Stock market corrections, although painful at the time, are actually a very healthy part of the whole mechanism, because there are always speculative excesses that develop, particularly during the long bull market.
– Ron Chernow, a writer, journalist, historian, biographer
Background
Over the past year, Chinese stocks have surged a staggering 142% in Shanghai and 132% in Shenzhen (comprised of smaller technology and non-financial stocks). Even the offshore stock market in Hong Kong with its H-shares (companies listed Honk Kong with mainland counterparts) is catching up with 13% increase in April alone. Data in mid April 2015 indicated more than 70% of mainland-listed stocks were fetching PE ratios more than 50 times earning and 40% had more than 100 times earnings. Yet, Shanghai Composite Index peak was 6,092 back in 2007, thus prompting some market observers to punt on possible further growth. But the main driver for the China’s bull run really lies in the policy impetus by the central government.
Source: Bloomberg (accurate as at 27 May 15)
Contributing Factors to the Bull Run and Beijing’s Policy Impetus
Global low interest rate environment, renminbi convertibility, Shanghai-Hong Kong connect, cutting of banks' RRR, interest rate cuts, margin financing to buy shares, unprecedented new opening of non-zero trading accounts
Encouraging a robust stock market helps Beijing to achieve a few policy objectives. Firstly, a thriving stock market enables companies seeking to raise funds by issuing equities instead of bonds, thus reducing China’s ballooning debts. In addition, this gives the Chinese another alternative asset class for investment besides real estate. Another key objective is for China to liberalise its capital markets. One recent initiative was allowing mainlanders to buy eligible Hong Kong stocks (known as H-shares), while global investors can buy selected mainland stocks (A-shares) up to a certain quota via the Shanghai-Hong kong “stock connect” scheme, henceforth boasting both volume and volatility. Similarly, a link-up between Hong Kong and Shenzhen will be set up later this year.
China’s aim to have renminbi convertibility (plan to include as part of the basket of official reserves included by the International Monetary Fund in November 2015) also meant that the currency would be supported and thus unable to be used as a monetary policy to support growth. With business investments, housing and exports slowing and funds exiting China, Beijing is more likely to boast the “wealth effect” by transferring money previously locked in property to the stock market, thereby increasing consumer demand and maintain 7% growth. People’s Bank of China (PBOC) implemented a series of monetary policy tools to encourage domestic lending and lower the cost of capital – interest rate cuts to counter deflation and slashing of banks’ reserve required ratio (RRR) to raise liquidity and slow down the outflow of funds. The consensus is for policymakers to implement at least one more interest rate cut (current 5.1%) and further steeper RRR cuts (current 18.5% for big banks).
Only with stablised environment like sustained growth can Beijing implement their structural reforms that include reforms in the state-owned enterprise (SOE) sectors as well as key investment initiatives such as its Silk Road, or “One Belt, One Road” overseas infrastructure initiative.
What Could Derail the Bull Run
The main risk lies in the rise in interest rates with 2 scenarios: 1) US Federal Reserve decide to raise interest rates, causing global rates to increase. 2) China to continue defend the renminbi to prevent devaluation. The latter will reduce supply of renminbi out of the system and thus causing interest rates to increase. An increase in interest rate will remove the fuel for margin trading which has already surged to RMB$1.7 trillion or about 3% of China’s stock market value in December 2014.
Investment Themes to Hong Kong’s Market
- Inclusion of China Shares into MSCI All Country Index. Currently the only reason for not having China’s weight to be the same level as Japan’s (10.6%) is because Yuan is not as convertible as other currencies. However, that would change in the near future. Henceforth, buying into blue chip China companies early would entail possible upsides when huge funds buy into the MSCI index to gain exposure to China[1].
- China’s Silk Road – “One Belt, One Road”. The main aim of “One Belt, One Road” initiative is to build new engines of growth for China hence companies like construction and infrastructure companies, railway firms, heavy equipment makers will benefit from the deals inked by the policymakers.
- Internet as Driver of Growth in 3rd and 4th Tier Cities. Companies such as Alibaba Group Holdings, Tencent Holdings or Baidu can enhance connectivity and decrease transaction cost for the entire value chain. This will be a greater enabler when such companies serve small and medium sized firms in other peripheral cities to reach the retail customers countrywide.
- Accelerations of Reforms in State-Owed Enterprise (SOE). Currently, a lot of the biggest firms in China belong to the state and as most SOEs are, productivity and efficiency generally lack behind the private sectors. To push through the reforms, there will be more asset sales, restructuring and mergers undertaken by the central government. Case in point, China CNR Corp and CSR Corp merged to become the world’s largest railway firm, renamed as China Railway Rolling Stock Corp [2]. Other possible reforms can take place in the oil, shipping, telecoms and utilities sectors.
Gaining Exposure to China’s Stock Market
Currently the Hang Seng H-Share Index ETF tracks the Hang Seng China Enterprises Index which comprises Chinese companies listed in Hong Kong and current valuation is about 10.5x earnings.
Current Valuation in Mainly China – Are There Still Cheap Stocks in China?
Source: Bloomberg (April 2015)
Compared to the region, Chinese stocks are trading at over 18 times 12-month forward earnings compared with 19.5x for Japanese stocks, 21x for Philippines, 17x for Malaysia and 14.5x for Singapore.
References
1. A-shares inclusion in MSCI indexes likely: analyst, http://www.wantchinatimes.com/news-subclass-cnt.aspx?id=20150410000138&cid=1102
2. China’s CNR, CSR kick off merger process with trading halt, http://www.reuters.com/article/2015/05/07/us-china-cnr-m-a-csr-corp-idUSKBN0NS06620150507
Disclosure – Caveat Emptor (Buyer Beware): The author has no positions in any stocks mentioned, and no plans to initiate any positions within a week. The author wrote this article to expresses his opinions and in line with market developments The author is not receiving any compensation and has no business relationship with any company whose stock is mentioned in this article. The phrase caveat emptor, meaning “Let the buyer beware”, arises from the fact that buyers often have less information about the good or service (shares are financial products!) they are purchasing, while the seller has more information. Defects in the good or service (any accountancy frauds) may be hidden from the buyer, and only known to the seller. Thus, before investing into any financial products, one must take into considerations and seek advices from professionals and/or trusted remisiers.
BYOPM 