Morgan Stanley (NYSE: MS) has upgraded its outlook on China's debt-laden property sector from "in-line" to "attractive," on the expectation that regulators will ease back on policies that have slammed the entire industry and brought developers like Evergrande to the brink of default.
"We believe that default risks and property market weaknesses have largely been priced in," wrote Morgan Stanley analyst Elly Chen on behalf of her team. "Property stocks will react on policy easing which looks more likely now."
Evergrande, the world's most indebted developer, has become a stand-in for what can be described as China's self-inflicted housing crisis.
Authorities have implemented stringent measures to curb debt and speculation in the sector, flattening home sales and starving developers of much-needed cash this year. Last year Beijing implemented a new standard known as the "three red lines," which places debt limits on developers based on their assets, cash flows, and capital.
After crossing all three red lines, Evergrande, unable to borrow more, lost the ability to fund its operations, sparking protests from contractors, employees and homebuyers who'd already paid upfront for apartments that might never be finished. The crisis came to the fore last month, as fears of financial contagion sparked a wide-reaching sell-off that caused the Dow to nearly shed 1000 points.
The developer has missed five separate interest payments to foreign bondholders since September. Other smaller developers, like Fantasia Holdings, have gone completely belly up almost directly due to Beijing's policies.
"There have been several defaults since 2020 and escalating risk for a major developer default in 2021," Morgan Stanley's analysts acknowledge. Chen and her colleagues note that the "adjustment process" to China's ongoing efforts to "manage system excesses" will likely continue for the next 6 to 12 months.
"However, property stocks are pricing in part of these risks, and we think systemic risk is manageable," Chen and company write.
Priced in is right; a Bloomberg gauge for China's property developers has fallen by 22% so far this year. However, the metric has since rebounded by 10% from its September lows as expectations of a policy pullback by Beijing mount.
Last month the Peoples Bank of China vowed to maintain a healthy property market, urging banks to help localities stabilize housing prices and expand mortgage availability. Furthermore, regulators in the far northwestern city of Harbin are releasing portions of pre-sale proceeds, held until now in government escrow, to help ease the strain on developers' cash flows.
Meanwhile, on Friday, the PBOC broke its silence on Evergrande, saying that risk from the declining developer was manageable.
"Policy is the most important leading indicator for property stocks," Chen and her colleagues note.
According to Morgan Stanley, residential investment accounts for 6.5% of China's economic activity, with property services accounting for a further 7.3%, meaning a 10% dip in the sector could cause a 1% drop in overall GDP, according to the bank.
"Further spillover could take the form of a negative wealth effect" Chen and her colleagues write, which is why they expect regulators will likely ramp up "meaningful support" for property markets.
As much as 40% of Chinese household wealth is pegged to property values, meaning a deeply felt housing crisis could pose a considerable threat to social stability, a reality that will likely give regulators the impetus to change course.
Morgan Stanley also notes that 16 of the 26 developers they follow are already meet the full criteria of the three red lines, with nine satisfying two and only one failing to meet any.
Analysts top picks are China Poly Group, Cr Land (OTC: CRBJF), Longfor (OTC: LGFRY), and Sunac.