16th July 2015
After rallying around 150% since the middle of 2014, mainland China’s ‘A Share’ market has corrected almost 35% since mid-June. Douglas Turnbull, head of Chinese equities at fund house Neptune looks at the reasons behind this recent volatility…
There were two main triggers for this pullback. First, the Chinese market regulator (the CSRC) cracked down on the amount of leverage used to make stock purchases – known as margin finance – which had reached a dangerously high level. Secondly, issuance, both IPOs and equity placements, had increased substantially through the early Summer, absorbing a great deal of market liquidity.
Once the selling started, a vicious cycle commenced whereby leveraged shareholders were forced to sell shares to meet margin calls as the value of their holdings fell, which in turn depressed market values further thus leading to more margin calls. Also, after the sharp rally, valuations were extremely high (as many commentators had been pointing out for months) and therefore provided no support.
The government has previously made it clear that it wants a strong but stable market and it now has some credibility at stake should the rout persist. Therefore, it is stepping up with increasingly strong policy measures to prop up the market; from cutting interest rates and providing liquidity, to reducing transaction costs and arranging a stabilisation fund to actively buy shares and directly support the market.
Whilst this is a long-term set-back to a more market direct and reformist agenda (and an anomalous exception to Chinese policymakers’ usual skill), the stockmarket does seem to represent something of a blind spot for the government. The degree of government support is increasingly unprecedented and is the more urgent near-term priority. This is because we are now in the midst of a tug-of-war between policymakers and a ‘stampeding herd’ of domestic retail investors (who make up over 80% of the domestic market) and are a fairly unsophisticated investor base.
The process and outcome of that tug of war is currently opaque but the received wisdom is to not doubt Beijing’s will and ability to win out and at least stabilise the market over the next couple of months. The immediate path that the ‘A Share’ market will take is very hard to say but, given the degree that the moves are based on sentiment and deleveraging mechanisms rather than anything more fundamental, it may well be that we will see further downside before it stabilise.
It is worth adding that the stockmarket is still a very small part of the Chinese economy relative to other nations, whether that is in terms of the exposure of the average consumer, or its integration into the financial system. As such, the ‘real world’ effects of these moves should be as limited on the way down now as they were on the way up recently. This is not a systemic economic collapse in China, it is a stockmarket correction that went too far, too quickly.
The effect on Hong Kong
These mainland moves have obviously had a big effect on the Hong Kong market (which is where we have our China exposure) as well. Whilst substantially underperforming the ‘A Share’ market on the way up, the MSCI China Index has been in a gradual uptrend since the second quarter of 2014, led by monetary and fiscal policy support for the economy and a longer-term reform agenda being pursued, allowing a valuation discount to be unlocked. The market also spiked up beyond this in April 2015 on expectations of cross-border flows into Hong Kong from China arbitraging these lower valuations.
This latter spike has now been fully corrected in line with the mainland, and the Hong Kong market is still vulnerable to the aforementioned tug-of-war playing out between Beijing and ‘A Share’ investors. It is very hard to see Hong Kong performing well until the ‘A Share’ has at least halted its precipitous decline. It does not necessarily need strength to follow, as Hong Kong can walk its own path, but ‘A Share’ weakness is probably too great a headwind.
Fundamentals remain in place
We see no real reason for a market collapse in Hong Kong as nothing that much has changed in terms of policy outlook, economic trends or company fundamentals. Hong Kong does not have the leverage issues of the ‘A Share’, nor did it enjoy anything like the same gains, whilst valuations in lots of places are now increasingly providing strong support. Given how hard it is to time a true inflection point in the ‘A Share’ market, there is a likelihood that Hong Kong may continue to fall some way further and overshoot to the downside.
However, we believe that the aforementioned uptrend remains in place and have been selectively adding to positions we like for the longer term but have been unduly punished by a market selling blindly and punishing anything other than defensive large-cap stocks. On the other side, we are looking to sell only a very few select positions, primarily domestic brokerages, given their direct sensitivity to domestic market activity and levels and where we are still sitting on good profits. These will be sold on strength.