Quarterly Market Update
In this edition of the BBVA Compass Market Outlook, Mses. Shackelford and Viguier-Galley take a closer look at the recent Chinese stock market correction.
Chinese policymakers are trying to control their stock market in a way so direct that no western government would even consider, most probably to prevent the escalation of panic and the questioning of whether the market crash is symptomatic of broader economic problems. But can the Chinese government overcome the invisible hand tenet of capitalism with their very visible fist? We cannot help but believe that they cannot, and that ultimately, policy makers will fail and market forces will prevail.
1. What has happened in the Chinese stock market?
The red hot rally that more than doubled the value of China’s stock market over the past year hit a brick wall in June and the Shanghai Composite Index turned down – in all indications, a classic market correction. The Index is still up over 30% to the end of June, although it declined over 30% from its June 12 high through July 8th before bouncing back slightly. In the last 12 months through the June 12 high, the Index more than doubled, returning almost 160%, the largest return posted worldwide for the period. The huge gains mushroomed the Chinese stock market valuation to over $11 trillion combined between the Shanghai Stock Exchange and the Shenzhen Stock Exchange, making the Chinese market second in size only to that of the U.S.
The state-owned media apparently widely encouraged Chinese citizens to buy stocks. Unlike the U.S. stock market that is dominated by institutional investors, the Chinese stock market is made up of a large number of individual investors who are often uneducated about equity fundamentals and who seem to be more interested in “short term trading” rather than fundamentally investing for the long term. Huge returns have allegedly attracted even the most inexperienced investor.
Increasingly the less-sophisticated Chinese investor has bought stocks on borrowed money. The amount of margin loans more than doubled this year to $320 billion, equal to 8.8% of the Chinese market free float. Such a level is as high a percentage as has been seen in any market, according to Goldman Sachs.
Although Chinese households’ exposure to the equity market has risen, overall exposure is still small. According to the China Household Finance Survey (CHRS) conducted by the South-western University of Finance and Economics, equity market investment represented less than 10% of Chinese households’ financial assets in 2013. And, according to Société Générale Cross Asset Research, Chinese households invest a large share of their savings in real estate. In comparison the equity allocation of U.S. households is estimated to be 34%.
Figure 1. Stock rally in Chinese markets stall.
2. What led to the stock market correction?
Valuations in the Shenzhen market seemed to have been momentum driven, speculative oriented, and amplified by leverage. A specific trigger has not yet been identified, but with Bloomberg PE valuations approaching 77 times earnings before the correction, investors were bound to realize that the market had become too pricey. What actually triggered the selloff is a bit of a mystery, as is typically the case with corrections. A cause is certain to be identified by pundits when the decline is clearly in the rearview mirror.
3. What measures has the Chinese government taken to prevent the stock market from declining?
The collective intervention measures, both direct and indirect, taken recently by the Chinese policy makers have been extraordinary. Some pundits contend that either the Chinese simply do not understand financial markets, or that they know more than outsiders about the seriousness of the situation. The measures include plans to allow the state’s $500 billion pension fund to invest in stocks, telling Chinese companies to buy their own stock, permitting about half of the companies listed on the major indexes to halt trading in their shares, banning companies’ major shareholders, executives, and board of directors from selling shares for six months, police warnings to some traders making short sales, and suspending IPO activity to prevent over supply.
In developed western economies, it isn’t unusual for the only policy response to be an interest rate cut to provide additional liquidity to the economy. Certainly, the Chinese have taken this step as well. To increase liquidity, the People’s Bank of China (PBoC) recently announced its fourth interest rate cut since November and provided additional cash to the China Securities Finance Corp, a state-run company that lends money to people so they can buy stocks.
4. Have foreign investors benefited from the huge run up in the Chinese stock market?
No, non-Chinese investors have always been limited in their ability to invest in China. In the past, Chinese companies listed on the Shanghai and Shenzhen stock exchanges sometimes issued B-share classes which were reserved for foreign investors, but today most investors trade China through the Hong Kong exchange. Last year China “opened” the Shanghai Stock Exchange to foreign investors, but the surrounding red tape has limited any significant activity. According to analysts, only about 1% of Chinese mainland shares are held by non-Chinese investors. Going forward, more foreign participation is expected, as Indices like FTSE of the London Stock Exchange start adding A shares to their composites.
5. How would you characterize China’s economy, relative to developed markets?
China is a managed economy. In the past decade, China moved from being a primary economy based on agriculture to an economy based on manufacturing and urbanization. Now China is transitioning to a tertiary economy; a service and consumption economy, and such transitions can take decades.
Stock markets are an integral part of this transformation and established, fully functioning, transparent stock markets are critical. Also, stock markets help replace debt burdens with equity. The dozens of Chinese IPOs brought in the last few months are part of this medium term strategy.
6. Why are these events so important to the rest of the developed world?
Now that Europe is going through turmoil and the global economy is recovering albeit slowly, it is even more important that the Chinese stock market issue does not indicate further economic weakening and a potential threat to global growth. China and Asia have been the growth engines of the world, while the U.S. and Europe are mature and growing more slowly compared to emerging markets. For this reason, developed economies need them to continue growing at an accelerated pace —so they will continue to be able to buy our goods and services. Chinese economic growth fell to 7% in the first quarter, the slowest pace since 2009, and although the economy is still expanding at a pace double and triple the remainder of the developed markets, any slowdown is felt in lower sales and potentially revenue growth of large multinational companies doing business in these markets.
7. How will all of this end?
The Chinese will likely continue to support the stock market, but no market can deviate from its economic fundamentals indefinitely. In the short term, investors should expect more volatility and bouts of headline risk. As the economic growth stabilizes, market education improves, and the Chinese government decides that they truly want to join the rest of the world in an “open market environment”, stock markets should eventually find their way. This, alas, will take a long time.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).