We started the week with quite a pronounced weakness in risk assets and outperformance of safe-haven assets. The main driver was the news surrounding Chinese real estate company Evergrande. The company has about $300 billion of liabilities, or 2% of China’s GDP, a significant number. This is a mixture of bank debt, corporate bonds, and onshore commercial liabilities.
Whether this triggers a systemic crisis and whether this is a ‘Lehman moment’ is still debatable. The Evergrande bond curve suggests that the market was expecting distress or some sort of default or restructuring soon.
The unfolding crisis will have a profound impact on the economic outlook for China. It’s less likely that Chinese consumers are now going to spend aggressively. Precautionary savings are likely to increase, and this ultimately means quite a grim economic outlook for China.
Secondly, what’s driving broader risk off is the deteriorating economic situation in developed markets. Economic data suggests we are in a stagflationary environment. A good way of observing this is by looking at the divergence between the economic surprise indices. If you look at the Citi Economic Surprise Index for the US, it is deeply in the negative territory, whereas the Inflation Surprise Index is in positive territory and the highest it has been for a long time.
What we are witnessing now is not ‘good inflation’, as it is caused by supply side issues. This ultimately leads to demand destruction. So, from an economic growth outlook perspective, this is quite negative.
Whether we stay in this stagflationary environment is debatable, but our team’s view is that the world we are moving between stagflation and deflation. Both of those environments are very negative for risk assets, but very supportive for the US dollar and longer-dated government bond yields as economic growth prospects deteriorate.