MARKET VOLATILITY AMIDST FINANCIAL UNCERTAINTY
September 27, 2021
When T. S. Eliot wrote in his poem, The Waste Land, “April is the cruelest month”, he obviously was not thinking about stock market returns. In fact, in the 20-year history of S&P 500 monthly returns since 2000, April’s average return of 2.4% was the highest for any month. In 2021, April’s return was even higher at 5.2%. September is actually the cruelest month, recording an average loss of -0.83% during the period. In 2021, September continued its historic weak performance, falling 1.5% through September 24th.
While there were myriad reasons for such negative prior performance, The Mather Group, LLC (TMG) would like to focus on several potential sources of this month’s market volatility. These include a looming debt crisis in China and uncertainty about future policy changes at the Federal Reserve Board. These appear to be transient in nature, and may soon lead to October, historically the second-highest performing month of the last 20 years. In addition, TMG will review the continuing financial strength of both US corporations and households.
China’s focus on both infrastructure and residential real estate construction has been a cornerstone of its rapid Gross Domestic Product (GDP) growth during the last decade. In support of its growth goals, the Chinese government, until recently, continued to relax credit quality standards, lowered interest rates and urged even local governments to lend to and invest in real estate construction projects. As a result, residential real estate sales approached 10% of GDP in 2019. In contrast, residential sales in the US accounted for only 4.2% of GDP in 2020.
A prime beneficiary of these national policies has been Evergrande Real Estate Group, China’s second-largest real estate developer. During the 10-year period beginning in 2010, it increased its constructed and for sale floor space from 7.9 million square meters to 80.9 million square meters, an annual growth rate of 125%. Like most developers, Evergrande fueled its growth primarily through the issuance of both local and international debt. When cashflow from sales was insufficient to pay interest or redeem its debt, it simply borrowed more or asked lenders to “roll over” its loans. Its current debt obligations now total ~ $300 billion.
Unfortunately for Evergrande and its lenders, two factors have severely limited its ability to make such further payments. As shown in the graphic below, China’s residential home price growth began falling in 2019 and actually became negative in 2020. While prices turned slightly upward in Q1 2021, recent demand for Evergrande’s completed or still under construction housing units has fallen sharply. Potential buyers, as in most deflationary situations, often decide to postpone planned purchases to await further price declines. Evergrande’s cashflow from sales plummeted.
A second factor, affecting both purchasers and lenders, has been China’s recent and strenuous efforts to rein in its growing credit bubble, both in construction and in other sectors like steel manufacturing. Credit standards have now been significantly tightened, affecting many mortgage applicants who might have bought an Evergrande unit, but also effectively limiting any further lending or “roll overs” to developers like Evergrande. During the last few months, facing looming interest payments ($119.5 million due just last week, and a further $549.5 million due by the end of 2021), Evergrande has attempted to sell numerous assets or has asked its lenders and unpaid contractors to accept completed real estate projects in lieu of cash payments.
Evergrande has been unsuccessful in these efforts and announced two weekends ago in Hong Kong, where its stock is listed, that it could not honor last week’s interest payments. When markets opened afterward in Hong Kong, a swift and deep selloff began circling the globe. Asian stocks fell first, followed by the European Union (EU) and London markets and then Wall Street. With a significant fear of potential “contagion” due to an immense—and looming--Evergrande debt default bringing down other lenders, both Chinese and international, many global investors began almost panic selling on Monday, 9/20, according to MarketWatch and New York Stock Exchange data. As of the end of the week, on 9/24, they had missed a $83.5 million bond interest payment, and are now in a 30-day grace period.
An open question, both to lenders and investors, is whether China’s government will now assist in an orderly bankruptcy and wind down of Evergrande, or will it step away and result in Evergrande becoming another potential restructuring challenge for its numerous lenders? An answer should be forthcoming shortly, but, until it is fully resolved, investors can expect continued market volatility. It is also important to note that Evergrande is less than 0.002% of TMG’s Moderate portfolio exposure, as of 9/22/21.
Another factor in recent US market volatility has been the “will he, won’t he” focus on Chairman Powell of the Fed. This includes when the ongoing $120 billion monthly bond purchases made by the Fed will be reduced, and when the Fed will raise interest rates. Unlike many market pundits, TMG does not believe these are simple, black-and-white decisions. For example, any tapering in the level of bond buying has to be considered within the context of its potential, near-term effect on our economy.
But, what effect, if any, could the recent Covid resurgence have on our economy looking out 1-6 months into the future? Will fear of Covid continue to keep some workers, such as in the hospitality and leisure sectors, from returning to their former jobs? When will existing supply chain challenges begin to be resolved to support continued economic growth? A lack of automotive chips, for example, could lead to fewer car sales in the near-term, which is already causing frequent but short factory closures. Will an additional $1-4 trillion stimulus be enacted? Chairman Powell and his colleagues obviously lack a simple framework for making this decision, given so many uncertainties. The market’s response, of course, is continued market volatility.
With respect to the timing and magnitude of a potential lift to current interest rate levels, “will he, won’t he” may be a moot question in a few months, if Chairman Powell is not renominated for a second term. This is another source of uncertainty for markets, and obviously another undercurrent adding to market volatility. The response of TMG given just these two uncertainties, is to continue the firm’s prudent, time-proven investment and risk management strategies.
Meanwhile, despite fears about credit bubbles, inflationary levels, supply chain bottlenecks and unfilled jobs, the financial health and well-being of America’s corporations and households continues to show increasing—and durable—strength. For example, corporate debt as a percentage of the market value of corporate equities has fallen from its Great Recession high of 40% to just 22% today. And, as shown in the graphic below, corporate profits have reached their highest level since 2016. Corporate profit margins are forecast to remain above 13% through 2023.
Households are sharing in this expansion as well. Despite an ongoing and robust level of household purchases, the personal savings rate is now 10%, higher than any level occurring in the four pre-Covid years beginning in 2016. And, as shown in the graphic below, consumer debt service payments as a percentage of disposable income have fallen from its 5.7% level at the start of 2020 to just 4.8% today. The continuing fall in mortgage interest rates has contributed strongly to this household debt service reduction, as mortgage debt servicing is now just 3.5% of disposal income, its lowest level since 2016.
September market volatility, whether historic or today’s, understandably causes concerns and raises questions for any market participant. However, the major sources of recent market volatility, as described above, appear to be resolvable before the end of 2021. Corporate and household balance sheets are strong, unemployment levels continue to fall and oversight of the Covid pandemic appears to be increasing.
One key to a successful retirement, at least financially, is to maintain focus on your retirement goals and your resultant financial plan. Your trusted advisor at TMG is ready to respond to any questions or concerns which you might have, and to assure that your financial plan remains both timely and actionable. Please reach out to your trusted advisor for counsel at any time.
Sources: Barron’s; Bloomberg; FactSet Research Systems; Federal Reserve Bank of St. Louis (FRED); Federal Reserve Board; Forbes; Hong Kong Stock Exchange; Standard & Poor’s Global Ratings; Statista; Wall Street Journal; MarketWatch
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