3Q, 2021: Shanghai Surprise

Third Quarter 2021

September 30, 2021

By Mark Oelschlager, CFA

Shanghai Surprise is a 1986 movie about a con man, a nurse, and a coveted supply of opium. Despite boasting Sean Penn and Madonna in their heyday as the headliners, the film was largely panned by critics and fared poorly at the box office.

Markets got a Shanghai Surprise of their own in the third quarter, as China’s “common prosperity” movement led to crackdowns on myriad industries. Education companies were forced to become not-for-profit, practically overnight. Internet behemoths faced new rules, as the government tried to control the spread of data. New limits on video game usage were implemented. These are just a few examples of President Xi’s mission to equalize wealth and make Chinese society more virtuous. Beijing has always maintained a large influence on its economy, with state-owned enterprises playing a large role. But the new policies, which represent a major change, had dramatic effects on Chinese stocks and those indirectly related. Many businesses became worth much less than they were before. This has always been a risk of investing in China; the government can do anything it wants at any time.

Following all this, the second largest property developer in China, Evergrande, warned that it was going to miss an $83 million interest payment on its debt. Evergrande has over $300 billion in debt outstanding, which may be the most of any company in the world. Debt isn’t a problem as long as a business is growing sufficiently and the capital markets believe in the enterprise. But once one of these factors changes, it can cause a downward spiral for the company and have cascading effects elsewhere. The real estate market in China has long been in a bubble. Tales of empty apartment buildings in unpopulated cities are hard to believe but true. This is the result of over-investment, brought about by the regime’s attempt to keep the economy humming. China is trying to correct this and become a more consumer-driven economy like the US, but the transition is long and painful. And given this, there is no guarantee the authorities will allow it to come to fruition. As mentioned, real estate is in a bubble – and it dwarfs what we saw in the mid-2000s in the US. The ratio of property prices to household income ranges between 40 and 50 in some of China’s major cities, like Shanghai. For perspective, the current ratio is between 5 and 10 in New York and San Francisco and less than 5 in Houston and Chicago. Again, this has been going on for quite some time. I can remember visiting China in 2009 and listening to our young tour guide talk about saving to buy a small apartment, which cost many hundreds of thousands of dollars. Interestingly, there seemed to be an acceptance of this. That it was just the way it was. Perhaps unspoken was the thought that as long as it maintains its value, I will eventually be able to sell it and be OK. So, in China there exists the strange dichotomy of empty apartment buildings and exceedingly overvalued properties – a sign of misallocated capital, a characteristic of a command-and-control economy. It feels like the property bubble in China has to deflate, but it has felt that way for many years. The Evergrande news rattled markets a bit, but given China’s positive trade balance, hefty reserves, and the power its authorities possess in managing the economy, it is unclear at this point how far-reaching its effects will be.

Here in the US, the market’s focus has been not just on the happenings in China but of course the domestic economy. The Federal Reserve’s (the “Fed”) easy monetary policy has likely helped to boost stock prices, so anything that threatens this draws the attention of market participants. As such, economic data is being watched more closely than usual, with monthly inflation and employment reports driving speculation about when the Fed will begin tapering its asset purchases. The reports also affect the Treasury bond market, which has become an important determinant of the dynamics within the stock market. The growth versus value race was fairly even in the quarter, but that belies the ups and downs that occurred. For much of the last three months, growth stocks led, as Covid cases rose, drawing into question the sustainability of economic strength and driving down bond yields (all of which make the secular growth companies more valuable on a relative basis). But late in the quarter, Covid cases declined and yields rose, which led to a sharp selloff in growth stocks. With the economy having largely recovered from the severe downturn of early 2020, Fed chairman Powell, who has been more dovish (monetarily accommodative) than likely any Fed chairman in history, finally gave an indication that tapering is around the corner. However, he emphasized that the end of tapering may not necessarily lead to interest rate hikes. Broader large-cap stock indices rose slightly during the quarter, extending the streak of positive returns to six quarters.

Supply chain bottlenecks continue to plague the economy, and now various nations are experiencing an energy crisis. It is interesting that a global economy that for years was characterized as having over-capacity is now capacity-constrained. The energy shortage is in part a result of the clean energy movement, which has resulted in under-investment in the traditional energy industries. Oil recently reached nearly $80 per barrel and the price of natural gas has doubled since the spring. One of the reasons we have a couple energy stocks in our portfolios is that capital expenditures (investment) by the companies across the sector have declined significantly, which set up the sector favorably from a supply-demand standpoint.

On the political front, Congress is battling over two gargantuan spending bills: a $1 trillion infrastructure bill and a $3.5 trillion package focused on areas such as healthcare and education. Concurrently, they are dealing with the need to raise the debt limit in order to avoid a government shutdown. As we type this it appears that Democrats and Republicans have agreed on a temporary solution that extends government funding without raising the debt ceiling. The avoidance of a shutdown is positive for markets, but the debt limit debate will eventually need to be resolved.

Mark Oelschlager, CFA Oelschlager Investments

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