting in further losses in a stock market that is already down close to 10% over the last year. That, by the way, is a period in which the S&P 500 is up well over 20%. That will cause some serious pain, and may even end in a recession in China.
The question for investors outside China is whether or not it will do the same elsewhere.
One might expect that a problem in the world’s second largest economy would inevitably lead to contagion, but that may not necessarily be the case here. As I said, this has been playing out for some time, and the downward slope of the chart for the Shanghai Composite since early in 2022 that you see in the chart above is the market gradually coming to terms with it. Over the last three months, though, Chinese stocks have continued lower. Meanwhile, in the U.S., the increasing confidence in a soft landing and lower interest rates this year have been considerably more influential than any problems on the other side of the world. As long as that confidence remains, the problems in China will essentially continue to be ignored.
The potential for a big problem comes if that confidence in a soft landing dissipates. Should that happen, then the problems in China’s real estate market will shift from being something that is contained to being yet another thing to worry about. It will not cause a big drop in U.S. stocks in itself but will serve to exaggerate one significantly if it comes. U.S. investors, therefore, should be aware of what is happening in China and track it closely. In an ideal world, the crisis there will pass while the U.S. economic outlook remains good, but should the mood here deteriorate, even a slow moving train crash could spread its debris wide enough to do damage over here.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
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