Can the Fed disrupt stock market gains, and why China’s evergrande is causing wobbles elsewhere

This week the much-anticipated Federal Reserve meeting is being held, yet financial markets are in risk-off mode due to fears about the world’s most indebted property company, Evergrande. The Chinese company has seen its share price tumble since it warned that it was at risk of defaulting last month. A property developer at risk of default is nothing new, however, Evergrande is the world’s most indebted property company and owes more than $300bn to creditors and suppliers and is due to pay its offshore bond payment on Thursday. Evergrande’s share price fell another 18% on Monday, and the sell-off has spread to other Chinese real estate companies and financial firms. The crisis at Evergrande triggered a 3.5% sell-off on the Hang Seng, while stock markets in China and Japan are closed for a public holiday.

Why Evergrande may not cause contagion elsewhere

While it is still too early to talk about contagion from Evergrande to other companies in Europe and the US, a catalogue of weak data points from China in recent weeks, including retail sales and industrial production, are converging to weigh on broad risk sentiment. However, it is only natural that investors in Europe and the US are starting to piece together the jigsaw of China’s credit problem that seems to lie with property developers. If Evergrande is not able to pay this Thursday’s offshore bond payment, then other developers must also be under extreme pressure to pay back dollar-denominated bonds in the coming months and years. China’s property developers are also at risk from political pressure from Beijing who could push listed real estate companies to cut the cost of housing in mainland China and Hong Kong. China has shown that it is willing to force through social change even if it means interfering directly in Chinese companies. The prospect of lower property prices is also weighing on banks in the region as investors wonder what will happen to China’s mortgage business if the Chinese government force through lower property prices? Thus, the Evergrande crisis could be the tip of the iceberg.

The risk to the broader Asian market

These are large questions for investors to ponder on a Monday morning. There is no certainty that political interference won’t weigh in China’s stock market and the Hang Seng in the future, thus, traders who want to trade in the region need to be careful. We would not recommend buying indices, and as we have said before we think that it is safer to be in sectors that complement China’s long term economic plan. For example, the industrial sector, especially firms that are domestically focussed and have a low profile. For now, we think that Asian markets will continue to sell off once Japan and mainland China’s markets re-open on Tuesday. We expect sentiment to remain shaky leading up to Thursday’s deadline for Evergrande to pay its overseas bond payment. We would note that China is rapidly trying to de-leverage its economy, so we do not expect a government bailout for Evergrande. However, we also think that the contagion risk to the rest of the world is low. Other Chinese real estate property developers have defaulted over the years and although they are not as big as Evergrande, they have caused little ripple effect. We believe that Evergrande’s main impact will be felt in China, and in regions and sectors that are linked to China’s highly indebted housing market.

Getting picky in Europe, why Holland and Austria are beating their bigger rivals

Interestingly, for those looking to cut their exposure to Asia, there are some key developments to watch out for in Europe. Firstly, the German Dax index is expanding to include 40 companies instead of 30, there is a FTSE 100 reshuffle, which could see WM Morrison’s replace engineering giant Weir Group. Also, the Dutch and Austrian indices are some of the best global performers so far this year. These often-overlooked indices are up some 34% and 33% respectively. The reason is not because investors are desperate to get exposure to the Dutch and Austrian economies per se, rather both indices have some important companies in their ranks. Demand for ASML, the producer of high-end lithographic machines that are used for semi-conductor manufacturing, makes up 40% of the MSCI Netherlands index and is driving demand to own the Dutch index. In the Austrian index, oil and gas producer OMV and electricity provider Verbund are the shining stars. OMV has benefited from the sharp turn-around in oil prices this year, while Verbund has bucked the trend for weaker share prices for the utility providers, since almost all of the energy that it produces comes from renewable sources. In the current environment, with natural gas prices having tripled and an energy crunch coming to Europe, Verbund is likely to see further gains in its share price this winter.

A hawkish message from the FOMC is coming, but it might not be about tapering

The big event for this week is the FOMC meeting, and the investment community will be watching closely to what Federal Reserve Chair Jerome Powell has to say about tapering. Will they bite the bullet and follow the ECB and announce that they will be scaling back their asset purchases? In August, Powell said that two conditions needed to be met before the bank would consider tapering: strong employment growth and inflation at 2%. Inflation is well over 2%, however, the last NFP report was much weaker than expected, and it suggests that there is still some way to go before the US’s labour market gets over its Covid shock. Right now, the Fed is purchasing $120bn of assets per month, consensus suggests that the Fed will strongly suggest that this amount will be tapered, however, possibly not until November or December. They may also tie a reduction in asset purchases to another month of good jobs data. The market will also be looking at the Fed’s dot plot, which is unlikely to show any dramatic changes, and the first-rate increase is still not be expected until 2023. This week’s dot plot will also give us the first look at expectations for 2024, where we expect there to be the bulk of rate rises, with three increases expected for 2024. An updated dot plot could be considered a hawkish development; thus, we could see the bond market sell off and yields rise on this announcement.

How to trade the Fed

The dollar is the big winner in the FX market today as stocks across the globe are a sea of green. In the UK, the FTSE 100 is down 1.8% so far, with companies linked to China, utilities and insurers some of the worst performers. On the plus side, IAG, the airline conglomerate is a top performer on the FTSE 100 and is up more than 2% on hopes that Prime Minister Johnson can persuade US President Joe Biden to loosen restrictions on leisure travel from the UK to the US during his trip to the US this week. Overall, it’s a rough day for risk at the start of this week. We think that the future of equities will depend on two things: a hawkish tilt from the Fed and rising benchmark bond yields. If Treasury yields can continue to rise, then this could be an important moment for stocks. In the last year, investors have had no choice but to buy stocks as they were not getting yield from elsewhere, for example from sovereign bonds. Thus, until bond yields rise stocks will continue to move higher. If the Fed meeting can turn the dial on bond yields, then the equity/ bond debate could shift, and stocks could come under sustained pressure. Right now, the market is pricing for a hawkish Fed, the dollar is also rising on Monday, and could be a big winner in the FX space this week if we see the Fed get serious about rate increases in 2023/24.