Robert R. Fragnito | Chief Operating Officer | Financial Advisor | Portfolio Manager
Markets got off to a rocky start this week as we witnessed significant declines across all major indices and all 11 sectors of the S&P 500 on Monday, September 20 (See Figures Below). The sell-off was prompted by worries of contagion fears over China’s real estate sector and persistent efforts by the government to increase regulatory pressure on various sectors of the economy.
In addition, markets on Tuesday finished in the negative after a volatile day of digesting a combination of factors retailed to Monday’s drop, China fears, and the upcoming U.S. Federal Reserve rate decision and potential monetary tapering.
Our bullishness for financial markets combined with this piece was articulated in our Market Commentary entitled: “A Renewed Confidence.” After following a more prudent approach in light of changes since 2020, we have re-aligned our sentiment for future returns in the market even as U.S. economic data continues to leave room for concern. This week’s Federal Reserve decision should give us further clarity.
MAJOR INDEX PERFORMANCE – SEPTEMBER 20, 2021
S&P GICS SECTOR INDICES PERFORMANCE – SEPTEMBER 20, 2021
Specific concerns over the Chinese real estate sector were centered on property developer Evergrande, a company holding over US$300 billion in debt, some of which could be approaching default on Thursday, September 23. Investors are concerned that a default by Evergrande could propel systemic declines across global markets.
Assessments by Goldman Sachs puts Evergrande’s domestic and offshore assets at about two trillion yuan or roughly two percent of China’s gross domestic product. Data in recent weeks showed that China’s housing market is slowing at record levels since the start of the pandemic, falling by 20% last month. Real estate accounts for over 40% of household assets in China and the risk of a default could lead to serious consequences for China and the world economy.
Keeping these fears in mind, the Evergrande story is another domino to fall in President Xi Jinping’s pursuit of achieving “Common Prosperity” in China. Monday’s sell-off in our view was, in part, Wall Street facing the harsh reality that today’s China under Xi is beginning to look more like Mao Zedong’s China of the past. As this begins to sink in, there is no precedent offering guidance on how to navigate this new shift. We must remember, there was no market economy in China during Mao’s time.
What is Common Prosperity?
Under Xi, regulators are engaged in crackdowns on several industries covering technology, housing, financial markets, private education, and personal gaming. The mantra is to deliver “Common Prosperity” to the Chinese people. In essence being dubbed by the Chinese media as a “profound revolution” aiming to return wealth from the capital-group to the masses. A return to a purer form of communism. From China’s geopolitical perspective, this would shield the Chinese system from suffering the fate of the Soviet Union vis-à-vis enduring an economic and political conflict against the capitalist United States.
As far as Wall Street has been concerned, news of these sweeping crackdowns have fallen on deaf ears—at least until now. One unsuspecting voice crying out in the desert was hedge fund manager George Soros, who a few weeks ago published a piece in the Financial Times warning Wall Street and the U.S. Congress about Xi’s true intentions for the domestic economy. Soros was explicit in claiming that Xi does not understand the market economy and that the crackdowns by the Chinese government are real. Soros’ conclusion was the following:
“SEC chair Gary Gensler has repeatedly warned the public of the risks they take by investing in China. But foreign investors who choose to invest in China find it remarkably difficult to recognise these risks. They have seen China confront many difficulties and always come through with flying colours. But Xi’s China is not the China they know. He is putting in place an updated version of Mao Zedong’s party. No investor has any experience of that China because there were no stock markets in Mao’s time. Hence the rude awakening that awaits them.”
Back to the Future
Soros is correct when he says Xi is putting in place a updated version of Mao’s party, and “Xi Jinping’s War on Everything” to quote Philip Orchard of Geopolitical Futures, is a return to the past. Orchard in his piece highlights many similarities and differences between Xi and Mao and his conclusions on the current situation are accurate. Both share one critical similarity; the Chinese Communist Party (CCP) must retain power. The party’s power ideology must be preserved even if it means sacrificing economic growth. In addition, they both believe in pitting the rich against the masses to maintain this power which is always under threat from internal and foreign influences.
I agree with Orchard, a takedown of Xi is virtually impossible. Xi has consolidated power within the party so successfully that for a faction to take him down at this point would effectively put the party at risk. The key difference between Mao and Xi is that Xi will never achieve the cult of personality that Mao did. This is not only forbidden by the CCP constitution, but the disastrous fallout of 1966 Cultural Revolution still remains sticking point among party leaders. The revolution set the Chinese economy and state back an entire generation.
Orchard said it best, “[i]n Xi’s China, in other words, the next crisis is always, inevitably, just around corner.” Perhaps Evergrande is the next crisis waiting around the corner for the Chinese Communist Party and then again perhaps not. At present it would appear that there is a lot of wishful thinking on the part of investors of a government bailout, yet there is no real clarity from leaders in Beijing to that effect.
Under the auspices of “common prosperity,” a bailout it is not very likely. Any form of bailout from the CCP would have to fit within the parameters of its current ideology and end in pain for markets, as Michael Every of Rabobank concludes:
“The outcome is likely to involve serious pain for some markets --and management-- as we have already seen under ‘common prosperity’. However, a variety of bail-outs and bail-ins may ensure ordinary people are not too badly bruised. The industry and banking sector can be consolidated, and the tab passed to the PBOC. Evergrande itself can be renamed or repurposed: perhaps building “productive” social housing(?) – at the very least, operating under a tighter leash.”
Wall Street argues this is not the Lehman Brothers scenario which ushered in the Financial Crisis over 13 years ago. To cite Barclay’s analysts, Evergrande is nowhere near the magnitude of Lehman citing various factors from “lenders’ strike” to “policy mistakes” which may not be evident in this case. In our view, given the direction of policy in Beijing, it is understandable to see what we witnessed on Monday.
Outlook: Geopolitical Reset Still a Reality
In the early part of this year, we published our 2021 geopolitical outlook entitled, “The Geopolitical Reset.” In this featured analysis, we concluded that the power dynamics in the international system were effectively reset by COVID, placing the three major world powers: China, Russia, and the United States at the geopolitical starting line.
What we are witnessing in China in relation to these industry crackdowns is an affirmation of the reset mentality, whether acknowledged or not, in an effort to seize dominance on the global stage and make an example of the United States. Given the harsh realities of these crackdowns, Wall Street is quickly realizing its potential impact, although the risk of a 2008 Financial Crisis contagion still remains to be seen.
The competition between China and the U.S. is still the most important issue in geopolitics and for markets in the long-term. Although we stated Russia had the most to gain from the reset, it has yet to rise to the occasion.
U.S.-China relations are effectively still tied together, but very slowly drifting apart. This was evident following a dismal summit in Alaska in March and in September’s phone call between U.S. President Joe Biden and his Chinese Counterpart Xi Jinping. The Biden Administration warned and cautioned against an unintended conflict while maintaining fierce competition. Meanwhile Xi highlighted “serious difficulties” and the need for a new direction in the relationship during their 90-minute call.
It appears that the newly reset geopolitical starting line has psychologically placed the United States at a crossroads. Does its model for a free and open world carry on or has its time since passed? In the past 5 years we have witnessed Brexit, the Trump Presidency, and the fallout of COVID.
Now we witness China going “Back to the Future.” If China’s past offers us an informed hypothesis of the future, then it cannot achieve its grandiose ambitions. The Mao era has already proved this, and the Xi era won’t be different.
This now presents a new opportunity for the United States to perpetuate its global hegemony and solidify confidence in its markets. In our view, the U.S. domestic economy will continue to be a haven for foreign and domestic investment provided there is sound fiscal, political, and monetary policy. The alternative in China is far too unpredictable and concerning.
To quote the Oracle of Omaha, Mr. Warren Buffet, “never bet against America.”
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The opinions expressed here reflect the judgement of the author(s) as of this date and are subject to change without notice. Information presented here is for informational purposes only and does not intend to make an offer, solicitation, or recommendation for the sale or purchase of any product, security, or investment strategy. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here. The information being provided is strictly as a courtesy.
Wells Fargo Advisors, “Close Market Commentary,” September 20, 2021 and September 21, 2021.