Why Are China's Evergrande and the Debt Ceiling, Dragging Markets Down? - 7investing 7investing

Why Are China’s Evergrande and the Debt Ceiling, Dragging Markets Down?

The market has had a rough week, but it's too soon to call it a crash.

September 22, 2021

Before very recently most Americans had likely never heard of Evergrande. The Chinese real estate company, however, has been in the news because it may default on some of its loan obligations and that has potential implications for not just China’s economy, but economies around the world.

Potential Evergrande default has been one of the big drags on U.S. stock markets. It’s more a case of people worrying about what might happen than any actual event taking place, but, as we have seen over the past few years, sentiment can sometimes mean a lot more than reality.

The stock market has struggled for more reasons than just Evergrande. Investors are also worried about whether Congress will take action on the debt ceiling. If it does not, the U.S. will no longer be able to borrow money and it will likely default on some of its debt. That’s a problem that has come up before — and Congress often takes things right down to the wire — but the current tense situation in Washington makes the threat of no deal being reached feel more real than it has in past years.

Maxx Chatsko joined Dan Kline on the Sept. 20 edition of “7investing Now” to break down what all of these threats, whether real or imagined, will impact the market going forward.

A full transcript follows the video.

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But before we do that, let’s talk a little bit about today’s market drop and comment on some of the reasons behind it. So the big reason maybe the one driving it is investors are worried about China, but it’s not the reason you normally think it is a default from real estate giant Evergrande, a company I heard of this morning for the first time, could ripple through global markets. Maxx, what does this mean? And again, please get in your questions and comments. What are you doing people you have a chance to talk to us here?

Maxx Chatsko  15:36  Yeah, so no, a lot of people have really heard of Evergrande. But it’s a big real estate company in China. You know, and maybe in recent years, we’ve heard stories about obviously, the crazy massive state investments that China’s made in infrastructure. Building highways for the first time building entire cities out of scratch for the first time. And we’ve also heard about maybe some overbuilding, some overspending, certainly a lot of debt. And for a while, you know, Evergrande, just kind of it’s always been like in this slow-motion train wreck. It’s a kind of staved off default. And it’s been, you know, paying people in weird ways, and just kind of prioritizing, you know, bills. And today, or at least recently, everyone’s like, Oh, crap, this is maybe going to actually go under. So the bill is finally coming due.

And people who are smarter than me and have written articles about this, say, this is from the Wall Street Journal, and quote, market participants increasingly believe that Beijing meaning China, the government, will let Evergrande did fail and inflict losses on its shareholders and bondholders. The company’s debt burden is the biggest of any publicly traded real estate company, or development company in the world, right? So debt total, $100 billion or more. In China, the government is gonna kind of send a message here, it’s gonna use Evergrande, as an example of what not to do. And of course, the government’s expected to actually help the little guy.

So if you put down a big down payment, you know, on an apartment, and the building was never finished, it’s been years, they’re not gonna let those people just kind of suffer and take the losses, but they might actually let this company fail, which is something the U.S. government never tries to do. We always try to bail everybody out. You know, everybody gift bags and things when the markets, you know, going down the tubes, and China’s taking a different approach. So that is kind of spooking markets. And, you know, look, this can ripple through the markets and the economy, the global economy, it’s increasingly intertwined in weird, weird way. So that’s kind of weighing on the US stock market today.

Dan Kline  17:29  We’ve got a viewer comment here, and I’d like to bring it up and let Maxx comment. Uncle Robbie, I think that’s what the name is, says Why would 600 billion in debt affect an American company? What’s Chinese debt have to do with Teladoc, for example? Well, let me let me jump in quickly. There is no direct correlation between Chinese debt and why Teladoc might be down today. I’m going to assume Teladoc is down today for the general broad market concerns we’re going to talk about later. But Maxx mentioned intertwined. But I’d be curious to know why particularly this company, this does not seem to be a high American interest company, do they own a lot of American real estate interests?

Maxx Chatsko  18:08  No, no, it’s not that it’s if you own the debt, if you’re a creditor of this company, and suddenly you’re not going to get paid? Well, that changes a lot of your calculations for how you run your business. So, you know, I don’t know this, specifically, maybe I shouldn’t name examples. But let’s say you’re Goldman Sachs and you own whatever, 10s of billions of dollars in this company’s debt, or you’re somehow three steps removed from companies that are going to take it on the chin, if this company defaults? Well, that’s where the ripple effects come into play. It’s kind of like, you know, in the last financial crisis, did it matter that a bunch of banks were packaging, really terrible mortgages in weird ways that they shouldn’t have been? No, that doesn’t affect everybody else. But eventually, it ripples down and, you know, three, four steps later, you know, it affects companies like Teladoc, or biotech companies.

Additionally, it’s important to keep in mind, you know, the markets are on a historic run, you know, from November 1 of 2020, through September 1 of this year, so earlier this month, the S&P 500 gained over like 36%. And since I’ve been alive, which granted is only like 13 years, but, you know, the largest annual increase in a calendar year for the S&P 500 was around like, 34%, that was in 1995. So, you know, to put that into context, the recent run where it just goes up all the time, and pretty much uninterrupted, is historic, so it’s not gonna take very much, maybe only a little nudge to maybe, you know, issue a little correction here, or there maybe just a little decline for a month, you know, doesn’t mean that recessions on the way necessarily, or anything like that. But, you know, the markets and asset prices are certainly expensive by most metrics. So it’s not that surprising, a good 2% decline or so forth. It’s not really that surprising in the grand scheme of things. So keep that in mind too.

Dan Kline  19:51  Join us Saturday afternoon for Maxx’s Bar Mitzvah. With that being said, I want to talk a little bit about this because when the markets are this hot, And obviously people have that, like markets only go up perception. We all know that markets have major pullbacks – big drops. And in the long term, it doesn’t necessarily mean anything. So we might see. And I think we’re still in this cycle that I think of as the pandemic cycle, where every now and then there’s just like a day where like a bunch of bad stuff happens. And people sort of wake up and go, okay, like, I’m a little bit scared. And I’m worried about the debt ceiling, which we’re going to talk about in a second, I’m worried about, you know, a handful of other things, China and inflation and car prices and whatever it might be. And the market just has a down 700 or 800 point day. Recent history on this has been recoveries, like within two weeks.

Now, I’m not saying that’s always going to be how it is the but right now, we’re in kind of an accelerated cycle. And do I think that will be forever? No, but the things we’re worried about, are still very, very tied to current market conditions. So you can’t talk about inflation without talking about what’s going on because of the pandemic. We’re going to get to more questions and comments, but I’d like to talk a little bit about what was supposed to be our main topic today, and that is the debt ceiling. Maxx I’ve heard a lot about the debt ceiling. But for those people who did not go to Hofstra University and study history where they actually never mentioned the debt ceiling. What is the debt ceiling? Why don’t you give us a little bit of a debt ceiling 101 here?

Maxx Chatsko  21:28  Yeah, Rumor has it in your economics professor was Professor Bernie Madoff confirm or deny? Is that true?

Dan Kline  21:34 No, no, no, Bernie Madoff is our most famous alumni, not a professor, I actually was really lucky that my advisor was professor Doug Brinkley, the NBC presidential historian, and a wonderful author. And a pretty delightful man. So I was very, very lucky in that experience. But what is the debt ceiling? Is it one of those popcorn ceilings that people complain about when they buy a house?

Maxx Chatsko  21:58 Yes, exactly. No. So we have this quote here from the US Treasury, the debt limit is the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. So importantly, you know, this doesn’t have anything to do with like, the US Congress wants to pass a $13 trillion budget for the next leg – that that doesn’t come into play for this. This is for obligations that are existing already on the books, people already demanding their money. So important to remember, a couple of details here, you know, this is we thought I thought it would be a good idea to start talking about the debt ceiling, because, you know, these deadlines are coming up, literally, we know that Evergrande would be the story today, but the US government’s fiscal year ends on September 30. So it doesn’t line up perfectly with the calendar.

And that means sometime in October, the US Treasury is probably going to run out of money to pay these obligations. Man, you know, keep in mind, the US federal government gives money to states, gives money to towns gives money for social programs, the military, and importantly, you know, principal payments on debt and interest payments on debt. So if the US defaults, really, really bad news, the Treasury will need to decide which obligations it would want to prioritize. A recession would be likely if we didn’t get a handle on it soon, you know, we could lose millions of jobs, or could be just widespread – we’re talking about ripple effects from some relatively large company, a real estate company in China, if the US government defaulted on its debt, I mean, wow, that’s gonna be really even way worse.

So, you know, the, the realistic things that would happen, I mean, you know, the US credit rating would probably be permanently impacted, asset prices would probably fall across the board, and interest rates would go up permanently, because, you know, if you default on debt, creditors are going to demand a little bit higher yields, because they don’t don’t want to be the next ones that you don’t pay. So that would actually affect consumers, cars, houses, credit cards, personal loans, everything, Bitcoin loans, I don’t know, you know, all those things would be jacked up. So it would actually affect consumers and, you know, be permanent. So this would be absolutely worst-case scenario for them.

Dan Kline  24:09  So I want to push back a little bit, because we’ve been to this Brink before. And we’ll talk about the politics without getting political in a few minutes. But when this happens, so let’s say we get to October 5, we’re quote, out of money, it doesn’t mean we have zero, it just means we have less money coming in than we do because you can’t borrow more. So you can still spend what’s coming in from taxes from from various other reasons. Here’s how I look at this. The US government is so gigantic, that people need us to borrow from them. And the reality is, it’s just like when you’re a billionaire who’s borrowing money, who owns assets that nobody wants, it comes down to you’re going to call your creditors, you’re going to say hey, yep, we’re not issuing tax refunds. That’s one that’s easy to push down the road for a while. But you know, hey, we have to pay these things.

And you’re going to negotiate just like any The person that has a lot of assets but has a cash flow problem, and you’re gonna say, Hey, we’re still gonna pay you, but it’s gonna be a little push down the road. I also think maybe, and again, Maxx, you can push back here because it because that there will be long term effects. But they won’t be as extreme or as long term. Because the reality is when you’re the biggest player in the room, or the second biggest player, depending how you look at it, people are going to want to loan money to you. And look, we’ve seen people with multiple bankruptcies, get specific loans, you know, get and get loans on favorable terms. And that’s not limited to the one person everyone’s thinking out there. This has happened with lots and lots of companies, lots and lots of people.

There is such a thing as too big to fail. And I don’t want to say the US government is too big to fail. But I’m pretty sure a two-week snafu in, you know, the political negotiating of raising the debt ceiling, which we know is what ultimately is going to happen. I’m not sure a delay in this is really going to have these catastrophic effects. Because I do think that could happen that we might get, you know, this forced to be passed along party lines, which will take longer for various complicated budget reasons. So I don’t know, I am not as worried about this as the rest of the news media appears to be Maxx, your thoughts here?

Maxx Chatsko  26:19  Yeah, that’s absolutely correct. So you know, this has become a political football in the last decade, right?

Dan Kline  26:24  It’s the worst kind of football by the way. That’s it’s, it’s even worse than like low-end College Football

Maxx Chatsko  26:29  It’s like what the Pittsburgh Steelers season is going to be this year. Oh. So yeah, a lot of drama, a lot of political grandstanding. And usually we you know, Congress will suspend the debt ceiling or raise it. So leading up to that decision that vote in Congress authorization, you know, the market can still be kind of volatile. But eventually, they end up doing the right thing, which is really supposed to be one of the most boring parts of their job, but somehow they turn it into all this drama. But you know, you’re right. I mean, even if we did default, or for a little while, or a credit rating took a hit, you know, not to brag, but like, Where else are people going to invest globally, right, like you’re you’re Europe is kind of, you know, you have negative interest rates there, China, obviously, we’ve seen is paying closer attention to some of its internal issues and concerns. So really, where else you’re gonna go if you’re a global investor, so like, the US is still a pretty good destination, in the grand scheme of things. So you’re probably right. But if we did have to increase interest rates higher that does kind of lit that impacts little guy. Meaning me, meaning consumers, you know, so

Dan Kline  27:37  Let me jump in on a couple areas. One, interest rates being a point or two higher would still leave them at like pretty near historic lows, when it comes to like buying a house like my, my first mortgage was an 8%, my parents was in like the 20. So like, if mortgages go from like three and a quarter to four and a quarter, that’s just historically somewhat irrelevant, though, in the short term, maybe it would cap some demand. That being said, like we’re looking at properties, and the mortgage company we’re using, told me, they’re 45 to 60 days out on closing, so maybe a little less demand might not be the worst thing in the world. The other thing I’ll say is we’ve learned some lessons from the 2008 financial crisis. Now a lot of the 2008 financial crisis was bad loans, like giving a loan to someone who legitimately couldn’t afford it.

Right now, we have loans essentially, to people who can afford it that might have cash flow issues. So we saw all across our economy during the pandemic we saw like, good mall companies say, Okay, alright, Cheesecake Factory, you can’t pay your rent right now. Because there’s not a lot of customers coming in? Well, what if we added six months to the end, and you pay 5% more a month, starting in a year from now. We’ve also seen banks be willing to do that with mortgages and go, okay, Maxx, you’re not working because you’re a waiter, but you’re a waiter at a high end restaurant, you make 150 grand a year, you know, or you’re in a field that’s had a big slowdown, but we expect will recover. So we’ll give you forbearance, you don’t have to pay your mortgage for six months, we’ve seen a lot more willingness to do that. I do kind of feel like as a government, we could probably figure out how to get, you know, a couple of months of leeway. Because I don’t know, Do they really want to foreclose on the Statue of Liberty like I’m joking a little bit, but it just doesn’t seem like a foreclosures in anyone’s best interest.

Maxx Chatsko  29:23  Right. But one thing to keep in mind too, even if interest rates go up, like 1% or 2%, or whatever it might be, they might go up more, you know, it’s sure in the grand scheme of things a 1% increase is small. But this would be offset by falling asset prices. So you’d be paying a higher interest rate and maybe the price for house falls by you know, 30-40% like that is so that changes the equation a little bit or you know, or if asset prices don’t fall, which is what usually happens when yields increase. Then look, think about people who don’t own a house yet. They have to pay high asset prices and high interest rates and I could just kind of keep stacking on.

Dan Kline  29:58  I understand because I’m in both situations. I own a property, but I don’t own a principal residence, so you know, it’s something I’m absolutely aware of. But I do think right now we’re in what I call a sad day cycle, where we just woke up today. And there’s a whole bunch of bad news. And that’s kind of a reason to sell, when a lot of people maybe are fearful of valuations in the first place. So if you were looking at a reason to, I don’t know, shed some Peloton stock well, their earnings report, which was mediocre, plus, you know, the market generally being down maybe that mentally got you to like geez, are people really going to buy a $1500 exercise bike and pay 49 bucks a month to ride it? So I don’t know, I just feel like tomorrow there’s going to be some mild piece of good news. And we’re going to see the market close up 140 points, am I reading this totally wrong. And then we’ll take Raul’s comment, which is one I don’t think we’re qualified to comment on. But I saw it so much in the news today, I’d like to address it.

Maxx Chatsko  30:57  No, I think I think you’re correct. You know, like, we wanted to bring up the debt ceiling, because investors gonna be hearing a lot about it between now and you know, the next three weeks or so. So we wanted to kind of prime you guys on that. And, yeah, overwhelmingly, the odds are that Congress is going to, you know, either do the right thing, let’s say, right. But, you know, again, man, there’s a lot of scorched earth in politics lately. Who knows, maybe they do let it default just to, you know, try to point the finger at the other. And that would not be good. But you’re right. And in the grand scheme of things, people are still going to come to the United States and invest. We’ll probably figure it out. But it could still be really interesting in the next month or so for investors nonetheless

Dan Kline  31:40  Daniel Delgado will take your comments at the end of the show. I wrote a hot he says an interesting thing related to the debt ceiling is the possibility the US Treasury mints a $1 trillion coin. I feel like there was a Simpsons where Monty burns had a trillion-dollar bill that was supposed to settle European debt, and he flew away with it. Maxx is this one you saw because like, here’s the weird problem about this. All money is theoretical, there is no backing to the US money. So literally, if we raise the debt ceiling, we literally could say, okay, we now have a bazillion-dollar bill with Guy Fieri’s face on it. Like, it doesn’t matter what you can do whatever we want. And as long as like there’s sort of global faith that the US is valuable and will pay it’s sort of made up not really attributed to anything dead. None of this kind of matters, right?

Maxx Chatsko  32:31 Yeah. In the grand scheme of things. That’s correct. And actually, as a kid, again, I can’t tell you, I probably got this three times. It’s like a birthday present over the years, but people would frame like $1 million bill, because they used to call me Maximillian. It was so cheesy, like, you know, like, I mean, they must have all seen that Simpsons episode too. So.

Dan Kline  32:50  And yeah, and here’s the thing, why are we here today is to calm you down a little bit. We’re not saying markets don’t have corrections that we’ve all experienced 20 30% drops that that last for, you know, six months, a year, even longer than that. But historically, good companies recover. It’s sort of one of the things we preach at 7investing, and it’s very difficult when you do what we do to not look at returns on a daily basis. But do you honestly don’t believe that the strong companies that are out there, you know, and I’ll pick one, just a random, strong company, is Microsoft weaker today? Because of any of this? And the answer is sure, they have some exposure of businesses can’t pay for as many seats.

But the reality, those are not likely to be foundational changes for the company. But Max, I want to talk a little bit about the Fed because there’s two days of Fed meeting today. And one of the concerns cited across many articles I read today was that the Fed might start to taper some of its, you know, its policies that sort of propped up the economy. And I will push back and say there is zero chance on a day the market is down 700 points, that the Fed is going to put any bad news out there, they will at least kick the can down the road to a to a next meeting. These are not dumb people politically, they are not going to send the market to a 2000 point loss on a day when it’s already down 700 points. So I’m going to argue nothing happens in the next two days, Maxx.

Maxx Chatsko  34:17  Yeah, I kind of disagree because the meeting that they’re having, and they have monthly meetings every month, that’s why they’re called monthly meetings, Maxx. Good. So but um, you know, this meeting, look, they’re talking about tapering, so they are currently buying $120 billion a month in mortgage-backed securities and Treasury notes. This is already actually priced into assets, equity or financial markets that the Fed is eventually going to begin tapering, which means reducing those purchases every month. So I think that’s already in the work. So they already are, like, pretty much guaranteed to begin tapering before the end of 2021.

Where I think you’re correct, though, is that now that the debt ceiling dramas taking place, the Fed certainly not going to begin doing that Before that risk is passed, because if if, you know Congress does allow the U.S. to default on its debt or not raise the debt ceiling in time. Well, the Fed suddenly has to spring into action. So they need to keep all the firepower they they possibly can, you know, in their pocket ahead of that decision. But, you know, once we pass that, you know, Congress raises or suspends the debt ceiling, you can expect, I think the Fed to begin tapering those asset purchases, I do think though it’s, you know, interest rates rising, which has maybe the bigger effect on stocks, that’s not likely to occur until, you know, maybe later in 2022, though, obviously.

Dan Kline  35:41 So one of the reasons we’ve heard for the Fed slowing down or, you know, or quote tapering is that there’s, quote, surging inflation, and improvement in the job market, I want to tackle both of these quickly. So I’ll push back on surging inflation. We’ve talked about this before, if you take out car prices, inflation is relatively minimal. If you also factor in the very weird cycle, for purchases like and I will point out, I’ve talked about this before, we had a very odd tourism season here in Florida, where the summer was much busier with local travel. So the target near my vacation home was sold out of towels. Well, they probably ordered a bunch of towels, but then came in. And I don’t have any bookings this month, because nobody wants to come to Florida, and school is back in session. So locals aren’t traveling. I know that’s a really, really silly, extreme example.

But a shortage of products or lumber costing more, because we’re building a lot more houses. That’s not necessarily inflation, if it’s a pipeline, so I’m not worried about inflation. And we get to the surging job market. Yes, we have a lot of jobs there are, there are way more job openings than there are people to fill them. But I would argue that there’s not a ton of great jobs out there that sure, if you’re out of work, it’s great that Target or Chipotle, lay or whatever else it might be now pays more than $15 an hour in a lot of cases. But I’m not sure that that’s great for the executive who got laid off during the pandemic, you know, who can’t replace his income. So I think both of these things aren’t exactly what they look like, Maxx, I’ll give you the last word on this one.

Maxx Chatsko  36:32  It is always interesting, right with the inflation discussion, because it kind of depends on how you look at it, or what numbers you’re looking at. I mean, even the Fed takes inflation indexes and adjust them to its own like, it literally takes out the top 30% of contributors and the bottom, like 20% or so contributors. And then it arrives at, you know, some adjusted inflation number.

And there’s some criticisms to go around for that as well. And then, like you said, you know how much is it is due to supply bottlenecks. How much of it’s due to easy monetary policy, I don’t think there’s really any easy way to tell right now, when we’re in the moment we’re living through it. So I kind of lean towards it being a little less likely to be transitory, I think some of this higher inflation is going to be a little more permanent, meaning like, lasting for several years, not just kind of going away next year after the year over year comparisons change. But I don’t know, I also didn’t run a toy store or optimizing at a ladder company like you did. So yeah.

Dan Kline  38:17  So look, I did buy commodities for four years and you had to sort of, you know, hedge your bets buying things that advanced we see that the airlines and the cruise lines do that with fuel, you know, where they’re, they’re okay, it’s low. So we’re gonna buy a lot now. But when it’s high, we’re betting on futures and things like that. There’s a lot of things you have to do. But this is the year it’s been hardest to forecast demand, add in the chip shortage. And all of a sudden, you have things like a shortage of laptops. Yeah, it’s really unfortunate if you need to buy a car right now, my personal trainer, his air conditioning is dead in his car. And he’s been desperately trying to put off buying a new car because it’s a terrible time to buy a new car. My cousin, for reasons I won’t elaborate had to move –  great time to sell her house. A bad time to buy a new one.

So yeah, for people who have to do this, like my son is coming up on a team, he’ll get his license, add a team because he didn’t take driver’s ed soon enough. And ideally, he’d have a car, but he won’t need a car, he can wait a few months to get a car. So I do think you feel like it’s really terrible inflation if you have to buy a new house at a time where home prices are really high. Or if I am, you know, I forgot my razor on a cruise ship about a year ago and I had to buy go buy like a really crummy one in Nassau. That was like $19. Like, that’s not inflation, but it feels like the price of razors has gone insane. So I’m not saying some of this isn’t real. And we haven’t seen some real supply shift or in some cases, maybe demand we’re going to take decades to catch up on with some of the chip stuff, maybe not decades, but maybe maybe longer than two, three years to really catch up there.

So there might be some items that are significantly more expensive, but I don’t think we’re gonna see across the board. Everything cost 12%. More like we saw this during the early days of the pandemic, where no one was hard to find certain cuts of meat, you know how to get around that? Get a different cut of meat like, and I think we’ve seen that with laptops, we’ve seen that with televisions where you’re right, you might not be able to get exactly the laptop you want. But you probably will be able to get a sub $400 laptop, this Christmas season Maxx, I haven’t shopped for you yet. So I can’t promise you’re getting a sub $400 laptop, but you know, hey, it is possible. I will give you the last word before we move on to a couple of comments and then hit our finisher.

Maxx Chatsko  40:36  Dan, all I know is if you give me a $1 million bill, it’s framed and says Maximilian, we’re gonna have to have a talk. So that’s all I’ll say

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