Last Monday, July 27, the Shanghai market suffered its greatest one-day decline in eight years, 8.5%. This followed a tumble that brought Shanghai shares down some 32% early in July from their peak in mid-June, a period when the Shenzhen market dropped 40%. The Chinese authorities intervened in a very heavy-handed way that appeared before last week to be creating a floor to these markets. Indeed, over the period from July 9, the market’s low, to July 23, the Shanghai market rallied about 20%. These measures included a ban on short-selling, a ban on sales by major shareholders and on new listings, massive coordinated buying by large state-controlled institutions (collectively called in China “the national team”), and very substantial direct credit support from the central bank. Also, during the peak of the selloff in early July, trading was suspended in 52% of the listed companies, accounting for 35% of market cap. Today almost 20% of Chinese stocks still are not trading.
Following last Monday’s market swoon, the authorities stressed that their support would continue, and the “national team” stepped up their buying. Friday the government took the additional action of cracking down on automated trading. The Shanghai Stock Exchange Composite Index ended the week losing 10% over the week and more than 14% for the month.
There appear to be a number of reasons for last week’s decline. An unexpected weak flash estimate of the July Purchasing Managers Index, PMI, for July, along with a reported 0.7% decline in industrial corporate profits in the first half of the year, implied further softness in the Chinese economy. But we would note that Chinese mainland equity markets are not very highly correlated with macroeconomic developments. Rumors in the market that the government might be ending its market support and recognition of the large supply overhang from the government’s equity purchases to date probably had a greater effect. Also the government’s heavy intervention has seriously impacted foreign institutional investor sentiment towards the Shanghai and Shenzhen markets. This may prove to be the most significant and long-lasting cost of the government’s actions.
The government’s efforts to prop up its equity markets have had damaging effects that will be difficult to correct. Burton Malkiel in a Wall Street Journal commentary titled “China’s Market-Intervention Folly” notes that “China needs more professional participants in equities markets. But why should institutions buy when governments can control if and when they can sell? And ordering state-owned enterprises and brokerages to buy stock with borrowed money to shore up prices only reinforces the notion that the market is rigged.”
We agree. The authorities disrespect for the market contributed earlier to creating the bubble by its encouragement for margin buying of stocks. And its current interventions have seriously impeded price discovery and market liquidity. Rigged capital markets cannot allocate capital to its most efficient and productive use. In recent days investors in these markets appear to be focusing heavily on actions of the above-mentioned “national team,” jumping in when those institutions are seen to be buying and withdrawing when further government support is not evident.
We conclude that the Shanghai and Shenzhen markets have been made more volatile and less effective in their fundamental market-allocation role. They are indeed “rigged,” although the authorities’ ability to manipulate prices is proving to be far from exact. In a July 28 editorial, the Financial Times said the government’s actions “… suggest the market is dictated more by the whims of the state than by anything objectively economic.” The state is now faced with the problem of how it can exit the market without causing a market decline that could well dwarf the drop it has sought to avoid.
We consider the China mainland markets now to be broken, not suitable for our investments. These markets already suffered from a number of structural problems that are reflected in the markets’ high volatility. In the past 25 years the Shanghai market has experienced 27 bull markets and the same number of bear markets. The swings have been wide. In the record bear market of 1993-1994, the decline was 67%. Shares are now about 40% below their all-time peak. Government and state-owned enterprise are estimated to account for almost 85% of the market. Institutional investors account for only about 10% of equity ownership; and foreign investors, due to government restrictions, own only 1% of China’s A-shares. Individual retail (and generally unsophisticated) investors account for 90 percent of the equity ownership. In the US, institutional investors account for more than half of equity ownership.
The near-term harm to the Chinese economy from the recent market developments will likely stem from the effects on market sentiment and the government’s credibility. The actual wealth effects from the losses to the gains on paper that had accumulated during the preceding boom will be modest. The share of equities in Chinese household financial assets is only about 12%. Moreover the market is still up around 100% since June 2014. The effect on capital-raising by Chinese firms looks even more limited, as only about 5% of that funding is via the equity markets.
The chances of China mainland shares being included in the MSCI benchmarks have probably has been reduced, perhaps significantly. Government intervention in equity markets does occur in other countries. A current example is found in Japan where significant purchases of equity ETFs are part of the Bank of Japan’s quantitative easing program. Other central banks are also adding equities to their reserves. But the nature and extent of China’s intervention in the markets’ price discovery is exceptional.
There is less likely to be any negative effects on China’s campaign to have its currency, the yuan, be recognized as a “reserve currency” and be included in the IMF’s Special Drawing Rights (SDR). The two criteria for inclusion are the currency’s share in global exports and that the currency should be “freely useable.” The recently developments in China’s Shanghai and Shenzhen equity markets are not likely to enter into the decision. In contrast to the equity market interventions, China does appear to be continuing with capital market reforms. It recently widened foreign access to its large onshore bond market. Regulations were loosened to provide access by central banks, supranational institutions, and sovereign wealth funds, dropping requirements for pre-approval and quota allocations. In this instance China is clearly seeking more long-term institutional investors.
While the Shanghai and Shenzhen markets do not seem to us to provide attractive risk-reward profiles, the separately regulated Hong Kong market is not “broken,” although it is clearly affected by mainland developments. The Hong Kong market has been doing relatively well. The iShares MSCI Hong Kong ETF, (ARCA:EWH), which is one of our current preferred national market ETFs, is up 9.65% year-to-date, more than twice the 4.01% performance of our benchmark iShares MSCI ACWI ex US Index Fund, (NASDAQ:ACWX).
Until recently, US investors have been very limited in their ability to invest in domestic mainland China shares. They (including Cumberland Advisors) have mainly used ETFs that invest in the shares of Chinese companies that list in Hong Kong, the US, or Taiwan. These markets are well-regulated and have high listing standards, and as a result they have been less volatile than Shanghai and Shenzhen. They provide a less risky way to participate in the still-strong growth of the globe’s second largest economy.
Cumberland Advisors uses the SPDR S&P China ETF, (NYSE:GXC), which holds all investable Chinese shares (excluding A-shares that are traded in Shanghai and Shenzhen) across all market-cap sizes. The website ETF.com considers that “GXC is about as good as it gets for broad exposure to the Chinese market.” Investors in GXC are about where they were at the beginning of the year, with a year-to-date performance of +0.22%, despite a 10.427% drop over the past month. Investors in Deutsch X-trackers Harvest CSI 300 China A-Shares ETF, (NYSE:ASHR), which invests in A-shares, suffered a decline of 10.63% over the past month, but they are still up 6.15% year-to-date. Over the past 12 months ASHR is up 60.83% while GXC has registered essentially no change over that period. The index that measures price differences between dual-listed companies in Shanghai and Hong Kong is at 135.39. Any reading above 100 indicates companies are priced at a premium in Shanghai. The current premium suggests the potential decline that could occur without continued government intervention.
A final comment about the Chinese economy, which appeared to be strengthening in June: In July new signs of weakness appeared that suggest a moderation in sequential growth. The July manufacturing PMI, published Saturday, stood at 50.0, moderated slightly from June’s 50.2 reading. Also, the indexes for production and new orders were both lower than in June. The index for new export orders was the lowest since June 2013. Corporate profits fell in June from a year earlier. Housing starts in the first half were 16% below the same period in 2014. Passenger car sales flattened in Q2. And exports are being hurt by the stronger currency. The financial sector will become a drag on GDP in the second half, following its strong contributions in the first half.
We expect the government will need to announce a number of supportive policy measures in the coming months as it seeks to meet its 7% growth target for the year. As an example, Prime Minister Li announced last Thursday a plan to modernize urban underground pipe systems. Additional public works programs for railways, other infrastructure, and affordable housing are expected. Moreover, further loosening of monetary policy is likely since overall liquidity conditions remain restrictive and capital outflows are continuing. Improving consumer and business confidence may be difficult to achieve, since credibility in the government’s ability to control the economy has probably suffered. With the expected additional policy stimulus, the Chinese economy may fall just a little short of the 7% growth objective for the year, perhaps registering 6.8%. While that is slower than last year’s 7.4% advance, the world’s second largest economy will still be expanding at a pace that is more than three times the 2% projected growth rate of the advanced economies.
Bill Witherell, Chief Global Economist