China stock market collapse

Although most of the markets’ attention has been taken up by the recent developments around a possible Grexit, investors are becoming increasingly worried by the collapse in the Chinese equities. The government has been unsuccessful, so far, in stopping the stock market crash. We nevertheless think that the correction could present a longer term buying opportunity for HK and US-listed China equities with solid fundamentals once the situation stabilizes.

What has happened?

Over the past few months, it has become increasingly clear that, that the impressive rally in the local A Shares market and the retail investors that we’re borrowing heavily in order to participate in it, was an accident waiting to happen. Seduced by an unrelenting upward trend, a wave of new and inexperienced retail investors in their millions pushed valuations to lofty, and often unrealistic, levels as they searched for alternatives to low savings account returns and a weak property market. A flurry of IPOs and the hope of a future inclusion in the leading FTSE and MSCI indices provided further optimism, with many reasoning that the only way was up for China A-shares. In the last week however, the Chinese government’s measures to stymie margin based trading triggered a correction, amplified by a subsequent wave of panic selling in the market. Local Chinese investors and their families have learned the hard way that markets can go down as well as up and buying on leverage can lose you more than just your savings.

The tightening measures to prevent a further explosion of margin-based trading taken by the Chinese government, were the main trigger for the correction, resulting in a panic wave and thus a strong equity market correction. Over the last month some 3.5 tn USD in market value has been gone off the A-share market value.

While it is difficult to have an exact level of the margin financing outstanding, according to some data it should represent around 15-20% of the total free float of the A-share market, and although it has decreased during the correction, it still represents a growth of 80% YOY. So there still is some considerable room and risk for more downside due to this deleveraging process.

What are the consequences?

After almost doubling since November 2014, the Shanghai Composite Index has already lost 30% of its value since June’s peak. The more speculative small cap and technology driven ChiNext index has dropped even more.

Currently most stocks are trading limit-down with more than 40% of all A-share stocks suspended. Bloomberg has suggested that in reality around 70% of the local A-share market is effectively closed. Nevertheless, trading suspensions and market stabilizing measures implemented by the government will do little more than postpone the selling pressure still to come. In spite of the government’s attempts to put a floor under the market and do “whatever it takes” to stem the correction (including rate cuts, bank reserve requirements cuts and allowing government linked institutions and pension funds to buy the market; as well as providing resources to do so). These efforts remain, so far, unsuccessful with investors continuing to cut their losses as soon as is physically possible.

While things look ugly at the moment and overall fear for a broader economic impact is growing, we would not be surprised that the government’s near term focus goes as much towards keeping social stability rather than economic contagion. The equity market correction should not have more than limited impact on the stability of China’s economy or financial system, especially given exposure to the recent margin-based equity market rally in the banking sector remains has risen but still remains limited. According to UBS data, even post the recent surge, equities account for around 20% of overall household wealth (12% if including property assets), while bank deposits still counts for more than 50%. Total assets of brokers and mutual funds should account for around 5% of the overall financial system assets, which is important but not enough to trigger a systemic crisis.

What’s more the correlation between economy and the equity markets’ performance has always been rather weak. On top of this, although the current market situation will not help the Chinese government in its efforts to stabilize the current economic downtrend, it still has a lot of room to stimulate the economy if the situation really deteriorates. Thus, we believe the risk of a systemic macroeconomic crisis remains small and are confident that recent events will not derail the long term reform efforts to develop and open up the financial system.

What is the impact for international investors?

Aside from the local mainland China stock markets, there is a large universe of (mostly much higher quality) Chinese equities listed outside of China; mainly in Hong Kong or the US. International investors should favor these markets over local China A-shares. While many of these stocks have benefited from the local market rally (especially those with a double listing in China and Hong Kong), they have not witnessed the same degree of ‘market mania’ witnessed across the A-shares market. The main constituents of the MSCI China including H-shares, Red Chips or other private companies are influenced to a greater degree by the international macroeconomic and geopolitical events and global financial market sentiment.

A buying opportunity in MSCI China?

Although the year-to-date performance of the MSCI China has been failed to match that of the China A-shares market, it has almost dropped almost as much in value. As a consequence, valuations of the MSCI China have become very interesting, in relation with its growth potential going forward. Currently, the average P/E of the MSCI China index is estimated at around 10, on the lower side of its historic range. In this context, we believe long-term investors should use this temporary sell-off to slowly start accumulating exposure towards Chinese equities (MSCI China, not the local A-share market). We believe the long-term damage will remain rather limited, not least as the government is determined to support the slowing (with or without the market correction) economy, irrespective of the market correction.

 
Source : Bloomberg

Conclusion

While it is probably not advisable to attempt to “catch the falling Chinese knife” at current market levels, we would suggest keeping some powder dry, as the on-going correction presents a good buying opportunity. This is especially the case for the many HK and US-listed China equities with solid fundamentals. As a result we advise investors to keep some powder dry. Once the situation stabilises, it would be interesting to start accumulating the Chinese market.

Jan Boudewijns
Head of Emerging Equity Management