On May 26, when global markets tumbled, the Shanghai Stock Exchange managed to add a 2% gain to the seven-year high it reached last Friday. On the 28, however, the Chinese markets reversed dramatically. The Shanghai Composite swooned by 6.5%, and the Shenzhen dropped 5.5%. The combined Thursday turnover in these two markets was $380 billion, some $132 billion more than the turnover on Wednesday in the US, a market more than twice the size. Including Thursday’s declines, Shanghai is still up 125% over the past 12 months and Shenzhen is up almost 160%. The less-volatile, popular China ETFs listed in the US, such as the SPDR S&P China ETF (NYSE:GXC), which invest in China equity shares available to international investors (mainly shares listed in Hong Kong or the US), were down about 3.3% Thursday. Friday the Chinese markets ended with little change.
Prior to Thursday’s declines, market observers expressed concerns that China’s equity market might have advanced too far too fast and could be getting into an unsustainable bubble. The excitement of domestic Chinese retail investors, who have been shifting from bank deposits and real estate to equities, was evident in the almost 5 million new share accounts opened in the first half of May. Chinese brokerage firms raised some $14 billion in capital so far this year and more than half of the proceeds have reportedly been used to finance increased margin lending.
Bust?
Do the Thursday declines signal the beginning of the bursting of a financial bubble in China’s equity markets? Or are we seeing a short-term correction in a continuing bull market and thus a buying opportunity? In this commentary the fundamental (economic, policy/regulatory, and valuation) factors affecting Chinese equities are discussed. In a separate commentary, my colleague Matt McAleer will address the current technical features of China’s equity markets. At Cumberland Advisors we combine fundamental and technical analysis to determine the investment strategy for our International, Global and US Equity ETF strategies.
There are several factors that probably contributed to the timing of Thursday’s China market declines. First, a number of brokers announced a tightening of margin requirements. Second, the People’s Bank of China (the central bank) requested some banks to provide more information on their stock market exposure. In addition the PBoC was reported as having drained some liquidity from markets. Friday we learned that action probably occurred several weeks earlier and was a technical adjustment for some institutions having excess liquidity. In other words, that action was not related to the equity market. And a state investment fund sold some shares in two banks, the China Construction Bank and ICBC. Finally market participants apparently were concerned that a number of upcoming new listings would affect market liquidity. Together these factors triggered a bout of profit-taking in a market that probably was getting a bit ahead of itself. These developments, however, do not undermine the fundamental factors that have driven Chinese equities higher. These are discussed below.
Excess Capacity, Weak Real Estate
The Chinese economy still appears to be decelerating, with the headwinds coming from sectors having excess capacity and the weak real estate sector. The May flash Purchasing Manager Index was up from April but slightly below market expectations. At 49.1 it is still below 50%, which implies further slowing. Industrial production in April was much weaker than expected. Retail sales growth also slowed in April. The service sector, however, is strengthening, with the April figure at 52.9. Further, strong wage growth should support consumer spending going forward.
Forecasts for China’s GDP growth for the year are in the 6.6–6.8% range, compared with 7.4% in 2014 and 7.7% in 2013. While significantly slower than the heady rates of the past 10 years, China’s growth this year will be exceeded only by that of India (estimated at 7.6%).
A decelerating economy would normally be expected to lead to weakness in the nation’s equity markets. However, in the case of China there is a positive market effect: the expectation of further policy stimulus. As liquidity conditions are still tight despite the central bank’s recent lowering of interest rates and injections of liquidity, further moves by the central bank do seem likely. The government has also announced a major increase in infrastructure spending.
While past measures by China’s policymakers may appear to have not been very effective, it should be recognized that the Chinese had two objectives: moderating the deceleration of the economy to achieve a “soft landing” while achieving a credit rebalancing to reduce the risks from an excessive build-up in debt. Balancing these two objectives is difficult. China will continue to maintain the tighter risk-control measures it has implemented while pursuing further liquidity injections to encourage desired credit flows.
While the economy has slowed, industrial profits have improved recently, getting a boost from better investment returns in the financial market. The central bank’s efforts to reduce real financing costs for enterprises should benefit profitability. The consensus earnings growth estimate for MSCI China is almost flat for the current year, +2%. However, a 12% increase is expected for 2016. The bull market in equities is having a positive effect on China’s economic growth through boosting profits and wages in the financial sector and through the stock market wealth effect on consumption.
Valuation estimates for the Chinese firms shares listed in Hong Kong and/or the US still do not look particularly elevated. The consensus P/E ratio valuations for the MSCN Index are 12.3 for 2015 and 11.0 for 2016, which are not significantly outside the range of the past four years. They are higher, but not exceptionally so, for the CSI 300 Index (A shares for the 300 largest firms listed in Shanghai or Shenzhen), at 18.1 for 2015 and 15.5 for 2016. For the Asia Pacific region as a whole ex-Japan, the corresponding estimates are 13.7 and 12.5. So despite the rapid advance in prices, valuations do not appear to be overstretched in general, though some sectors may be stretched.
Room To Grow
We think that the bull market in China still has further to go and that corrections, such as the current one, will offer buying opportunities. Our reasons are based heavily on the financial market reforms that have been made or are expected in the near term. China is opening up its capital markets in an accelerated but still step-wise fashion in order to get an early decision by the IMF to recognize the Chinese yuan as a “reserve currency” and to have it included, along with the US dollar, the euro, the Japanese yen and the British pound in the currency basket that makes up the IMF’s special drawing rights (SDR). The Chinese understand that this process of liberalizing their capital account should yield important dividends in strengthening their financial system.
The financial market reforms have been a powerful stimulus to China’s equity markets, making it easier for funds to flow from Hong Kong to Shanghai and vice versa. The most recent reform, announced last Friday, is a framework for mutual fund recognition between Hong Kong and China. International asset managers will be able to sell Hong Kong-registered funds to investors in China, and Chinese asset managers will be able to sell their funds to investors based in Hong Kong. A two-way link between the Hong Kong and Shenzhen markets is expected soon, parallel to the one established last November between Hong Kong and Shanghai. Shanghai-Hong Kong Stock Connect had a slow start, but the flows have increased dramatically as the markets surged ahead this year.
Another notable development, linked to China’s moves to liberalize its capital markets, is the decision by FTSE Russell to include domestic Chinese shares in its global benchmarks. Their inclusion will likely have a significant effect on international investments in Chinese equities, as investors that allocate significant funds to such broad indexes will, in effect, be allocating more funds to China equities. Should MSCI decide to make a similar move, which they resisted doing a year ago, the effect would be even stronger. MSCI is scheduled to make this decision on June 9.
In Sum
Fundamental factors, particularly the major structural changes in China’s capital markets, lead us to think the bull market in China’s equity markets has room to grow further. The government is looking favorably on this prospect, although, it may feel it necessary at times to act to counter pressures for the market to get overbought. Further monetary loosening should provide support for the economy and the market. While there may well be further short-term corrections, buying on the dips appears justified by the fundamentals.
Bill Witherell, Chief Global Economist