By Aniket Bhaduri
Chinese equities have consistently made headlines over the last few quarters. Having gone up nearly 150% from its June 2014 lows, the markets swiftly corrected by 30% in the matter of a month. Volatility has surged significantly amidst the proverbial ‘greed and fear’ and policy actions undertaken by the government. What does this mean for your portfolio and where do the opportunities lie?
A history lesson first. Back in 2013 when the gold prices plunged sharply, scores of Chinese middle-aged women bought nearly 10% of global gold production—worth 100bn yuan—in less than two weeks, forcing the likes of Goldman Sachs to reverse their short positions. The world took notice and the Wall Street Journal called them ‘Dama’ or big mothers. Over the last 12 months it would appear that the Chinese Dama are back!
If the Chinese stock market was a casino, the lights would be blazing and the music back on. After six years of lack-lustre performance, Chinese equities have surged and the benchmark indices have doubled over the last one year. The amount of wealth created in the process—nearly US$6.5trn—has been mind-boggling. It’s enough money to buy the entire London property market twice, or Apple Inc. eight times over, or circle the earth 250 times with US$100 bills. Stock prices have been flying higher and higher as ‘Investor interest’ is back. With millions of new demat accounts opened (mandatory accounts allowing one to carry out a transaction in stock exchange), both the retail and institutional investors have made money. Insatiable greed, fear of losing out and the willingness to suspend belief has added to the fire power.
However, the recent, equally as sharp “correction” has dampened down the party somewhat, with questions being raised on whether the rally is sustainable. While there is some consensus on what has led to this up turn, the investment community is split on where this is headed.
On the face of it, the signs are ominous. Underlying economic fundamentals are worsening; margin trading has skyrocketed—sucking in a whole new generation of retail investors. Indices have ratcheted up; some say, too much, too soon, as valuations rose to unprecedented levels. After the markets trebled in the 18 months to October 2007, it took less than six months to plunge and give away more than half of those gains in 2008. And this was at a time when the economy was growing at a brisk pace. Today, it is slowing down. What if history repeats itself? Remember it takes a gain of 100% to cover a loss of 50%.
However, beyond the economic fundamentals, there are other factors underpinning the current rally. The most vocal school of thought says that the rally is driven by the Chinese government; and for good reasons. It is not difficult to imagine just how much sway the Chinese authorities can have on their domestic markets. It is well known that the government is in the midst of implementing long-term structural changes in the economy and it is very likely that it could be using the wealth effects of a bull market to soften the deflationary pressures of the painful reforms. The timing of the surge in equities, just when the reforms are being implemented, could be more than just a coincidence. Decades of economic growth have been fuelled by scores of state-owned and private enterprises piling on unmanageable proportions of debt in their books. The country’s large shadow banking system had compounded the problem. Deleveraging, without any alternate source of capital, would certainly result in a hard-landing for the economy. An upturn in the equity markets has provided the much needed relief to the corporations to offload some of the existing debt and shore up their equity base.
As part of the reforms process, the government intends to liberalise its financial markets. Late last year, authorities opened the doors for the domestic investors to access Hong Kong capital markets via the Shanghai-Hong Kong Stock Connect programme. They also allowed Hong Kong based mutual funds to raise money from the mainland. However, this could mean a serious risk of capital outflows, if there are no options available domestically. As property prices cool and the famous Chinese wealth-management products disappear, the rush could turn into a torrent. A galloping domestic equity market helps save the flight of capital.
What does this mean for a foreign institutional portfolio? Whist the recently opened Stock Connect programme is a way to access A-shares, the cap on daily turnover of approximately US$2bn dissuades foreign investors. However, the inclusion of China’s domestic shares in two of the world’s largest index providers, FTSE and MSCI will have a more profound impact on the portfolios in the longer term. Earlier this year the FTSE announced that it will launch two “transitional indexes”, which will include A-shares. The initial weighting of these shares in such indices will be 5% and will increase to 32% when the markets open up completely. Also the MSCI, a more widely tracked index provider, said that it was working with the country’s capital market regulator to address their concerns before inclusion of mainland shares in their indices. What this means is that a portion of all the passive funds in the region will have to be allocated to the China market. The MSCI estimates that a decision to include domestic shares in their indices would lure US$20bn into the Chinese markets, which could rise to US$400bn over time.
But that would be in the longer-term. In the near term, the impact is expected to be limited. Currently, foreigners are not allowed to directly invest in the A-shares (Yuan denominated, domestically traded securities). Most of the exposure to Chinese equities is currently through stocks listed in Hong Kong. According to estimates, less than 3% of the total market capitalisation in the country is owned by foreign institutional investors. As a result, the surge in the volatility has had little or no impact on global portfolios.
Nevertheless, the precipitous fall in the stocks since June has dampened sentiments. It is said that “no one rings a bell when the market tops-out”, but elements of frothiness were hard to ignore. Valuations had stretched across the board and were outright absurd in some instances. The PE multiple for the Shanghai composite was close to 23 in May while stocks in ChiNext, China’s answer to NASDAQ, were trading at 90 times earnings—more than twice for its US counterpart during the dot-com bubble. Margin financing—a fancy term for leverage—soared as the rally gained momentum. Lending jumped nearly five-fold over the course of the last year to CNY2.3trn at the peak in June. Further, as the bull market hit the frenzy, a big chunk of the millions of new accounts opened were opened by small-time investors—most of whom had not finished high school and knew little about the basics of how a stock market functions.
When the markets began to slide in late June, the authorities pumped more liquidity into the markets. That proved to be insufficient and the descent continued as margin calls surged. As fear gripped the markets and the fall precipitated, the authorities stepped in each time with a slew of measures including pumping liquidity into the system. Unable to arrest the sell-off, Beijing, in a sign of desperation, eventually halted trading in nearly 1,300 shares (or about 40% of the market capitalisation), freezing US$2.6trn of value. The move exacerbated the anxiety, creating a feedback loop as market participants believed that the government was panicking and the stocks tumbled further. Towards the middle of July, there was some semblance of calm. However, the respite was short-lived as the markets plunged nearly 8.5% on 27 July, the biggest single-day decline since 2007, as the government’s will and methods of stabilising the markets came into question again.
The Chinese authorities like to manoeuvre the direction of whatever they can, be it the economy, the corporations, the currency et al. However, in reality, the financial markets have a mind of their own. When the sentiment turns, no amount of support, explicit or implicit, can turn the tide, particularly in the short term! Periods of extreme volatility, such as this one, could prove counter-productive for the administration, as it damages the very confidence that it is trying to establish in the international financial markets. Actions like halting trading in securities, undermines the trust of global players in the markets. Lack of liquidity and free and fair market movements is a risk that continues to remain for foreign investors in China.
For investors with a longer horizon, however, opportunities continue to exist. The current rally began when the valuations for the broader market were at a dismal nine-times earnings, while it trades at nearly 18-times in the developed world. Contrast that to the growth picture where China is growing at 7% and most of the developed world is grappling for 2%. Further, even after the massive rally, the market capitalisation to GDP ratio stands at 40%—a measure that has historically peaked at nearly 100% for developed economies.
In conclusion, we recognise the volatility of the Chinese equity market but with doors opening up for foreign investors, we believe very strongly that there are opportunities to be grasped. In order to capitalise on these opportunities, investors should be seeking active equity management as the optimal way forward.
Aniket Bhaduri is a senior investment consultant at JLT Employee Benefits
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