I wrote the following article for the April issue of Mint Indulge expressing doubt on the Chinese equity bull run. As markets in Shanghai swoon, the link seems to have gone dead with a 404 error. Happenstance? Coincidence? Or the start of a beautiful conspiracy theory? Anyway, the original article (pre-edited version) given below.
Also, it is quite amusing to note the rhyming of history as Chinese brokerages have come together to stabilise the market by pledging to invest nearly $20 billion. As J.K. Galbraith masterfully details in his epic 'The Great Crash 1929': "Thursday, 24 October...At noon the organized support appeared...determined men were moving in. They were the nation's most powerful financiers. They had not yet been pilloried and maligned...A decision was quickly reached to pool resources to support the market."
--------------------------------------------------
Chart
1: NASDAQ and Shanghai Composite
Footnotes:
Also, it is quite amusing to note the rhyming of history as Chinese brokerages have come together to stabilise the market by pledging to invest nearly $20 billion. As J.K. Galbraith masterfully details in his epic 'The Great Crash 1929': "Thursday, 24 October...At noon the organized support appeared...determined men were moving in. They were the nation's most powerful financiers. They had not yet been pilloried and maligned...A decision was quickly reached to pool resources to support the market."
--------------------------------------------------
The dizzying rally in Shanghai Composite index has sparked
much commentary in the financial pages. The index has doubled since the second
half of last year generating a 150%+ annualised growth rate for investors lucky
enough to have picked the bottom. The rally has also increased the
vociferousness of public debate between cheerleaders and sceptics of the
Chinese model. The former cite China’s impressive economic growth as the
lynchpin of the equity market rally. In addition, they argue that the rally is
likely to continue as households, which have hitherto shunned the market, rush
to embrace equities. In contrast, the sceptics continue to harbour doubts on
the sustainability of the Chinese growth model. To them, the current stock
market rally bears all the hallmarks of a bubble. So who is right and more
importantly, what investment strategy should you follow?
There is no doubt that Chinese economic growth has been
spectacular. Since the start of the century, China has added eight trillion
dollars to its GDP. In the process, it has become the second largest economy in
the world and generated a vast amount of wealth, both for Chinese nationals and
foreigners. Per-capita GDP has grown more than six times from less than $1,000
dollars in 2000 to $6,800 dollars in 2013[1].
Even when compared against other BRIC economies, Chinese growth has been
exceptional. From comprising 47% of aggregate BRIC GDP in 2000, China comprised
60% in 2013[2].
Despite the breakneck growth, the stock market only went up slightly more than
50% (Shanghai Composite was 1366 at the start of 2000 and 2116 at the end of
2013[3]).
Therefore the argument seems plausible that the current rally is merely the
market catching up with economic reality. This is further supported by the fact
that in the US, the S&P500 index broadly tracked the increase in GDP of
about 60% between 2000 and 2013 by going up 40%.
However, equity represents a claim on future income and
sceptics argue that stock prices seem disconnected with future growth outlook.
The fruits of past growth have already been distributed. For the stock market
to rally now implies that the future is likely to be as rosy. Chinese GDP
growth has slowed to 7% and official targets have been revised down again to
“around 7%” for 2015 from 7.5% in 2014, which were in turn reduced from the 8% target
in place since 2005. Moreover, sceptics argue that the heavy dependence on investment
for fast growth has led to a lopsided economy which will constrain future
growth[4].
The credit-fuelled, investment-led model is already showing signs of faltering
with bank NPLs rising to the highest in 4-years[5].
As the credit cycle turns, equity markets are unlikely to do well.
The second argument in support of the equity market rally is
increasing participation by Chinese households as they shift portfolio
allocation away from low-yielding bank deposits and a rapidly cooling property
market. The argument is credible since before the current rally, equity market participation
rates were roughly half of the US[6],[7] and household wealth sitting in bank deposits more than double. Moreover, the
property market has cooled substantially with year-on-year change in newly
built house prices collapsing from a 7.7% increase in March 2014 to a 6.1% decline
in March 2015 (the 7th consecutive month of decline[8]).
This has meant that households have moved from property to the stock market to
preserve and enhance wealth.
However, the rapid increase in prices certainly seems to
have some of the hallmarks of a mania. As the chart shows, Shanghai index is
closely following the pattern of the final euphoric rise of the NASDAQ in the
second half of 1999.
Note: NASDAQ = 100 on 1-Jul-1999; SSE = 100 on 1-Jul-2014
Source: Yahoo Finance, Author’s calculations
Similar to the dot-com bubble, Chinese stock market analysts
are citing that “traditional measures of value have little sway”[9].
The expectation is that the government will not discourage the equity rally in
order to support household wealth as the economy slows. Therefore monetary
policy will remain supportive. It seems awfully like the Chinese version of the
‘Fed put’.
The evidence strongly indicates that the Chinese equity
rally has become a self-feeding spiral with speculators entering in
anticipation of a further rise. This is supported by the rush to open new
trading accounts and the growth in margin debt, which has increased by RMB 1
trillion (~$160 billion, 1% of GDP) since August 2014 according to BNP Paribas[10].
On balance, the sceptics seem justified in doubting the
sustainability of the rally. However, as several investing stalwarts learnt in
1999 and early 2000, betting against a momentum-driven market can be a very
unprofitable endeavour. However, riding with the herd is equally foolhardy.
Although largely unplayable, the Chinese equity market offers
valuable clues on the larger China story. The rush into stocks is pulling
capital away from other areas such as loan and bond markets (traditional wealth
management products offered to retail investors were used to channel money into
credit markets). This is likely to exacerbate the credit problems which are
beginning to surface. Further, the stock market rally, being liquidity fuelled,
does not contradict the thesis of slower future growth and economic
readjustment. This does not bode well for commodities due to China’s role as
the marginal consumer. Therefore prices are likely to stay at current low
levels for a while longer. Also, the Yuan is likely to weaken further as Chinese
authorities try and manage the slowdown and downturn in the credit cycle
through easy money. The fact that the PBOC has already cut rates twice in the
last six months strongly suggests this to be the case.
In the final analysis, rather than trying to
negotiate strong currents in the equity market, investors may be better off
punting in connected markets.Footnotes:
1. Google -
multiple sources
2. BRICS Joint Statistical Publication 2014, http://brics.ibge.gov.br/downloads/BRICS_Joint_Statistical_Publication_2014.pdf
3. Google finance
4. Michael Pettis being one of the best known sceptics on the Chinese model’s
sustainability – an example: http://blog.mpettis.com/2013/09/rebalancing-and-long-term-growth/
10. http://ftalphaville.ft.com/2015/03/25/2124803/this-is-still-nuts-chinese-equities-edition/
