Bullish on China

Bullish on China

Chinese A-share markets started 2016 on a volatile note, dropping 7 per cent on the first trading day of the year and triggering a trading halt through a new circuit breaker.

Stocks have undergone a choppy month, with both the CSI 300 Index (which tracks A-shares) and MSCI China Index (which tracks H-shares) having declined by about 15 per cent year-to-date.

Further volatility over the short term may come as no surprise, but we think much of the negative news on China is overhyped. There is no denying that China is facing headwinds, but as medium to long-term investors, we are not unduly concerned. Here’s why:

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1. Retail investors dominate Chinese A-shares, so market gyrations are to be expected.

The volatility in early January was fuelled partly by concerns that a six-month ban on share sales by significant shareholders, implemented in July 2015, would expire on 8 January this year. The People’s Bank of China’s move to lower the renminbi’s (RMB’s) mid-point rate on 7 January was also a key catalyst to China’s stock market plunge.

More importantly, Chinese A-shares are dominated by retail investors, accounting for more than 80 per cent of the trades, which tend to be short-term and speculative, with a “herd” mentality. There is a lack of participation from large institutional investors, who would usually start to bottom-fish for inexpensive stocks when markets fall.

A case in point: since 2005, there have been 86 trading days where the CSI 300 Index gains/losses were larger than 5 per cent. In contrast, there have only been 24 trading days during which the S&P 500 Index gains/losses were bigger than 5 per cent.

2. Chinese authorities are learning, and rapidly rewriting the rulebooks.

The Shanghai and Shenzhen Stock Exchanges scrapped the circuit breaker almost immediately after realising that the mechanism induced fear and panic rather than stability. China’s circuit breaker triggered 15-minute trading halts when stocks swung by 5 per cent, and a full-day halt after a 7 per cent fall, a narrow range, especially in a retail-oriented market. By comparison, in the US a 7 per cent/13 per cent swing effects a 15-minute halt, while a 20 per cent decline stops daily trading.

3. Chinese H-shares remain attractive versus A-shares.

The MSCI China Index currently trades at a 12-month forward price-to-earnings (P/E) ratio of 8.1x3 – back to levels seen before the 14 American Depositary Receipts (ADRs) were added to the index in end-November. In comparison, the CSI 300 Index is trading at a forward P/E of 10.6x.

4.The RMB’s devaluation may be a new normal, and should not cause too much concern.

To put things into context, the RMB’s depreciation in 2015 was less steep than that of major Asian currencies. With China’s ongoing capital account liberalisation and gradual shift towards a less managed exchange rate, further RMB devaluation looks likely.

In addition, Chinese regulators likely want to further depress the RMB because, first, a weaker currency helps exports, which may in turn boost a flagging economy. Second, they may be trying to avoid what Japan experienced in the 1990s, during which the yen appreciation hurt exports and led to gross domestic product (GDP) contraction and a massive stock market correction.