Research Update: Evergrande and China’s Property Sector

September 28, 2021

Investors have become increasingly concerned about excessive borrowing in China’s property sector and within Evergrande Group, one of the country’s largest property developers, particularly as the Chinese government has taken steps to tighten credit conditions. Moreover, the latest news about the property sector has come amidst other regulatory crackdowns in China (such as in the for-profit education industry).

We have followed these events closely as part of our ongoing research work on China and emerging markets. Thus far we are of the view that these risks will be contained, and therefore we are not currently contemplating any changes to our portfolio positioning. Further, once through some of the short-term pain that we are seeing currently, new opportunities could emerge for investors in China.

Evergrande and the Outlook for Emerging Markets

Our research process takes risk into account when assessing the relative attractiveness of emerging markets by requiring a significantly higher extra return (return premium) than we would for a less volatile asset class. Risks particular to China are explicitly factored into our return requirement. The other side of the coin is growth assumptions, and while there are strong long-term positives, we have chosen to remain conservative in our view of the relative attractiveness until there is more clarity on the rules of engagement for regulation and on credit conditions in China.

We remain comfortable with our current portfolio positioning considering the risks and opportunities we see in China and emerging markets and appreciate the diversification benefits and long-term return potential it brings. Ultimately the reality in investing is that information like the problems facing Evergrande is quickly priced in (and more often over-priced in) and so the question is whether this is just louder-than-usual short-term noise or whether it is revealing a more fundamental long-term change that deserves to impact our long-term risk and return assumptions. This question is the focus of our analysis, and we’ll share a few highlights here and expect to share more in our quarter-end commentary that will be available in early October.

A catalyst for the Evergrande-related turmoil is the Chinese government’s steps to rein in speculation that they believe is leading housing to become increasingly unaffordable, which is contrary to their long-term sustainability goals, such as reducing inequality. In turn, these sustainability goals are surfacing issues related to excessive leverage in the property sector that have built over many years. As investors, we are focused on understanding how large the problem is and whether China will manage this adjustment well—two unknowns that become clearer with time.

At present, we share the widely held view that it is not likely we will see a Lehman-like disruption locally in China or globally. (The 2008 collapse of Lehman Brothers set off a negative chain reaction in the financial sector). For one, we don’t see the same feedback loop between China’s property sector and the global economy. In addition, Chinese citizens have a lot of wealth tied up in property, so it is in the government’s interest to avoid a chaotic wave of defaults and the government has the means to stabilize the financial system since it is the majority owner. A more orderly restructuring still seems the more likely scenario coupled with government monetary and fiscal stimulus.

It is also the case that a lot of bearish sentiment has been priced into emerging markets stocks; in fact, some of our managers are selectively seeking opportunities in China with a view toward long-term return potential. That said, we will continue with our analysis and if we conclude the impact is likely to be long term versus temporary, we will factor that into our portfolio positioning.

Litman Gregory Investment Team

 

Important Disclosure
This written communication is limited to the dissemination of general information pertaining to Litman Gregory Wealth Management, LLC (“LGWM”), including information about LGWM’s investment advisory services, investment philosophy, and general economic market conditions. This communication contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice and should not be considered as a solicitation to buy or sell any security or engage in a particular investment strategy.
There is no agreement or understanding that LGWM will provide individual advice to any investor or advisory client in receipt of this document. Certain information constitutes “forward-looking statements” and due to various risks and uncertainties actual events or results may differ from those projected. Some information contained in this report may be derived from sources that we believe to be reliable; however, we do not guarantee the accuracy or timeliness of such information.
Past performance is no guarantee of future results, and there is no guarantee that the views and opinions expressed in this newsletter will come to pass. Individual client needs, asset allocations, and investment strategies differ based on a variety of factors.
Investing involves risk, including the potential loss of principal. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management feeds or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.
Nothing herein should be construed as legal or tax advice, and you should consult with a qualified attorney or tax professional before taking any action. Information presented herein is subject to change without notice.
A list of all recommendations made by LWM within the immediately preceding one year is available upon request at no charge. For additional information about LGWM, please consult the Firm’s Form ADV disclosure documents, the most recent versions of which are available on the SEC’s Investment Adviser Public Disclosure website (adviserinfo.sec.gov) and may otherwise be made available upon written request to compliance@lgam.com

 

LGWM is an SEC registered investment adviser with its principal place of business in the state of California. LGWM and its representatives are in compliance with the current registration and notice filing requirements imposed upon registered investment advisers by those states in which LGWM maintains clients. LGWM may only transact business in those states in which it is noticed filed, or qualifies for an exemption or exclusion from notice filing requirements. Any subsequent, direct communication by LGWM with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides.