OpinionApr 23 2015

Fragile China

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2015 is the year of the sheep according to the Chinese zodiac calendar, and is associated with the characteristics of calmness and prosperity.

Only one of those applies to Chinese equity markets at present - and it is certainly not calmness. The domestic stock market in China has gained nearly 100 per cent in the last 12 months and valuations in the market are starting to look very lofty, prompting calls of a market bubble. The demand for equities is so great from Chinese investors that enthusiasm is spilling over into the Hong Kong market. So can the momentum in Chinese equities be sustained, or is this really a bubble on the brink of bursting?

The domestic stock market in China has gained nearly 100 per cent in the last 12 months

First, a few technicalities.The local Chinese market is known as the A-share market. A-shares are stocks in companies that can only be purchased by local Chinese investors or by foreign investors who have been given special access. Chinese companies that want to access international capital markets can also list on the Hong Kong stock exchange and have an H-share or international share class. If the same company is listed on both exchanges, it can trade at different prices because each can only be accessed by certain investors. This is why A-share stocks have historically been more expensive than the H-share stocks.

Near the start of the year, the Shanghai-Hong Kong Stock Connect programme was launched, allowing investors in China to invest in the H-share stocks and investors in Hong Kong to invest in the A-share class. However, the amount of money that could flow north and south was restricted, as were the investors who could access it. But as the A-share market hit a seven-year high, the restrictions on who could use the Stock Connect programme were relaxed, allowing Chinese mutual funds to take part in the programme.

The euphoria of Chinese investors at being able to buy the cheaper H-share market is clearly evident in the surge of new investment accounts being opened in China, with a jump to 1,670,000 against an average March value of 240,000. To some degree, this enthusiasm is being propagated by the Chinese government,which wants investors to shift their focus from the increasingly expensive local market to an international one.

The market rally has been staggering, with the Hong Kong Hang Seng Index gaining just over 10 per cent in three days - up 17 per cent this year. This is not stopping the money flowing and the Stock Connect’s daily quota of US$1.7bn (£1.14bn) continues to be tested. This has led to speculation about a possible bubble, but the trouble with bubbles is that they are very hard to identify until they have popped.

Any asset or market index that rises this far, this fast is ripe for a large correction and some near-term consolidation or profit-taking seems sensible. However, over a more medium-term timeframe, the H-share rally could continue.

The catch-up in the Hong Kong market could run for a little longer as valuations in that market are lower than their Chinese counterparts. The Hang Seng is still trading at below its long-run average and A-shares are still at a premium to H-shares. Until that gap closes, demand will persist.

“Bad news is good news” as far as China’s economy goes. Economic growth is slowing faster than Chinese officials might want, with increasing expectations of further rate cuts from the People’s Bank of China and fiscal stimulus measures from the government.

Finally, the market may be supported by flows. The quota on the Stock Connect may be extended and, given the difference in size between the A- and H-share markets, there is still plenty of pressure forcing capital through that system. Meanwhile, some funds may be forced into buying Chinese equities, if only to keep up with benchmarks. China accounts for 22 per cent and 24 per cent of the MSCI AC Asia Pacific ex Japan Index and the MSCI Emerging Market Index, respectively. So any benchmark-focused investor who has been underweight China could now be forced into buying shares.

But once the arbitrage opportunities have faded, investors will need to see tangible evidence of significant improvement in China’s economic fundamentals and corporate earnings. Without this, the rally could be very short term indeed and prove not to be the sheep with the golden fleece after all.

Kerry Craig is global market strategist for JP Morgan Asset Management