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.
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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.
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