Over the years, we have occasionally told clients that “Debt is never a problem, until it’s a problem … and then, it’s a really big problem.” We are witnessing the truth in this cliché.
We write this on Monday, September 20th, a day when the broad markets opened the trading day down on heavy volume, ultimately closing down ~3% for the day and ~8.7% from the September 2nd high. Quoting a CNN Business article, “Analysts expect the Chinese government to intervene to limit the fallout if Evergrande were to default.” In contrast, the markets’ action today appears to be driven by fear that Chinese President Xi Jinping will actually not bail out Evergrande after all. You might recall the very similar scenario during the Global Financial Crisis (GFC) when the United States Government refused to bail out Lehman Brothers. The rest, as they say, is now history.
Evergrande is a very large real estate company in China. It is also a member of the Global 500, an index similar to the S&P 500. Therefore, a debt crisis from one of the world’s biggest business entities is very big news indeed. According to Bloomberg, Evergrande has ~$300 billion in debt. The company has continued to finance their growth by more and more debt. Up until recently, there has not been much concern.
When Hicks & Associates Wealth Management began 23 years ago, the US media would have given this scant attention. But these last two decades have seen the Chinese economy become the second largest in the world while the world has also become more and more globalized. So, if Evergrande does indeed default on their loans, it is far more likely that it will have a cascading effect.
Here in the United States, we also have a mounting debt problem. See the chart below.
Chart 1 – Data Source Optuma & St. Louis Federal Reserve (FRED)
The chart above is our federal debt as a percentage of our nation’s Gross Domestic Product. Our debt is currently at 125% of GDP. Keep in mind that one difference between Evergrande’s debt and our national debt is that Evergrande’s loans can be secured with liens (mortgages) against their property. Our federal debt, on the other hand, is based solely upon our nation’s “ability to pay” making it much more akin to credit card debt than a secure loan.
Historically, our nation’s leaders would borrow money so as to finance the navigation of some crisis or another. Unfortunately, our leaders long ago lost the discipline of paying down that debt once the crisis has passed. Whether or not we are past the current COVID crisis is irrelevant. When your credit card debt is already 125% of your gross income, you might not have the ability to wait until the crisis passes; the debt collectors will start calling as soon as you start missing your payments. And the United States Government is projected to hit their debt ceiling limit next month.
As our cliché states, our nation’s debt is not a problem … until it’s a problem. This is what Evergrande is experiencing now and what Lehman Brothers experienced back in 2008. Countless others have experienced the same phenomenon over the years – if debt is not controlled, the borrower becomes slave to the lender.
This is closely tied to the #1 concern we have had all year: inflation.
The chart below is the one-year rate of change chart for the Consumer Price Index. The good news is that the recent data has shown a decline in this rate of change. However, as you can see, we are still at an elevated rate. Unfortunately, one of the ways that many nations have delt with their high debt loads over the decades is by inflating their way out of it. In essence, history shows us that many nations keep on borrowing to finance further growth in hopes that the growth in the economy will be greater than the growth in the debt.
That’s been Evergrande’s strategy too.
Chart 2 – Data Source Optuma & St. Louis Federal Reserve (FRED)