Is the Chinese property sector simply too big, too overvalued and too important to fail?

We discussed the Chinese property bubble in our last blog as residential properties in Beijing, Shanghai and Shenzhen are now trading at 43 times average earnings. The property sector makes up 25% of China’s GDP growth which is three times more than the relative weighting of the US property bubble of 2007.

This bubble is now the worlds largest and there is trouble expected within this sector. The Evergrande Real Estate Company is one of China’s largest real estate businesses and is now the worlds most indebted property developer weighed down with US$300bn of debt. Shares in Evergrande have collapsed as contractors wait on payments and buyers are worried that deposits could be lost. Contagion amongst China’s other leading property developers is inevitable.

The Chinese authorities do have the capacity to step in and rescue this company as the knock-on effects of any collapse on the debt laden Chinese property market will hit the Chinese economy and damage global growth. Any failure of Evergrande and the default of US$300bn of debt will have wider consequences not lease a Chinese debt crisis. However, the reality for the Chinese authorities is that the property sector is simply too big, too overvalued and now too important to the wider economy to fail. Therefore, the reaction by Beijing to this threat to economic stability will be closely watched. China certainly has the liquidity to resolve the problem but some analysts think that this may not occur and that property speculation needs to be reined in. The general view is that a restructuring of debt will occur.

Other factors that are making world markets nervous this week is the Federal Reserve’s expected announcement over the rate at which bond purchasing reduction will take place. Markets so far have been at ease over Jerome Powell’s announcements and we hope this will continue. The Fed has suggested that QE tapering will start in November but the rate of reduction is yet not clear. Additionally, Europe is being hit by an energy supply issue as Russia limits the gas supply to the Eurozone, while alternative energy sources have suffered coincidental setbacks.

Our exceptionally low natural gas reserves have left the UK vulnerable to a global supply squeeze on gas supplies. We will become reliant upon cross channel interconnectors in order to satisfy demand which may be limited if Europe also faces power shortages.

This reduction in back up supplies have occurred due to the closure of the Centrica owned Rough gas field storage facility off the Yorkshire coast in 2017 and the subcontracting of gas storage to Germany and the Netherlands. The UK reserve levels are currently 1.7% of our annual consumption while energy security specialist think this should be over 20%. Dutch reserves are usually 85% of annual demand but are now running at 52%.

Several things have gone wrong at the same time for the UK energy supplies. Covid has disrupted gas production while the shipping of LNG has been reduced. Asia has consumed a far greater level of LNG forcing price rises. Vladimir Putin has taken advantage of this crunch in supply and restricted the normal European supply through Poland and the Ukraine in order to pressure the EU to agree to the new Nord pipeline on his terms. Gazprom are also working to rule resulting in reduced gas production.

Renewable power, which is seen as the future, has an intermittent nature to supply as it is reliant upon the sun, wind or tide. The move from carbon to green energy will need to be backed up while the change occurs. Our limited reserves of gas have exposed how poorly prepared the UK is for this major change.

The result of petrol price rises, energy costs and widespread supply chain inflation makes us feel that UK and global inflation will last longer than some analysts suggest. We are happy to have taken steps within our portfolios that have given protection against inflation with durations on our fixed interest securities limited to an average of 3 years and having an increased proportion of index linked returns. We also significantly reduced our exposure to both China and emerging markets within our Edition 35 portfolios.

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