China’s locally listed shares (A shares) have experienced massive volatility over the past three quarters, with short-term movements comparable to 2007 to 2008 levels. The Shenzhen and the Shanghai Composite Indices jumped 156.9% and 131.6%, respectively, between the end of last August and June 12, 2015. They subsequently reversed course, slumping 21.3% and 16.9%, respectively, as of June 30 (price returns in USD). We believe the China rally was not fundamentally driven, and the correction was inevitable. Our view is that, in this case, sooner is better than later. 

The Quintessential Policymakers’ Dilemma: The liberalization in interest rates, banking sector reforms, and reforms in China’s state-owned enterprises (SOEs), in our opinion, are all constructive long-term initiatives. Equally important are government initiatives addressing local government financial vehicles’ debt. China’s transition from a growth model centered on investments and exports to a more sustainable consumption and services model is proceeding gradually. A buoyant stock market would benefit several of the government’s reform initiatives. However, fanning an overheated equity market by encouraging further retail buying is dangerous. Retail investors pouring their life savings into an expensive market is nothing new in China. It happened in 2007, and the damage to the retail investors’ trust in local equities took nearly seven years to heal. We believe it is in the best interest of China’s policymakers to contain irrational exuberance in China’s local equities. Of course, the tradeoff between near-term pain and long-term benefit is the quintessential policy dilemma.

Not a Fundamentally Driven Rally: We believe China’s equity fundamentals certainly did not drive the rally. China’s GDP growth is weak and the economic slowdown is broad based. Although earnings growth is in anemic single digits and many other corporate metrics are also weak, multiples on the Shanghai Composite Index are at five-year highs (according to Bloomberg).

Speculation has risen sharply, with margin balances swelling and with about 600 IPOs in the pipeline. In fact, some of the recent secondary market sell-off stemmed from investors liquidating in anticipation of upcoming IPOs. This selling drove prices lower, triggering margin calls in an already overbought market.

Why the Rally? … The “Damas” Got Sucked In: A combination of policy initiatives, gossip, and rumors lured China’s retail investors (the “Damas,” or aunties) into the A share market, which is more than 85% retail driven, and where volume has risen more than six fold since last year.

The government initiated the Shanghai-Hong Kong Stock Connect Program (Shanghai-HKEX) in November 2014. Retail investors, who saw this as a big liberalization policy initiative, started buying on expectations that foreign investors would pour in (what is called “northbound” flows). However, the Shanghai-HKEX connect had a strict quota on maximum “northbound” flows, and foreign investors did not even exhaust that quota. Nonetheless, A shares remained aloft on rumors of various other stock connect possibilities involving exchanges such as Shenzhen and Hong Kong, Taiwan-Shanghai, Taiwan-Hong Kong, etc.

The Chinese Central Bank (PBoC) has cut banks’ lending and deposit rates four times since November 2014, while also reducing banks’ reserve requirements twice. The Central Bank’s monetary easing measures, along with verbal props from various policy circles, were interpreted as support for local equities by China’s retail investors. Moreover, the government’s clampdown on shadow/trust financing and the slowdown in the real estate market had retail investors looking for new opportunities. Rising retail participation in Chinese equities was reflected in the spike in new brokerage accounts, with margin financing soaring and regulators allowing individual investors to open multiple accounts. 

City National Rochdale, LLC is a Registered Investment Advisor and wholly owned subsidiary of City National Bank.

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• May Lose Value

 

Important Disclosures 

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as on the date of this document and are subject to change.

There are inherent risks with equity investing. These risks include, but are not limited to, stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, economic and political instability. Emerging markets involve heightened risks related to the same factors as well as increased volatility, lower trading volume, and less liquidity.  Emerging markets can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets.

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The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT) and taxable gains are also possible.

Investments in below-investment-grade debt securities and unrated securities of similar credit quality, commonly known as “junk bonds” or “high-yield securities,” may be subject to increased interest, credit, and liquidity risks.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.

Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk.

Past performance is no guarantee of future performance.

Index Definitions

The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

Core Personal Consumption Expenditures Price Index (core PCE) is the personal consumption expenditures (PCE) prices excluding food and energy prices. The core PCE price index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.

Shanghai Composite Index (SHCOMP): A capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange.

Shenzhen Composite Index (SZCOMP): An actual market-cap weighted index (no free float factor) that tracks the stock performance of all the A-share and B-share lists on Shenzhen Stock Exchange.

MSCI China Index (MXCN): A free-float weighted equity index. It captures large and mid-cap representation across China H shares, B shares, Red chips and P chips.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.