China’s Roaring Market
Chinese stock markets have roared in the past year, since May 2014. The Chinese government has announced a $40 billion “Silk Road” fund to build a network of railways and air links to bring China and Central Asia closer together; China launched the Asia Infrastructure Investment Bank in October 2014, and since then there has been a rush to join, not only from China’s neighbors, but also five of the G7 leading economies, excepting the US and Japan; and recently, the IMF (International Monetary Fund) released estimates, without fanfare, showing the aggregate size of China’s economy is now the largest in the world. The fashion these days is to decry China’s prospects. But China doesn’t seem to be listening.
China vs. Hong Kong Stock Markets
Chinese domestic stocks began moving higher in May 2014. In the year to April 30, 2015 the Shanghai Shenzhen CSI 300 Index rose 127%. The markets really got going in November after China cut interest rates. Since November there have been two further interest rate cuts, accompanied by additional liquidity easing measures. Domestic Chinese stocks that had been trading at a discount to the equivalent Hong Kong-listed lines moved to a 30% premium.
Many wonder whether the valuation gap could be closed by a collapse in the Chinese A share markets? We got one answer in April when Chinese regulators made some adjustments to the Shanghai-Hong Kong Stock Connect scheme, which was designed to allow investment in both markets, for Chinese and International investors, for the first time. The challenge for regulators was to structure this scheme to allow increased movement in flows through the capital account, but in such a way that it did not blow a hole in it. The structure was necessarily tight with regard to flows coming out of China. At the end of March restrictions were eased and a wave of Chinese money flowed into Hong Kong and pushed Chinese stocks listed in Hong Kong 16% higher in April 2015.
It appears that Chinese stock investors are still bullish. The market rally in China and Hong Kong has been driven by broad-based institutional and retail participation and on record high volumes in both markets. This rally has been primarily in response to a relaxation in short-term liquidity and lower interest rates in China; secondarily, it probably reflects negative sentiment toward investment in the real estate market which is dogged by oversupply and which the government has been trying to support by lowering down-payments and easing access to mortgages. However, the premium of Chinese A shares over Hong Kong listed stocks has not narrowed much, and international investors for the most part are still doubtful.
International Investor Skepticism
China is a developing economy weighed down by debt under its investment-led model now seeking to transform its economy and create a financial sector that is suitable to support it. That is a fundamental change, and investors are rightly cautious. However, the economies and markets in which they place greater faith, as valuations would suggest, carry potentially greater risks.
The S&P 500 Index has continued to hit new highs, and trading on a Price Earnings (PE) multiple of 18.75x historic earnings, which (except the effects on earnings in the 2008-9 period) is the highest since 2004. This has come against a backdrop where the average yield on the 10 Year Treasury was 2.39%. In the 5 years to the beginning of 2008, the average yield was 4.38%. Economic growth and stock markets have risen in an environment of unprecedented and sustained monetary policy support. At some point, these policies must normalize, but markets do not appear to be pricing this in.
Contrast this with China. Everyone is aware that China’s investment-led economic model has passed, and the debt accrued represents a threat to economic stability and future growth. China’s policies, including currency internationalization, credit tightening, clampdowns on shadow-banking, deregulating interest rates, expansion of open-market operations, increasing bank capital adequacy, restructuring state entities and even anti-corruption drives, are all directed to attacking this problem.
Chinese companies listed in Hong Kong, known as H shares, which often have an equivalent line of stock trading in Shanghai or Shenzhen, trade on a PE multiple of 10.11x historic earnings. The five year average has been 9.45x, compared to a ten year average of 12.84x. Investors have assessed these uncertainties, and market valuations have reflected them. Chinese domestic investors have clearly taken a more positive view, with domestic A shares trading on a multiple of almost 20x historic earnings, above the ten year average of 18.62x.
We argue that slowing growth and the economic challenges that are the legacy of investment-led growth are well known. They have been widely discussed over the past four years and therefore are likely priced into current valuations. Investors should now evaluate what comes next.
There is a framework within which to consider Chinese policy and economic development. The base line has been the desire to move China from a middle-income to a high income economy, which requires growing domestic consumption and scaling back domestic investment. There has been progress with the report that services contributed more to economic growth than investment.
To support the domestic economy, China has emerged with a coherent international strategy whose parameters should likely be set for the next thirty years. This means using its financial reserves to build political and trade links in emerging markets from South America through Africa and across Central Asia. China has been doing this ad hoc for years, and often not well, but the “One Belt One Road” strategy ties it together conceptually and financially.
Investor impatience as China aims to change its economic legacy has likely been a problem. But the accelerating pace of policy reform signals determination and urgency. Investors should look at policy changes under three groupings: short term actions to ensure stability, medium term actions to make the transition to a market-led and consumer model, and long term strategic policies to secure a leading world economic and geo-political position to end its comparative isolation.
The short and medium term policy groupings should interest investors. In the shorter term we expect to see monetary conditions stay loose with economic growth still under pressure. Money market rates are likely to stay low through additions of liquidity by further releases of banks’ statutory reserves. Further interest rate cuts are unlikely unless economic growth slows further or consumer price inflation falls close to zero. These conditions are likely to support the stock market.
In the medium term, we expect to see further moves to cut excess capacity in the state-owned sector, which will drag growth, offset by moves to increase investment in urbanization and affordable housing. We also expect to see policies supportive of higher value added industry that support higher wages and a focus on environmental issues that pushes the use of alternative energy. Fears of monetary tightening caused by the inability of local government financing vehicles to repay maturing debt have been alleviated by the establishment of a formal municipal bond market. The municipal bond market will lengthen maturities, increase transparency and draw a formal distinction between debt with explicit government backing and debt without. This lifts a weight of uncertainty from the banking sector and is also positive for the market.
China is working towards an economic plan that sets its path to the middle of this century, while commentators and markets have continued to focus on what economic growth will be this year and next. We are optimistic about the long-term prospects of investing in China, and foresee a possible continuation of the market rally we have seen in the short-term. Chinese stocks in aggregate, traded in Hong Kong and available to international investors are significantly cheaper than their mainland counterparts, trading on PE multiples of 12.25x 2015 earnings and 10.82x 2016. We believe this should continue to attract flows from domestic Chinese investors who are increasingly able to invest in Hong Kong.
Fund Manager Edmund Harriss
Opinions expressed are subject to change, are not guaranteed and should not be considered investment advice.
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Mutual Fund investing involves risk. Principal loss is possible. Investments in foreign securities involve greater volatility, political, economic and currency risks and differences in accounting methods. These risks are greater of emerging markets countries. Investments in derivatives involve risks different from, and in certain cases, greater than the risks presented by traditional investments. Investments in smaller companies involve additional risks such as limited liquidity and greater volatility. Non-diversified funds concentrate assets in fewer holdings than diversified funds. Therefore, non-diversified funds are more exposed to individual stock volatility than diversified funds. Investments in debt securities typically decrease in value when interest rates rise, which can be greater for longer-term debt securities. Investments focused in a single geographic region may be exposed to greater risk than investments diversified among various geographies.
Shanghai Shenzhen CSI 300 Index measures 300 Chinese A share stocks listed on the Shanghai and Shenzhen exchanges.
G7, or Group of Seven, is the economic alliance of Canada, France, Germany, Great Britain, Italy, Japan, and the U.S.
PE, or price earnings multiple or ratio, measures how expensive a stock price is.
S&P 500 Index is based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. You cannot invest directly in an Index.
Shadow-banking refers to financial intermediaries involved in facilitating the creation of credit across a financial system, but whose members are not subject to regulatory oversight.
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