I do not plan on discussing the Evergrande situation itself in detail. I’m sure most of you have heard about it, and better publications than this one are more qualified to report on it, so refer to the following sources:
Readings on the Evergrande situation:
Fitch - Credit Event at China’s Evergrande Could Have Broader Effects
Reuters - China Evergrande’s liquidity crisis deepens, report flags interest payment miss
Aljazeera - What could an Evergrande debt default mean for China and beyond?
Equities
I want to discuss the potential contagion which could result, and how I’m getting a sense of deja vu watching US markets shake off the negative news.
Today is options expiration for September. During the week of OPEX, volatility is typically suppressed and I believe US equities are being lulled to sleep while a forest fire is beginning to rage outside. The deja vu feeling is similar to January and February 2020, when everyone participating in the market knew of COVID spreading in China but since markets had not yet reacted to the news, nobody was worried.
It’s typical herd behavior. If there’s a fire in the theater but nobody yells “FIRE!!”, will the crowd panic, or will everyone assume it’s being taken care of? I believe OPEX is lulling the crowd into believing the fire is under control, but in reality it’s probably time to GTFO.
Here’s a note I posted last night on Twitter:
Even if I’m overstating the Evergrande risk to broad equity markets, I think market participants will use it as an excuse to take some profits off the table. Moreover, we’re heading into that seasonal period of September and October where volatility seems to spike.
The risks are pilling up and markets are generally expensive.
Commodities
Let’s quickly review the situation across a range of commodities:
Oil futures look strong:
Copper futures look like they’re consolidating. The risks will rise if prices fall below 4.00/lb:
Iron Ore futures have sold off hard, perhaps reaching a selling climax today:
Metallurgical coal futures are still making new highs:
Thermal coal futures remain elevated:
Natural gas futures remain elevated, consolidating the recent climax high:
Summary
The fundamentals remain positive for most commodities and they’re associated equities. The exception to this list is definitely iron ore which I believe is suffering from the Chinese crude steel production caps and the negative steel production outlook for the next 3 to 6 months. You can read more about that here. Otherwise, we should not worry too much about commodity equities if we have a long term time frame of a year or more. That being said, there is short term broad market downside risk that we should be cognizant of and that we should prepare our portfolios for.
What I’m doing:
Taking some profits in names that have had a good run.
I am continuing to reduce leverage.
Aggressively hedging in order to protect downside risk in our core positions.
Moving forward over the next couple of months, I plan on using the selloff, which I’m assuming is forthcoming, to reallocate capital at a lower cost basis in core positions and to add leverage back into coal equities which should have positive earnings reactions in late October and early November. I believe we could actually be fortunate to get a selloff in front of potentially blowout earnings in a handful of the names we have been trading since this publications inception.
We also have the unfolding energy crises this winter to prepare for. A dip in many of these related energy names could be a rewarding opportunity.
It should be fun and lucrative, and I’m looking forward to it.
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Many thanks, it's hard to get a feel as to whether china will allow Evergrande bankruptcy or not. Any ideas on that?
What hedges are your preferred, if I may