Investors have become increasingly concerned about excessive borrowing in China’s property sector and within Evergrande Group, one of the country’s largest property developers, particularly as the Chinese government has taken steps to tighten credit conditions. Moreover, the latest news about the property sector has come amidst other regulatory crackdowns in China (such as in the for-profit education industry).

We have followed these events closely as part of our ongoing research work on China and emerging markets and thus far we are of the view that these risks will be contained and, once through some of the short-term pain that we are seeing currently, new opportunities could emerge for investors in China.

Evergrande and the Outlook for Emerging Markets

First, important context is that we take risk into account in assessing the relative attractiveness of emerging markets by requiring a significantly higher extra return (return premium) than we would for a less volatile asset class. Risks particular to China are explicitly factored into our return requirement. The other side of the coin is growth assumptions, and while there are strong long-term positives, we have chosen to remain conservative in our view of the relative attractiveness until there is more clarity on the rules of engagement for regulation and on credit conditions in China. Second, we value the portfolio diversification benefits from having an allocation to China, in terms of opportunities and types of risk.

We remain comfortable with our portfolio positioning considering the risks and opportunities we see in China and emerging markets. Ultimately the reality of investing is that information like the problems facing Evergrande is quickly priced in (and more often over-priced in) and so the question is whether this is just louder-than-usual short-term noise or whether it is revealing a more fundamental long-term change that deserves to impact our long-term risk and return assumptions. That is the focus of our analysis, and we’ll share a few highlights here and expect to share more in our quarter-end commentary that will be available in early October.

A catalyst for the Evergrande-related turmoil is the Chinese government’s steps to rein in speculation that they believe is leading housing to become increasingly unaffordable, which is contrary to their long-term sustainability goals. In turn, these sustainability goals are surfacing issues related to excessive leverage in the property sector that have built over many years. As investors, we are focused on understanding how large the problem is and whether China will manage this adjustment well—two unknowns that become clearer with time. This uncertainty is being priced into the markets in typically messy fashion.

At present, we share the widely held view that it is not likely we will see a Lehman-like disruption locally or globally (the 2008 collapse of Lehman Brothers set off a negative chain reaction in the financial sector). For one, we don’t see the same feedback loop between China’s property sector and the global economy. In addition, Chinese citizens have a lot of wealth tied up in property, so it is in the government’s interest to avoid a chaotic wave of defaults and the government has the means to stabilize the financial system since it is the majority owner. A more orderly restructuring still seems the more likely scenario coupled with government monetary and fiscal stimulus.

It is also the case that a lot of bearish sentiment has been priced into emerging markets stocks. That said, we continue with our analysis and if we conclude the impact is likely to be long term versus temporary, we will factor that in to our portfolio positioning.

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