“A very small cause which escapes our notice determines a considerable effect that we cannot fail to see, and then we say the effect is due to chance.” – Jules Henri Poincaré (1854 – 1912)
The “Butterfly Effect” is commonly referred to as the large unforeseen consequences that can occur due to a small event. Over the past week I have been asked by a number of our clients and advisors how a potential default on debt by the largest property developer in China might affect a US investor. For anyone who has not been reading through the Wall Street Journal lately, Evergrande is one of the largest property developers in the world. Based in Shenzhen China, this real estate developer has about $300 billion worth of liabilities, which is more than any other property developer in the world.¹ For context, the debt that they have issued accounts for approximately 16% of the outstanding high yield notes in China.² It is worth noting though that the $300 billion is also only 1.8% of the total outstanding debt in China.³ While the company’s ability to make debt payments has been a concern for weeks, the concerns came into greater focus this week because $83.5 million in interest came due on Thursday, September 23rd. Investors are understandably asking “What would happen to my investments if this developer can’t make their debt payments?”
The first question that many investors might ask is “Who holds debt issued by Evergrande?” The debt is held by 171 domestic (Chinese) banks and 121 other financial firms.⁴ So it may be that these banks and financial firms will be negatively impacted if Evergrande is not able to pay their debt. Failure to pay this debt could easily cause should negatively affect the bank’s share price. Firms such as UBS, BlackRock and HSBC Holdings are reportedly holding some of this debt.⁵ As of June 30, these firms combined to hold over $1 Billion of the outstanding Evergrande debt. Though that is an insignificant amount of money to these firms (BlackRock alone had a record $9.1 Trillion under management as of March 2021)⁶ it would be fair to see their stock prices suffer some based on the fact that they hold debt that may default. However, the degree to which the stock prices of these companies declined cannot be fully explained based on how minimal their actual exposure is.
The second logical question that an investor might ask is “What other stocks are going to lose value?” The answer to this question can be complicated. There is a Goldman Sachs basket of Russell 1000 companies with the highest sales exposure to China. These stocks tumbled by 3.3% on Monday. There is another basket of stocks that collectively have supply chain dependencies on China. These stocks lost 3.7% of their value on Monday at their worst before recovering slightly. China is a global manufacturing force so it makes sense that basic commodities used in manufacturing would lose value. If Chinese manufacturers were to go bankrupt, we could reasonably expect the prices of copper, iron ore or crude oil to decline.
An investor might let out a deep sigh of relief at this point because they would determine that they are basically unaffected by any of these issues. They would look at their safe portfolio of US centric companies and feel good, knowing that their Tesla and Apple stock are unaffected. Unfortunately, they would have breathed that sigh of relief a little too early. Apple booked approximately 15% of its revenue in 2020 from sales in China while that number was 21% for Tesla. If a Chinese consumer is suddenly less inclined or unable to buy a car or cell phone then both of those companies could be negatively impacted.
However, any number of stocks were part of a steep decline on Monday that had no perceptible exposure to the Chinese economy. An index of U.S. regional bank stocks lost 3.9% and Twitter (which is not directly accessible in China) lost 4% at one point. Even Kroger, with zero grocery stores in China, lost value. The reality is that we live in a global economy where there are deep and sometimes unseen connections between companies and countries. Inter-related supply chains and sales channels create dependencies that are complicated to say the least. Instead of focusing on details that are impossible to predict let’s focus on what we can control.
The first step is to simply review your financial plan with your advisor to ensure that you are on track to meet your financial goals. You should also review your risk appetite. It’s easy to believe that you have a high-risk tolerance when markets are gaining value, but maintaining discipline is harder when markets are headed down. Make sure that your portfolio accurately reflects your risk necessity, tolerance and capacity. Finally, don’t allow financial headlines to dictate your behavior. Instead of reacting to headlines, work with your advisor to make sure that you are executing a long-term plan that allows you to achieve your financial goals. Let’s not let the Butterfly Effect (whether it is real or not) dictate our financial future.
¹The Annual Report from Evergrande Corporation.
⁶BlackRock 2020 Annual Report