Weekly Research Briefing: Body Shop Required

September 21, 2021

The slow-motion car wreck named Evergrande is now inches from hitting its destined tree. With interest due on its bonds and to lenders this week, there is no more running. Equity holders are nearly wiped out, debtors want their payments and homebuyers want their properties. The world has been watching this bad driver out of the corner of its eye for the past few years. But yesterday, the second largest property developer in the world was being placed under the market's microscope. Contagion looks to be rippling across other Chinese property companies given that real estate touches one-fourth of its GDP, one-third of its bank credit exposure and half of its consumer savings. Without government assistance, Goldman Sachs calculates that an Evergrande failure could cut 4% off China's economy next year. It will also raise the cost of capital significantly to all remaining property developers in the country, while at the same time negatively impacting property values. We shall soon see if the government wants to step in to act now or if they want to stay and watch the first few acts of “Lehman Brothers: The Musical."

The markets have their eyes on a few other developments right now:

  • Wednesday's Fed meeting should give us another glance at their crystal ball. Taper guidance coming?
  • Washington, D.C. spending uncertainty grows as the Dems squabble and the GOP resists.
  • Oh, and yes, another political sandbox fight over the debt limit.
  • U.S. economic data remains strong even as market sentiment and earnings guidance ebbs.
  • As we head into earnings next month, sales and orders are not the issue. Input prices and labor availability is where a company will beat or miss its numbers.
  • Aside from all the worries, the credit and lending markets remain rock solid, Europeans can now travel to the U.S., and the Pfizer vaccine shows "robust immune response" for kids aged 5-11 years old.

So, let's watch and see what China does about Evergrande. This will be a key read on how the country views its economy and population's investment in property. It could also have a near-term impact on foreign investment's appetite for investment into Chinese banks and other lending companies. This event will also be a good test for global commodity and equity prices. Will they disconnect from the Evergrande meltdown or use it as an excuse to ride the seasonal September/October pullback lower? Buckle up because we are about to find out.

Evergrande was the name of the elephant hiding behind the Aspen tree for the last few years...

Free Fall


The Evergrande situation was not unknown. What is unknown is how far the Chinese government will allow the failure to impact its economy...

When the troubled Chinese property giant Evergrande was starved for cash earlier this year, it turned to its own employees with a strong-arm pitch: Those who wanted to keep their bonuses would have to give Evergrande a short-term loan.

Some workers tapped their friends and family for money to lend to the company. Others borrowed from the bank. Then, this month, Evergrande suddenly stopped paying back the loans, which had been packaged as high-interest investments.

Now, hundreds of employees have joined panicked home buyers in demanding their money back from Evergrande, gathering outside the company’s offices across China to protest last week.

Once China’s most prolific property developer, Evergrande has become the country’s most indebted company. It owes money to lenders, suppliers and foreign investors. It owes unfinished apartments to home buyers and has racked up more than $300 billion in unpaid bills. Evergrande faces lawsuits from creditors and has seen its shares lose more than 80 percent of their value this year.

Regulators fear that the collapse of a company Evergrande’s size would send tremors through the entire Chinese financial system. Yet so far, Beijing has not stepped in with a bailout, having promised to teach debt-saddled corporate giants a lesson...

The biggest concern for the authorities is Evergrande’s unfinished apartments. The company has nearly 800 developments in progress in more than 200 cities across China.

Evergrande, which often presold apartments to raise cash before they were completed, may still to need to deliver as many as 1.6 million properties to home buyers, according to an estimate from Barclays.


Evergrande's credit break this summer screamed at us to pay attention...

Evergrande's Moment of Destiny


And while Evergrande's bonds began to break, so did the Chinese property market...

The most important recent developments are in the property market. Housing activity fell sharply in July and weakened further in August. At the same time, concerns over Evergrande are rising and signs of financing difficulties spreading to other developers are emerging. We estimate the potential impact on growth under different scenarios. For now, our baseline remains that any potential default or restructuring of Evergrande would be carefully managed by the government with limited contagion effect in both financial and property markets. This would require a clear message from the government soon to shore up confidence and to stop the spillover effect, the absence of which we think poses notable downside risk to growth in Q4 and next year.

(Goldman Sachs)

Another month of weak housing activity in August

Goldman Sachs estimates that the hit to China's GDP will be between 1.4% and 4% depending on the extent of government intervention...

With policymakers showing no signs of wavering on property market deleveraging, the latest headlines regarding Evergrande likely suggest that housing activity may deteriorate further in the absence of the government providing a clear path toward an eventual resolution for Evergrande. As our credit strategy team points out, Evergrande is large (total assets of RMB2tn, or 2% of China’s GDP) and complex (with over 200 offshore and nearly 2000 onshore wholly and non-wholly owned subsidiaries). But it accounts for only 4% of China’s total property sales and its 123,000 employees and 3.8 million contractors make up a fraction of China’s over 400 million urban labor force. In the event of an orderly default of Evergrande and limited spillovers to both the financial market and broader property sector, the macro impact should be manageable.

(Goldman Sachs)

Three scenarios of the property market impact on growth

Evergrande has become increasingly contagious to the other China-exposed property developers...

Tweet from @SoberLook

A slowdown in Chinese property development will directly touch commodity prices...

Tom Price at Liberum's estimate of how a real estate crunch in China impacts global commodities.

It’s generally well known (among resources sector investors, at least) that China’s share of global commodities consumption = 40-70%.

But what share of global consumption is China’s property sector? Of China’s total commodity supply, its property sector consumes:

  • 40% of steel flow (380Mtpa = 20% of global total)
  • 20% of copper (2.7Mtpa = 20% of global)
  • 15% of aluminum (6Mtpa = 9% of global)
  • 15% zinc (0.7Mtpa = 5% of global)
  • 10% nickel (0.2Mtpa = 8% of global)

ANSWER: China property = 5-20% of global commodity supply. - so yes, Evergrande’s potentially a big deal to Commodity World.


The largest component was seeing a freefall in prices yesterday...

Iron ore was down 10% yesterday in Singapore.

Iron Ore Futures

Two-thirds of portfolio managers think inflation is temporary. Evergrande could help prove them right...

Investors think inflation is transitory

And will the new slowdown in commodity prices dent the new long-term bull market in commodities?

The Biggest Picture: YTD annualized return from commodities best since 2000; 10-year rolling return from commodities now positive (0.6%) 1st time since 2014.

A secular bull market begins


The Chinese government has also let it be known that it will become much more active in its regulation of the Macao casinos...

We are lowering our ratings on our 3 Macau SAR centric U.S. listed companies (LVS, MLCO and WYNN) to Neutral from Overweight following the Macau Government’s announcement to tighten its casino regulatory oversight, which could have potential implications on gaming patron spend, as well as reduce the casinos’ ability to repatriate Macau FCF back to the U.S. (obviously if/when trends inflect) at least relative to the past. We are not overly concerned about licensing renewal terms (impossible to predict but nothing new) and we expect a renewal term that’s less than the current 20 years.


Rough Week


The Wall Street Journal is noticing a firmer government hand in the regulation of Chinese corporations...

For most of the 40 years after Deng Xiaoping first unleashed economic reforms in China, Communist Party leaders gave market forces wider room to flourish. That opening helped lift hundreds of millions of people out of poverty and created trillions of dollars in wealth, but also led to rampant corruption and eroded the ideological basis for continued Communist rule.

In Mr. Xi’s opinion, private capital now has been allowed to run amok, menacing the party’s legitimacy, officials familiar with his priorities say. The Wall Street Journal examination shows he is trying forcefully to get China back to the vision of Mao Zedong, who saw capitalism as a transitory phase on the road to socialism.

Mr. Xi isn’t planning to eradicate market forces, the Journal examination indicates. But he appears to want a state in which the party does more to steer flows of money, sets tighter parameters for entrepreneurs and investors and their ability to make profits, and exercises even more control over the economy than now. In essence, this suggests that he aims to rewrite the rules of business in what could someday be the world’s biggest economy.

“China has entered a new stage of development,” Mr. Xi declared in a speech in January. The goal, he said, is to build China into a “modern socialist power.”

Mr. Xi’s overhaul has generated more than 100 regulatory actions, government directives and policy changes since late last year, according to a Journal tally, including steps aimed at breaking the market dominance of companies such as e-commerce behemoth Alibaba Group Holding Ltd., conglomerate Tencent Holdings Ltd. and ride-sharing leader Didi Global Inc.

The government’s recent measures to tame housing prices are worsening a cash crunch at China Evergrande Group, a heavily indebted real-estate developer, sending chills across global markets. Beijing is unlikely to bail out Evergrande the way it has rescued many state firms, analysts say, and could further tighten the regulatory screws on other private developers.


At the end of the day, I will always look into the eyes of the credit market to tell me about the health of a market...

And right now, this chart gives me few reasons to be excited.

Bloomberg China USD HY Index

And while the Evergrande situation is beginning to impact the EM debt markets, it is having little impact on the U.S. markets...

Credit default swaps high yield and emerging markets

In fact, the U.S. high-yield debt and loan markets have rarely been stronger...

Analysts and investors expect bond and loan sales to each set full-year records. With rates low, companies are taking advantage of investors’ demand to refinance higher-cost debt, lowering their interest costs and pushing off repayment.

In the junk-bond market alone, U.S. companies have issued more than $361 billion of bonds with speculative-grade credit ratings through Sept. 14, according to S&P Global Market Intelligence’s LCD. That is the second-most junk bonds ever sold in a single year and on pace to surpass 2020’s $435 billion record, analysts say...

The rally in junk debt marks one sign of investors’ retreating worries about the recent jump in inflation, which erodes the purchasing power of bonds’ fixed payments and can drive the Federal Reserve to raise interest rates. The consumer-price index spiked above average yields on junk bonds earlier this year, upending the conventional logic of investing in bonds, which are typically prized for protecting investors’ money.

Sales of junk bonds and leveraged loans


The U.S. consumer showed its strength last week in the form of much better monthly retail sales...

And where auto and housing-related purchases paused, the other categories picked up the slack.

Retail sales show resilience in August


Besides thin inventories, high prices are causing consumers to delay auto purchases right now...

Buying Conditions for Vehicles

Consumers also think it is not the best time to buy a house right now...

The share of people who think now is a good time to buy a home fell in September to 29%, extending the plunge from March when the proportion was more than twice as high, data from the University of Michigan consumer sentiment survey showed Friday. It’s also the smallest chunk of respondents since 1982.

Back then, the average for a 30-year fixed rate mortgage topped 15%. That compares with yesterday’s 2.86% rate, according to Freddie Mac.

The figures highlight how property price appreciation has rattled prospective buyers and more than offset the bright side of cheap borrowing. Prices have skyrocketed amid low inventory as Americans compete for space, with year-over-year gains on previously-owned, single-family homes exceeding 20% --surpassing the inflation-fueled increases seen in the late 1970s and early 80s, according to the National Association of Realtors.

Little Reprieve


But good news for California's big cities: Rising real estate development and falling housing prices...

Fresh off his recall election win, California Gov. Gavin Newsom has signed three bills that will make it much easier to build multi-family housing in the housing-starved Golden State. One bill allows property owners to build duplexes and fourplexes on residential lots previously zoned for single-family homes. Another makes it easier to build smaller apartment buildings near public transit and jobs. The third one maintains restrictions on local governments’ ability to downzone and accelerates the approval process for housing projects. Taken together, Newsom’s actions “functionally eliminate single-family zoning across the state,” according to Bloomberg City Lab reporter Sarah Holder.

This is all far bigger news than the recall win itself, although without that victory, obviously, the legislation might have continued to languish. Given California’s size and influence, Newson’s actions are an important step in creating nationwide momentum to solve America’s housing problem. They show it’s possible to defeat entrenched NIMBY sentiment.

And it’s about time. For decades, local regulations have made it hard to build new housing, especially in some of the nation's most productive and high-wage job markets. These artificial supply constraints have, consequently, made too many of these cities unaffordable to working-class Americans. And those who do move to these cities find that high housing costs significantly eat into their wage gains. "The data show that many people, even those in the middle of the income distribution, have been excluded from these high-wage places because of rising housing prices," writes economist Daniel Shoag. What’s more, a recent NBER working paper by economists Joseph Gyourko and Jacob Krimmel estimates that these “zoning taxes” — the amount by which land prices are bid up due to supply-side regulations — works out to hundreds of thousands of dollars in places such as New York, San Francisco, Seattle, and Los Angeles.


Another lower peak in COVID, which could lead to a better holiday and year-end spending season...

@carlquintanilla: JPMORGAN: “We do not expect permanent demand destruction from this fourth Covid wave, but rather a delay in the global reopening... an increasing number of indicators are pointing to an inflection in the Delta variant, setting up for a powerful holiday season (unlike last year).”

Global COVID-19 Cases


Plenty of tidbits in the last week from conference pre-announcements and comments...

Definitely a more negative bent to the comments this Q3 from the Q2:

  • Cable stocks weakened after CMCSA says it has seen a "little bit of a slowdown in net adds" at the end of August after CFO speaks at conference.
  • JPM said today at a conference that it sees 3q trading revenue down 10% sequentially and y/y and sees 3q investment-banking fees up y/y and down q/q
  • PNC CEO: worried about real estate risk - Barclays conf comments
  • Amazon  Exec: increased its average starting wage in US ~6% to more than $18/h from $17/h in order to attract workers - financial press interview - Plans to hire another 125K warehouse and transport workers in US
  • Capital One reports August net charge-offs 1.54% vs. 1.45% last month and reports August 30-plus day delinquencies 1.79% vs. 1.71% last month; SYF reported August charge-off rate 2.59% vs. 2.24% last month and reports August 30-plus day delinquencies 1.33% vs. 1.37% last month
  • YUM China says same-store sales in August declined by mid-teens percentage Y/Y, or close to an approximately 20% decline compared to August 2019; said its adjusted operating profit would take a 50% to 60% hit in Q3
  • DRHorton cuts Q4 Rev $7.7-7.9B v $8.23Be (prior $7.9-8.4B), homes closed 21.3-21.7K (prior 23-24.5K), raises home sales gross margin 26.5-26.8% (prior 26.0-26.3%). Guidance cut due to continuing significant disruptions in the supply chain, including shortages and delivery delays in certain building materials along with tightness in the labor market.
  • AMERICAN EXPRESS: "You saw a very strong July in the U.S. in terms of T&E spending, then you saw some softness in August sequentially... I will say that if I look at the early days of September though it looks a little bit stronger in the U.S.”

Earnings estimates are beginning to flatten out along with their increasingly less positive guidance...

Are Forward Earnings Estimates Starting to Flatten Out After a Record Run

(Morgan Stanley)

The Godzilla in chips moves to raise prices, which should ripple across many corners of manufacturing...

Prices of chips and of the electronic devices they power are on track to rise into 2022 as the world’s biggest contract chipmaker joins its rivals in ramping up production fees.

Prices of semiconductors have been climbing since the last quarter of 2020 amid a global supply crunch. But news that Taiwan Semiconductor Manufacturing Co was preparing its biggest price rise in a decade still came as a shock to some, bringing home just how entrenched chip price inflation has become.

TSMC controls over half the global foundry market, making chips for the likes of Apple, Nvidia and Qualcomm. Known for its cutting-edge tech and high quality, the Taiwanese company normally commands production fees around 20 per cent higher than its rivals, according to industry insiders.

Since the end of last year, however, smaller foundries have repeatedly ramped up their prices, so that United Microelectronics, the world’s third-largest manufacturer, now charges more than its bigger compatriot for some services, four industry executives told Nikkei Asia.

These higher prices stem from a range of factors, including higher material and logistics costs as well as the race by device makers to secure adequate chip supplies, that have emerged since the chip shortage first began to bite late last year.

Prices are surging in the chip supply chain


It is a good time to be a school bus driver or a container ship captain...

WCI Composite Container Freight

Speaking of ships, it wasn't too long ago when I saw my first Amazon truck driving around the neighborhood...

@CameronWalkerSZ: First time I've seen Amazon containers... Slowly taking over the world... Credit to @JoonasGebhard

Ship Carrying Amazon Container Freight

I know some local gas producers who would be very happy with $17 natural gas prices...

It is supposed to be offseason for demand, and prices haven’t climbed so high since blizzards froze the Northeast in early 2014. Analysts say that it might not have to get that cold this winter for prices to reach heights unknown during the shale era, which transformed the U.S. from a gas importer to supplier to the world.

Rock-bottom gas prices have been a reliable feature of the U.S. economy since the financial crisis. Gas crashed and never recovered thanks to the abundance extracted with sideways drilling and hydraulic fracturing. Gas is burned to generate electricity and heat homes and to make plastic, steel and fertilizer. A substantial and sustained increase in price would be felt from households to heavy industry...

The supply deficit is particularly acute in Europe, where inventories are thin thanks to hot weather, lackluster wind-power generation and lower imports from Russia. Goldman Sachs Group Inc. analyst Samantha Dart said that stockpiles in northwestern Europe have recently been about 24% below average.

Prices have risen so high in Europe that Ms. Dart estimates U.S. prices need to climb to $17 with no corresponding rise overseas before it becomes uneconomic to ship liquefied shale gas across the Atlantic. She recommends that gas consumers buy out-of-the-money call options, or options to pay more than current futures prices, to guard against price increases should this winter turn out colder than normal...

The challenge in forecasting how high prices could rise lies in the unprecedented ties between the once isolated U.S. market and international prices, said Christopher Louney, an analyst with RBC Capital Markets. LNG export facilities were built along the Gulf and East coasts to relieve the shale-gas glut and enable domestic producers to capture higher prices abroad. Now higher overseas prices are lifting those in the U.S.

Natural-gas futures price, weekly


Speaking of, the U.S. liquid natural gas export business is becoming extremely profitable...

Spread between JKM Japan-Korea Cargo Swaps

I wonder what kind of FCF to shareholders the energy companies will return if natural gas prices head into the teens...

We think the most important narrative for E&Ps is the potential return of significant levels of FCF to equity holders. Whereas excess FCF has been largely utilized for debt reduction in 2021, we think 2022 will be the year of cash return to equity holders. Another key narrative is the stark improvement in gas and NGL fundamentals driven by U.S. shale spending restraint, robust export trends, and rising demand as economies continue to recover from the pandemic induced demand collapse last year. Since mid-year, the 2022-23 natural gas strip has moved to $4.25/$3.34 from $3.14/$2.79 (up 35% and 20%).


It looks like investors are lining up into energy again...

Largest inflow to energy since Jun 21


Individual investors are expecting much higher returns than financial professionals...

Amazing to me how bullish investors have become as rear-view mirror returns have turned significantly positive.

Global Average Expectations

While U.S. individual investors lead in optimistic return outlooks, most every geography is still expecting twice the after-inflation returns than financial professionals are expecting...

Return Outlooks


Meanwhile, a glance at a VERY BIG portfolio shows you how they are budgeting long-term forward returns...

@Cunningham_PI: CalPERS' investment staff recently showed potential future portfolios

CalPERS potential future portfolios


CavMan's PE finished the fiscal year + 98.7%. Whoa!

University of Virginia Investment Management Co.'s pool of $14.5 billion in endowment assets and other long-term funds returned a gross 49% for the fiscal year ended June 30, according to an annual report posted on UVIMCO's website...

The best-performing asset class for the most recent fiscal year was private equity, which returned a gross of 98.7%, followed by public equity at 51.4%; real assets at 49%; long/short equity at 33.3%; credit at 29.9%; marketable alternatives at 4.8%; fixed income at 1.4%; and no cash...

The pool's actual allocation as of June 30 was 29.9% public equity; 26.4% private equity; 17% long/short equity; 10% real assets; 5.2% marketable alternatives; 4.8% credit; 3.9% fixed income; and 2.8% cash.


This week, let's throw PE venture capital funds under the microscope...

In the last two weeks, we've looked at PE buyouts and PE growth, which are the two largest categories of investment in the private equity space. I received many calls to take a look at VC, which has been increasingly popular as returns have jumped in the last year. So, as you can see, PE VC funds returned almost 3.5x what the MSCI World Index returned in the Q1. As you would expect, this category of private equity has more observed volatility of returns, which can be affected by the exit environments surrounding IPO appetites and public company M&A environments. But surprisingly, over the previous 101 quarters, the quarterly volatility is only slightly higher than the public markets, with returns more than 1.6x better than global stocks.

Growth of 1 invested in PE Venture Cap vs. MSCI World

And when it comes to investing in PE venture capital, this is where buying professional advice to find a manager can most pay off...

As this chart shows, manager dispersion is enormous over the trailing 10-year window. Sure, getting the average return of private equity will be better than investing in stocks, but if you can get help to find the top quartile of managers, you will be dining with CavMan at the next Pensions & Investments awards dinner.

Private and Public Manager Dispersion


A good refresher on how we will wash our energy production clean...

The green energy future has arrived. Energy accounts for 80% of U.S. greenhouse gas emissions, making the energy sector the top target of any plan to fight climate change. Bill Gates’ How to Avoid a Climate Disaster, Pulitzer Prize winner Daniel Yergin’s The New Map, and the International Energy Agency’s Net Zero by 2050 report are the most recent illustrations of how reimagining energy's role in society will have substantial financial and geopolitical consequences. Investors must prepare for an epochal shift in how society consumes and delivers energy.

We forecast a 40% reduction in electric power sector carbon emissions during the next decade. This trajectory could get the U.S. close to net-zero power sector emissions by 2050, whereby emissions are eliminated or offset by carbon-capture or carbon-removal technology.

Utilities will play a role in eliminating as much as 75% of energy sector carbon emissions, including emissions cuts in the power generation, transportation, commercial, and residential sectors.

We forecast that clean energy will be 65% of electricity generation by 2030, higher than other forecasts but short of President Joe Biden's goal of 80% by 2030 and 100% by 2035.

Morningstar Clean Energy Climbs to 65%


Solar should continue to be a big winner during the next decade, eventually matching wind generation...

Wind and Solar Drive Clean Energy Growth Outlook


Usually an industry over-forecasts future growth, but not in solar's case...

Humans and even expert forecasters are prone to underestimate

Just a wild chart...

So if crypto implodes, the pain might be felt most by future university endowment gifts? Keep an eye out for a future hedge on Yale's books.

The crypto revolutionaries


Remember long ago when Apple had two or three price points for their phones?

When Apple unveiled its latest line of smartphones at a virtual event last year, not only did the company introduce more models than ever before at a single event, namely four, but it also kept more of the older models around than many had anticipated. That precedent was upheld yesterday, when the iPhone 13 was revealed, along with the latest iterations of the mini, Pro and Pro Max.

As the following chart shows, Apple now has an iPhone for (almost) every wallet, starting with the budget-friendly iPhone SE from $399 and ending with the top-of-the-line 1TB 13 Pro Max for a whopping $1,599 in the United States.


An iPhone for Almost Every Wallet


The author has current equity ownership in: Amazon.com Inc., J.P. Morgan & Co., & PNC Financial Services.

The information presented here is for informational purposes only, and this document is not to be construed as an offer to sell, or the solicitation of an offer to buy, securities. Some investments are not suitable for all investors, and there can be no assurance that any investment strategy will be successful. The hyperlinks included in this message provide direct access to other Internet resources, including Web sites. While we believe this information to be from reliable sources, Hamilton Lane is not responsible for the accuracy or content of information contained in these sites. Although we make every effort to ensure these links are accurate, up to date and relevant, we cannot take responsibility for pages maintained by external providers. The views expressed by these external providers on their own Web pages or on external sites they link to are not necessarily those of Hamilton Lane.

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