Covid-19 shocked our world and the way we work, communicate, and interact over the past 18 months. Thankfully, as investors, the financial shocks were fleeting moments due to the combined – and unprecedented – actions of governments and central banks. The real economy however was a different story, what had started as a demand shock evolved into a supply shock in early 2021.
First, it was the availability of vaccines doses – but now it’s energy, labour and the bursting of property bubbles that are causing these disturbances.
As the origin of the Covid-19 virus, China went through everything first. Lockdowns, recovery, new local lockdowns, vaccine distribution etc. But one thing China has experienced that western nations haven’t so far is the refinancing shock, although this was mostly self-inflicted by Beijing.
To rein in rampant property speculation and excessive financial risk to the economy “three red lines” were introduced by Beijing regarding the expansion of debt. The red lines focused on the ratio between debt and assets, leverage and short-term cash-on-hand to pay maturing loans.
Authorities also introduced limits on the growth in annual debt, initially set at 15%. However, if you violated one of the three lines, this growth quota was reduced to 10%. A second violation, down to 5%. Violate all three and, like the naughty schoolboy, you get put in the corner with your debt growth is set to zero.
This wouldn’t be an issue for cash-flow positive companies but when you start to rely on pre-sold goods and services to finance yourself… you can see how things can spiral. Welcome to the Chinese property market and Evergrande.
Evergrande at centre of storm
Evergrande, the country’s largest property developer, has defaulted on several debt instruments, within China and offshore. A property developer failing isn’t necessary bad – but when it’s endemic in the underlying market then questions are being asked. Thankfully, Beijing’s efforts to date have kept this problem largely within the Great Wall – but other issues relating to manufacturing and energy consumptions has impacted other parts of the world.
To be seen as more environmentally friendly, China has been making a transition to gas from coal for electricity generation. Normally this would not be an issue, but when you introduce the Covid-19 shocks and the subsequent impact for labour at storage facilities and refineries, liquified natural gas (LNG) quickly becomes a hot commodity.
Energy headlines have dominated financial media in recent months, firstly with the UK-French transmission network having a fire at its Kent landing station causing market electricity prices to skyrocket. LNG storage levels are at the lowest they have been in several years, both in the UK and on the continent.
Russia not flush with gas
Commentators are squawking that Putin is turning off the taps to Europe. True, he is he likely to manipulate the situation to accelerate approval of Nord Stream 2, the high poiliticed gas pipeline, but Russia is also running much lower on LNG than it has done historically. How things play out will be dependent on the weather during winter. A cold winter will be very bad for consumers, as prices will continue remain elevated – if not charge on even higher. Only a fool would try to predict the weather over the next months. Both events, to use the terminology of Federal Reserve Chairman Jerome Powell, are “inherently transitory”. One factor which isn’t, however, is the labour market.
Both sides of the Atlantic offered generous benefits to insulate the economy from complete collapse, but this has also meant that it has been slower to recover as consumers and companies took advantage of these schemes right up to their expiry date.
The question we – and the market – are debating is whether the market is actually very tight, or just masking structural weakness. Could we see a wave of early retirees cashing in their chips after a bumper 18 months? What about the high levels of savings consumers currently have?
The next few quarters will hopefully alleviate some of the fog in markets that we are currently experiencing. It will either and up being a repeat of what we saw in the early to mid-2000s, where value investing ruled the roost – or a repeat of the 2010s, where growth was king. One thing we do know, central banks have begun their tightening cycle. That, in itself, tells a story.
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