With all the Evergrande worries in the market last week, I thought it would be worth bringing some perspective to how major bear markets work and why Evergrande is unlikely to be the start of one.
Note, this doesn’t mean I’m not bearish on the impact of Chinese policy on financial markets. I am actually very bearish, but these events tend to take longer to play out than people expect.
History Lessons
The biggest thing to remember is that major bear markets give you lots of warning. If you look at what happened with the internet bubble and the financial crisis, it took over two years for markets to bottom. By contrast, once markets bottom, they tend to rally strongly and quickly and you have to act quickly to get in.
For example, the financial crisis began with the Bear Stearns initial subprime fund losses in early 2007. However, after an initial selloff, the market rallied and reached new highs by October 2007 when Bear and Countrywide’s troubles began to become more clear.
If you were someone who was waiting for years for the housing bubble to collapse, you probably would have gone all in on your short in April of 2007. While you would have ultimately been right, it wouldn’t have been a fun six months.
Similarly, in the internet bubble, the market went largely sideways for about six months (it was still up for the year in September 2000) before really falling off.
One other historical note worth knowing is in the 70s, 00, and 08 crashes, stocks went down roughly 50% and erased about five years worth of gains. If the S&P declined 50% from here, it would also wipe out five years of gains.
So, it’s not unreasonable to think a 50% drawdown could happen in the S&P if China, the Fed, inflation and all the other worries coalesce at once.
However, there’s little point in trying to call it ahead of time. If you wait until there is more certainty on the outlook, maybe you miss the first 10% but you’ll get the next 40% and hopefully with a bigger position size because you’ll have more confidence in the timing.
Probability of a Crisis
While investors like to say they don’t ring a bell when a bull or bear market starts, they actually kind of do. But you have to be paying attention and looking for the right signs.
For example, the Draghi “bazooka” speech in 2012 was the all clear sign that crises were behind us and you could get extremely bullish.
Conversely, the market was off its highs at the time of the Bear bailout in early ’08, but it still went down 50% from there before bottoming. You didn’t need to wait for Lehman. Bear’s collapse was certainly a bell ringing.
So what might be the Chinese equivalent that we are beginning a major bear market? It feels to me like it would be something that signified a long term change in China’s interest in trade as this would be a shock to the financial outlook of many corporate multinationals.
Why might that happen? Xi’s recent actions and remarks have made clear they are looking to move away from the blend of capitalism with socialism to a more strict socialist economy with less individual success permitted. “Common prosperity” has replaced the philosophy of “socialism with Chinese characteristics“.
We have seen this in the recent actions towards Alibaba, Didi, Tencent, and others. Punitive actions have also been taken on the education industry and now real estate. There will likely be more.
However, it is hard to have a financial crisis without a debt crisis. There is not a widespread derivative market in China where financial firms can get overexposed. Most debt is held by the government or is at least priced in yuan. The banks are all extensions of the government.
Thus, the excess leverage all lies in the public sector. While many municipalities are extremely extended, Beijing can paper things over with them. The banks are probably bankrupt on a mark to market basis, but they will never be forced to recognize the losses in real time. Thus, the government can string out the pain there too.
None of this is good for Chinese growth prospects. However, it probably doesn’t cause a crisis. Financial crises get caused by either excess private market leverage or foreign currency debt which can cause major devaluations.
By the way, given the government knows growth is about to slow, it makes logical sense to villainize “the rich” before you ask the masses to share in the pain.
Potential Catalysts
So how do we get to crisis stage? Let’s return to the trade thought. If China can essentially manage the pain of any internal losses by spreading out the pain over time, then they can largely handle any banking or real estate issues.
However, once the pain leaves China’s borders, things get murkier because foreign companies can be overlevered and interconnected to other overlevered companies. Strategically, China might not mind exporting its economic adjustment to foreign competitors to “prove” that it’s system handles stress better.
The most well telegraphed threat is Chinese aggression towards Taiwan which either restricts semiconductor production or, worse, China takes over Taiwan Semi and restricts access to western markets. This would obviously cause huge disruptions to many industries, some of which have fairly levered balance sheets.
However, there are other options China has that could be even more harmful. Why do we assume China will only penalize successful domestic companies? If they are targeting certain behavior, why would an American company in the same sector be off limits?
And would it be hard to imagine a manufactured crisis where the Chinese accuse an American company of stealing Chinese secrets and seeks to expropriate their facilities?
There are also sneakier, more provocative ways to harm foreign companies. We know China is concerned about capital leaving China as wealthy Chinese try to get their wealth offshore (most recently seen in the new Bitcoin crackdowns). What if China told corporates their profits can not leave China?
So, in theory, foreign companies can continue their operations as is, without restrictions. However, they can never repatriate profits to the US. The capital is trapped. What is the present value of a stream of profits which you can never touch? Arguably, it’s zero!
At a minimum, it would reduce the debt coverage of all multinationals operating in China. At worst, shareholders would write off the value of any Chinese assets and tank stock valuations.
Companies worldwide would have to reconsider manufacturing in China (even where they contract, rather than own, due to the increased uncertainty). Delivery times would extend, productivity would tank. We’d be talking about a true crisis.
Watch, But Don’t Act
As mentioned at the beginning, none of these threats are imminent. If you’re operating a company and thinking of buying a Chinese asset, well, in that case, I’d think awfully hard about whether that’s such a good idea.
However, if your main concern is financial markets, any actions that would significantly harm trade are probably a few years away. What’s important is to pay attention to the signals coming from China, so if the threat level does increase materially, you are positioned to act quickly.