While the U.S. is not immune to disruptions in other parts of the world, we do not view the situation in China as a contagion risk that will derail the bull market.

The financial media are filled with stories about the dire condition of China Evergrande Group, one of China’s largest property developers. Evergrande is the second-largest property developer in China and the world’s most indebted. However, its debt burden is not news to bond investors who have increasingly required very high yields to lend to the company. In fact, three major credit-rating agencies have downgraded its debt deeply into junk territory, reflecting their view that the potential for a default is imminent.

Background

Although a technical default may occur—reports are circulating that Evergrande will fail to make its scheduled interest and principal payments due this week—the ultimate ripple effects seem contained but aren’t completely known. Absent government intervention, a default would be messy. Most of the company’s assets are unfinished properties that will require additional capital and build-outs before they can be sold. Furthermore, its portfolios of completed properties may not be easy to sell in a residential market that was already experiencing a slowdown. Indeed, these concerns could weigh on the overall property market by sparking other anxious developers to slash prices to move their own inventories.

There is also a risk that the government wants to make an example out of Evergrande, to impose some discipline on property buyers and developers. Despite repeated warnings, Evergrande has not fully complied to policymakers’ recently established guidelines to rein in property market excesses. This may not suggest Evergrande will be left to fail, taking bond and common stock holders down along with it, but Party members enforcing President Xi’s mantra of “common prosperity” might turn away from offshore investors and wealthy members of the company’s management.

As China goes, so go other economies reliant on its appetite for imports. Therefore, the hit from an Evergrande failure, predicated upon how it is triaged, could not only impact China’s growth but have spillover consequences to other markets as well. Resource economies like Brazil, Chile, and Australia that export iron ore, copper, and other base metals to feed China’s construction and infrastructure, could be hurt. Even Europe- and Japan-based suppliers of machinery, equipment, and raw materials could feel a chill.

While the U.S. is not immune to such disruptions in the rest of the world, it is generally less susceptible to isolated troubles, especially when financial institutions in America have minimal links to the Middle Kingdom.

Summary

The bottom line is that we do not view Evergrande as a contagion risk that derails the bull market. Certainly, policymakers may want to make an example of it, but not to the point that they will stand by in the face of a broad contagion. In a worst-case scenario, a credit event could ripple across China and into some neighboring markets, tempering investors’ enthusiasm for risk for a short while. However, we believe it is unlikely to impart a severe or lasting impulse in the U.S.

Disclosures

This report is provided for informational and educational purposes only and shall in no event be construed as an offer to sell or a solicitation of an offer to buy any securities or a recommendation for any strategy or to buy, sell, or hold any product. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. Employees of Janney Montgomery Scott LLC or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed here. The information described herein is taken from sources which we believe to be reliable, but the accuracy and completeness of such information is not guaranteed by us. The opinions expressed herein may be given only such weight as opinions warrant. This Firm, its officers, directors, employees, or members of their families may have positions in the securities mentioned and may make purchases or sales of such securities from time to time in the open market or otherwise and may sell to or buy from customers such securities on a principal basis. This report is the intellectual property of Janney Montgomery Scott LLC (Janney) and may not be reproduced, distributed, or published by any person for any purpose without Janney’s prior written consent. This has been prepared by Janney Investment Strategy Group (ISG) and is to be used for informational purposes only. In no event should it be construed as a solicitation or offer to purchase or sell a security. Past performance is no guarantee of future performance and future returns are not guaranteed. There are risks associated with investing in stocks such as a loss of original capital or a decrease in the value of your investment. For additional information or questions, please consult with your Financial Advisor.

About the author

Mark Luschini

Chief Investment Strategist, President and Chief Investment Officer, Janney Capital Management

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