Last week I wrote about the September selling season. It picked up big time Monday morning, with what can only be called a mini crash. Remember how I said there had not been even a 5% sell-off this year? Monday put an end to that streak. That led to the first technically oversold situation on the year. It’s really the first since the 2020 election. Remember, the Market was way overdue. Monday’s sell-off wasn’t driven by the situation with Evergrande, but it definitely seemed to provide the spark. Importantly, there was no stress in the Bond Market. The emotions were relegated to the Stock Market. It’s corrective. It’s quite healthy. And can you believe that the near 1,000 point Monday decline on the Dow has been completely erased? Both the Dow and S&P finished higher on the week. Escalator up, elevator down; That’s the Market way.
Stating the obvious: There was a lot going on this week. I plan to touch on the major events, explain their significance and outline where we think we’re headed. So depending on when you’re reading this, feel free to open that bottle of wine or have that second cup of coffee. This might be another long one. But I will try to keep your attention and interest. Let me know how I did.
I will pose the questions and answer them, based on information we know and anticipation of significance. The subjects of today’s piece are Evergrande, the Fed and the political games in Washington, from a Market standpoint. I’m content to let you draw your own conclusions pertaining to the political angle. We learned a lot about monetary policy this week at the Fed meeting. We also learned that China has a more immediate debt issue than previously thought. Something we already knew, but are increasingly forced to contend with, is our Federal government’s inability to govern together as a unit. It’s finally becoming an issue that the Market can’t and won’t ignore.
The word Evergrande became a household name this week. I heard someone ask if it was something on the Taco Bell menu. Creative, but no. It’s pronounced Ever-Grand. You might have been surprised to hear that it is a Chinese real estate developer. It’s China’s second largest. It’s not a small, insignificant company. But its significance seems to rest exclusively within Chinese borders. News that Evergrande was about to default on its debt payment sent stocks cascading lower Monday morning. It was not a pleasant wake-up call. But a couple of points here: 1. Both the Chinese and Japanese stock markets were closed on Monday, so the liquidity flowed to Europe and the United States. Fast money sold what they could. 2. The Bond Market didn’t even flinch. There were no signs of stress in the American Financial System. That is perhaps the most important point. The Bond Market is always the first to sniff out trouble. People were quick to draw comparisons to Lehman Brothers in 2008. That sure gets headlines. The Financial Crisis was a global contagion. This seems isolated to China. The Bond Market is still not worried.
So what is exactly happening? The short answer is over-leverage. Evergrande has $300 Billion in debt. Importantly, just $19 Billion of it is in US Dollars. Like the U.S., China has a debt issue. Unlike the U.S., China doesn’t borrow to cut taxes or pay for its entitlement obligations. China has been investing heavily in manufacturing, infrastructure and property. China has been focused on growing its Economy and dominating the Digital Age. It’s also been transitioning from an export-led economy to one more driven by consumer spending. That’s the American model. China has also been increasing its governmental control. It’s been a bumpy transition. China has incurred a lot of debt.
President Xi has been tightening market forces and restricting how innovators and investors get paid. Private enterprise exists in China. But it is increasingly state-run. Companies are being managed how the Communist Party dictates. Since Capitalism has been facing criticism for decades, especially after the Financial Crisis, China believes its model is superior. It is certainly attracting attention around the globe.
Back to Evergrande: The property developer was scheduled to make $84 Million in coupon payments on its USD bonds Thursday. Bondholders are still waiting on payment. Another $47.5M payment due next week. As of this writing, Evergrande had not yet made any statements. However, the company has a 30-day grace period before technically defaulting. There are multiple other Chinese companies that have previously made payments during their grace periods. It’s our sense, using multiple sources, that Beijing is not looking for a bailout but is working to avoid a contagion. This will be an issue over the weekend and into next week.
The Federal Reserve had a meeting this week. Investor eyes were laser-focused. There was no rate hike, nor taper. Action was not expected. What they said was the substance. The Fed tripled down on its belief that the current rate of inflation is temporary and not a lasting issue. The Fed pulled forward rate-hike expectations. Fed Chair Powell also signaled a tapering announcement at the November meeting. You may recall, tapering is simply allowing the Fed’s balance sheet to run off slowly as the bonds they own mature and won’t be reinvested into new ones. Tapering is expected to end around mid-2022 and liftoff from zero rates could occur after that, although 2023 still seems the most likely timing for the start of rate hikes for now. What seems clear is that inflation is likely to be the determining factor for liftoff and the pace of rate hikes. The Fed is expecting inflation to run above 2% through 2024 even as they keep rates below their neutral 2.5% estimate. That shows how committed they are to fostering as strong of a labor market recovery as possible.
Here’s a reminder of how we got here. The pandemic lockdown and subsequent recession in early 2020 led to unprecedented asset purchases by the Federal Reserve as emergency measures to save the Economy from falling off a cliff. The Fed went big; Bigger than it’s ever gone before. The central bank has been buying $120 Billion in assets every month for a year and a half, which has provided massive amounts of liquidity in the system. Asset prices have responded big time, as evidenced by the Stock Market and Housing. Even though the Market and US Economy are no longer in need of emergency methods, the Fed seems terrified of being the cause of another economic slowdown and Stock Market decline. There are no signs of aggressive quantitative tightening anywhere. But the test for tapering has been met. The test for liftoff in rates is much higher and yet to be completed. Even with a taper, the Fed will still be injecting large quantities of liquidity into the system. That’s staying for a while longer. The Market likes it.
What’s expected now are higher yields, but slow moving. That should be supportive of growth. Most importantly, it will start the removal of dependence from the central bank. The Market will operate more naturally. The forecast is 1 rate hike in 2022 and 3 in 2023. Keep in mind, that’s a long time from now. Anything can happen in that wide window.
The Yield Curve steepened heading into the weekend. It initially flattened after the Fed meeting on Wednesday. Thursday brought a reversal, and the Yield Curve steepened. The 10-Year Treasury yield saw its biggest one-day move since February, and broke above 1.4% for the first time since July. It closed out Friday at 1.46%. Its high on the year was 1.8%, reached in the Spring when inflation fears ignited. The 30-Year Treasury yield had its biggest one-day move since March 2020, at the height of the Covid crash, when the Fed announced QE. These are big moves in Bond Land. But the Market seems to be taking it in stride and considering it healthy and positive.
This is my least favorite topic to write about. I’m a bit of a political junkie, but the politics of today are so divisive and infuriating. Cable News and Social media add fuel to the political fire. But today’s politics are inescapable. The Market has been ignoring them for a while, but things are coming to a head with what’s become a common partisan dispute: The Debt Ceiling. It’s the Federal borrowing limit. It’s been raised 98 times before. The government is slated to run out of money by mid-October. The risks are still low. It’s just unbelievable that there’s even a question whether the United States of America will pay its debts.
From our Washington source:
“Lawmakers from both parties are primarily concerned with two things: 1) retaining their jobs and 2) enhancing their own political power. As a result, the 2022 congressional midterm elections loom large in the political calculus lawmakers are applying to both the $1.2T bipartisan infrastructure deal and the $3.5T partisan spending plan. Senator Joe Manchin (D-WV) has indicated he would support a smaller partisan package up to $1.5T and supports the $1.2T bipartisan bill that he helped negotiate. House progressives have threatened to withhold their support of the $1.2T bipartisan bill that passed the Senate in August unless it is paired with the $3.5T partisan package. Progressives run the risk of holding out for a larger number only to end up with nothing which would feed into a narrative of ineffectiveness, if not incompetence of unified Democrats’ unified control of government. The prudent move would be to deliver a smaller package of accomplishments to run on rather than nothing. “
The immediate issue is that Democratic progressives oppose a House vote this coming Monday for the Senate-passed bipartisan infrastructure bill. They argue the $3.5 Trillion reconciliation package should be considered first or at least on the same track. But moderates want the House to pass the infrastructure bill on Monday, believing that negotiations over the reconciliation package should come later. This is all internal fighting within the Democratic party. The Republicans are calling a bluff, forcing the Debt Ceiling to be a Democrat responsibility as majority party which can be addressed through reconciliation. The Market seems to believe that a deal will be made and a default is not an option. But like everything in Washington, it will likely come at the eleventh hour with a lot of stress.
Senate Majority Leader Chuck Schumer filed cloture on Thursday in order to break a Republican filibuster of a House-passed government funding bill to keep our Federal agencies open into December. The Senate vote on the motion to proceed to this bill, which also includes language to suspend the debt limit until December 2022, will take place on Monday. In case you were wondering, that’s just 72 hours before the government would be shut down. September 30 is near. Is it any wonder that 62% of Americans disapprove of the job Congress is doing?
I wrote my History Thesis at Cal on Mark Twain and the Western Frontier. The American icon left the Mississippi River and headed out west a young Sam Clemens and returned back east a budding writer, philosopher and humorist known as Mark Twain. He had a way with words like few others. Writing this week’s piece made me think of 2 of his quotes. I will leave you with both. I hope you stayed with me and made it this far!
“Suppose you were an idiot. And suppose you were a member of Congress. But then, I repeat myself.”
“The more I learn about people, the more I like my dog.”
Thank Heaven for Sam Clemens.
Have a nice weekend. We’ll be back, dark and early on Monday.