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Marcuard's Market update by GaveKal Dragonomics
While the world’s headlines are concentrating on Greece, the real drama in financial markets is happening much further to the East. Since its peak in mid-June, the Shanghai Composite Index has now fallen by almost -30%, putting mainland Chinese shares in what is generally accepted to be bear market territory. Intra-day volatility has reached mind-blowing levels, with the index swinging by more than 6% from peak to trough in each of the last four trading days. Although what happens in the Shanghai market may not be directly relevant to most international investors, its fluctuations have profound implications for Hong Kong-listed equities. As always, however, assessing exactly what is going on in the mainland’s markets is a tricky business.
Firstly, despite the current sell-off, China still stands out as the star performer among the world’s large markets this year. Over the year to date, the Shanghai Composite ranks fourth among all global indexes, with a US dollar total return of 24.5%. Among major developed markets, Hong Kong is second only to Japan, with the Hang Seng Index returning 14.4% and the H-share index of locally-listed mainland companies on 10.6%.
Secondly, the headline sell-off of the Shanghai index disguises a sharply bifurcated market. While the median performance of the top 25th percentile in Shanghai has been flat since the peak of the market on June 12th, the median stock among the bottom 25th percentile is down -43%. The steepness of the declines for the worst-performing stocks reflects a signal feature of the earlier rally: shares with a relatively small free float traded limit-up time and again over the last year as margined retail investors piled in with borrowed money. Similarly, as the market has sold off, volatility has been amplified on the downside. With many stocks popular with leveraged investors down by half, the chance of further falls rises as more investors who bought in on margin get flushed out.
Thirdly, the sell-off has not been driven by any general policy tightening from the authorities, who remain broadly supportive of the market. True, the regulators have selectively tightened the rules on margin trading. Last week, the securities regulator said that investors had been forced to sell stocks worth RMB 6.2 bln in two and a half days to satisfy collateral requirements. However, at the same time the government is trying to smooth the de-leveraging process via other channels. Following last month’s interest rate and reserve requirement ratio cuts, the authorities announced plans to cut the stamp duty on stock deals and to allow the state pension fund to invest in equities.
Can Beijing succeed in de-risking the system without causing share prices to sink further “under their own weight”? We think it likely—and not only because we accept the so-called “fallacy” that it would be reckless to “fight the PBOC and the Chinese government”. Looking at the performance of China’s banks, they have barely fallen in the last few days despite the forced selling elsewhere. We recently detailed reasons why investors should consider rotating into Chinese banks. In addition, we also expect the risk premium that has been attached to banks on fears of a disorderly interest rate liberalisation to diminish. With deposit rate liberalisation almost complete, there are few signs that competition to attract depositors is significantly driving down net interest margins, which means there is a great deal more confidence that Chinese banks will be able to maintain a respectable return on equity going forward. Finally, the property market has stabilised, assuaging investors’ worst fears about bank asset quality.
Putting all this together, it is likely that Chinese shares listed in Hong Kong, with their disproportionate weighting to the banking sector, should soon begin to attract more interest from investors. www.marcuardheritage.com
