The rally in the Shanghai stock market that began last year has seen the index rise nearly 90 percent since July 1, 2014 — from 2050 to 3860 as of this writing. The Shanghai and Shenzhen stock exchanges are the markets most accessible to mainland Chinese investors, and until last year were relatively inaccessible to outsiders. Recent regulatory developments have started to change that, and participation in these markets — known as A-share markets in distinction from the H-share market in Hong Kong — has become accessible to investors outside China through a small but growing number of ETFs.
Shanghai Market Roars
Source: StockCharts.com
China’s A-share markets are extremely volatile, and driven by domestic Chinese demand. When they outperform, they do so dramatically. But for many years of the past decade, real estate has been the outperformer, as seen in the chart below.
Source: Morgan Stanley Research
The A-share markets outperformed under two circumstances: during the global blow-off that preceded the Great Recession, and during the massive stimulus that the Chinese government unleashed to deal with that crisis. In short, they outperformed when there was a stimulus from elevated global demand, or when there was a stimulus from a determined Chinese government.
We believe the current A-share rally, in spite of its size and speed, can continue, because although the global demand environment is weak, the Chinese government will support it for several deep, fundamental reasons. We believe the government’s support for the rally will dovetail with other fundamental forces as well. Some analysts are calling for a further appreciation of 20 to 40 percent in A-shares this year, and such performance would not be out of line with historical precedent.
What Is Supporting the Rally?
First and foremost, the Chinese government wants the domestic stock market to appreciate, because it wants to draw investors out of the troubled assets that the government would like to deleverage. Articles in official media have emphasized that an active and healthy equity market is critical to the government’s structural reform efforts. China is in the midst of a transition that several of its Asian neighbors have made — from early- and mid-stage development led by heavy industry, to a more mature phase led by the domestic consumer.
In China, the period of rapid industry-led growth has led to excesses — particularly in the property market, but also with various “wealth management” products (WMPs) where savers sought better returns than those offered by mainstream banks. The Chinese government is slowly unwinding those excesses as it navigates the shift to more moderate, consumer-led growth. So as it reins in property speculation and moves to bring WMPs under control, it is setting policies in place to encourage mainland investors to buy stocks — reducing restrictions and fees on trading accounts, for example. In January, the government caused a mini shock by increasing margin trading requirements — but the market quickly recovered, as it historically has when such a move occurs in the context of bullish fundamentals.
The government is also boosting demand for mainland stocks by making it easier for outsiders to buy them, and A-shares may soon be included in several MSCI indices (for the world, for China, and for Asia-Pacific ex-Japan).
Second, Chinese investors themselves are seeing stocks as the best way to invest their savings, and that’s creating a positive feedback loop. With returns fading from real estate, bonds, and WMPs, that just creates more demand for stocks, which continues to drive the bull. Historically, mainland stock market performance has closely tracked the rate at which new trading accounts are being opened — and between Shanghai and Shenzhen, new accounts are being opened at the fastest pace on record.
Source: Morgan Stanley Research
Third, the Shanghai market is cheap — in comparison to both its own history, and to other major global markets. We at GIM tend to be GARP investors by orientation, looking for “growth at a reasonable price.” With the U.S. market fairly valued, and overvalued in some sectors, we find it difficult to locate the reasonably priced growth we’d like to buy. Our bullishness on Europe and Japan is based primarily in the accommodative monetary stance of their central banks — in terms of price, they could correct modestly at any time, but remain very positive in the intermediate and long term. In China, however, we do see real value. Even the relatively expensive Shanghai index trades at 13.8 times forward earnings, a significant discount to the U.S. (the Dow is trading at 16 times, the S&P at 17 times, and the NASDAQ at 19 times). It is also a significant discount to Shanghai’s history — not much higher than market troughs in 2005 and 2008.
Shanghai A-shares Historical Trailing 12-month P/E History
Source: Morgan Stanley Research
Earnings growth has been very strong, with a CAGR of 14 percent over the past decade.
Shanghai A-shares Trailing 12-month EPS, in Yuan
Source: Morgan Stanley Research
Fourth, more easing measures are on the way from the People’s Bank of China (PBOC), so the Shanghai markets fall under our “don’t fight the central banks” rubric. Analysts expect further rate cuts and reductions in reserve requirements this year, even after easing in November and February. Zhou Xiaochuan, the PBOC’s governor, warned a week ago that the country’s growth rate had slipped “a bit too much” and said that the central bank has plenty of room to support its 3 percent inflation target.
What About the Risks?
There are risks, of course. Primarily, those risks derive from the very deleveraging that’s pushing funds into mainland stocks. We do not believe that China will face a financial meltdown; the banking system is too insulated and too robust for that to occur, even under severe scenarios, as we have often written. However, a crisis is possible within the next few years, and although it will not bring down the banking system, it will surely usher in a severe bear market for equities.
Investment implications: We have often said that Chinese stocks are a short-term investment, not long-term. We will be extremely vigilant for indicators that a financial crisis is developing, and use those indicators as our signal to exit China. For now, with the government and the central bank behind the rally, valuations attractive, earnings strong, and local investors still coming in, we believe the trade is still on. To buy, use a 10 to 15 percent correction; on that correction, consider the Market Vectors China ETF (PEK). As foreign investors seek to join the China party, we believe Hong Kong stocks can rise as well.
For more commentary or information on Guild Investment Management, please go to guildinvestment.com.
