All Things in Moderation

Vital Statistics:

	Last	Change
S&P futures	4,341	-80.2
Oil (WTI)	70.17	-1.75
10 year government bond yield		1.32%
30 year fixed rate mortgage		3.07%

Stocks are lower this morning on fears of a hard landing in China. Bonds and MBS are up.

 

The big event this week will be the FOMC meeting on Tuesday and Wednesday. The markets don’t see any changes in the Fed Funds rate, however we could see some further language about reducing bond purchases. Aside from the FOMC announcement, we will get housing starts and new home sales.

 

The NAHB Housing Market Index improved a point in September to 76. This is a sentiment indicator for homebuilders.

 

Fears are increasing that the Chinese government is going to let property developer Evergrande fail. Evergrande is the most indebted property developer in the world, with something like $300 billion in liabilities. “Everyone is looking at Evergrande and saying ‘has the time come for a major default in that area, and then the potential for contagion into the broader property sector?’” said Edward Park, chief investment officer at Brooks Macdonald. “It’s an imminent risk now rather than being a theoretical risk as it has been for the past few years.”

The consensus so far seems to be that Evergrande won’t be a “Lehman-type moment,” in reference to the 2008 decision to let Lehman fail, which supposedly caused the 2009 financial crisis. The hope is that a collapse in Evergrande would be limited to the real estate sector and not impact financial sector (and therefore the overall economy) too much.

I suspect this is probably not going to happen. People who insist that Lehman and “subprime” blew up the economy in 2009 have it backwards. The issue was not the financial sector – that was the symptom. The issue was a real estate bubble – which was the disease. Real estate is such a leveraged product that if real estate prices fall by a meaningful amount, equity can be wiped out in a hurry. Real estate bubbles are therefore the Hurricane Katrinas of banking and the contagion spreads fast. When real estate bubbles burst, they throw shrapnel everywhere.

Managing a burst real estate bubble can be done – Japan did it. While there were a few developer and bank failures over the course of the decades that followed, Japan managed to prevent the economy from entering a Great Depression style tailspin. What was the cost? Little-to-no GDP growth from 1989 onward, and a debt-to-GDP ratio of 2.4x.

What does this mean for the US? I suspect the punch line is that we will see a flight to the US dollar and US Treasuries, and that will prevent rates from rising too much. If the Chinese economy hits a hard landing, they will try and export their way out of it, so import prices will fall and that should keep inflation from getting out of hand.

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