CHINESE EQUITIES: Ground zero

03/05/2010 | Sid Verma

Market jitters over withdrawal of stimulus policies and looming asset bubbles in China are weighing heavy on domestic stocks. But what happens in China may well give warning of what happens to global markets when stimuli are unwound in advanced economies

China’s equity market is often viewed as a barometer for the state of global financial markets – even though the market is dominated by domestic investors, and foreign investment is strictly regulated.

Back in February 2007, for instance, a 9% fall in the Chinese equity market set off a global panic that presaged the onset of the credit crunch. And more recently, in mid-August 2009, a near-20% fall in the Shanghai Stock Exchange led to a sharp decline in global equity markets.

This year’s pullback in Chinese equities may now serve as a warning shot to the growing ranks of global market enthusiasts, for whom China’s frenetic economic rebound is evidence the worst has been left behind. Having notched up a 105% gain in the first seven months of 2009 – when 85% of China’s new bank loans were extended as part of the government’s Rmb4 billion stimulus package – the Shanghai Stock Exchange so far this year has underperformed the US benchmark, the Standard & Poor’s 500.

The CSI 300, an index that tracks the 300 largest companies on the Shanghai and Shenzhen bourses, has shed 9.7% this year, compared with the 1.7% rise in the benchmark MSCI All Country Index. Meanwhile, China-focused equity funds experienced net outflows in the first nine weeks of the year, while new inflows in recent weeks have yet to compensate for the outflow, according to Emerging Portfolio Fund Research (EPFR).

What accounts for the softer market tone in an economy that the IMF predicts will grow 9.9% in 2011? Concerns over the pace and timing of China’s exit from stimulus policies blight the outlook, says Francis Cheung, head of China/Hong Kong Strategy at CLSA Asia Pacific Markets in Hong Kong.

Stocks have pulled back on fears over monetary tightening, a looming property market bubble and new share supply. In recent months, Chinese equities plummeted when the central bank twice raised banks’ reserve requirement. Most recently, the Shanghai Stock Exchange tumbled 5% on April 19 on news the government will introduce new measures to cool the property market.

Scepticism

More fundamentally, China’s domestic policy mix has met with a growing scepticism globally. Many economists say China’s fiscal and monetary stimulus programme – with a Rmb4 billion stimulus for the 2010 fiscal year and a 33% surge in new bank lending last year – are hallmarks of excess. A number of leading commentators, including star hedge fund manager James Chanos and former IMF chief economist Ken Rogoff, have warned that a credit bubble will lead to an economic crisis in China. Meanwhile, Citigroup’s chief economist Willem Buiter has warned that China is in the early stages of a classic boom/bust cycle. A bubble is forming in the real estate market, which will spread to stocks, and the bubble could burst in the next three years, he claimed in late March.

“Whenever credit conditions like those seen since late 2008 in China have presented themselves in countries where the fundamentals are strong... and where the monetary, regulatory and fiscal authorities are untried and untested (as they are in China today), a boom, bubble and bust sequence has occurred,” Buiter wrote. “This time is unlikely to be different, unless the authorities in China act differently from the authorities in China and elsewhere in the past.”

Says Cheung: “Last year, everyone was going on about how great China’s command economy was and how great they were on reflating their economy. Now there’s been a 180 degree turnaround, and everyone is saying China will be in crisis.”

Shifeng Ke, director of Martin Currie Investment Management, says: “Some people say China is a huge bubble that will cause a regional slump in the next 10 years; others say the Chinese property bubble is 1,000 times that of Dubai. This is not true.”

A tug-of-war has broken out between China sceptics and proponents, many of whom proclaim financial power has shifted decisively east. Even with the rush of global and domestic liquidity, the divided market opinion has served to cap Chinese equity valuations to “reasonable levels”, says Antoine van Agtmael, chairman of Emerging Markets Management, which oversees up to $14 billion of stocks globally.

The current forward price to earnings ratio for the CSI 300 is 16.3 times, compared to 26 times in August 2009. Similarly, the forward price to earnings for H-share companies, which are Chinese firms listed in Hong Kong and traded in the Hong Kong dollar, is 12.4 times, compared to around 16 times in August 2009. Investors are preparing for a healthy return on equity this year, at 15.6% in the H-share market and 12.6% for the A-share market, which are renminbi-denominated shares that trade on the mainland. According to Citigroup, this compares favourably with the projected 13% for Latin stocks and 11% for the emerging markets globally

Bricks and mortar

Ke at Martin Currie says fears over China’s economic outlook have tempered the investor push into equities. Specifically, bears say the sky-high valuations in the Chinese property market reek of “irrational exuberance” that will drag down financial markets. The country’s closed capital account and underdeveloped capital markets leave its citizens with few investment options. As the global market tumult wiped away savings invested in the equity market, Chinese investors have now opted to snap up real estate as the primary conduit for their investments. According to Credit Suisse, Beijing and Shanghai house prices have risen by 190% and 130% respectively since 2004. And in the high-end markets in these so-called tier-one cities, a 50–100% rally in property prices took off last year, partly fuelled by misdirected bank loans, says Morgan Stanley’s China strategist Jerry Lou.

As markets are still licking their wounds from the US real estate bubble, fears are growing that Chinese banks will be knocked by a wave of non-performing loans and asset write-downs. “It’s pretty difficult to convince investors to commit new capital into stocks in a country where there is a property bubble, localized or not,” says Cheung. “Property is a critical part of any economy, and investors are still digesting the impact of the real estate crash in the development market.”

But Ke at Martin Currie is quick to downplay the systemic risks. He says the bubble is confined to major cities and high-end housing. Meanwhile, banks mandate an average 35% down payment for first homes, 50% for second homes and further loan restrictions for third homes. These regulations have disciplined the market and will ensure a lack of loan defaults, he says.

Says Lou at Morgan Stanley: “The impact of the bursting of the property bubble will be limited to high-end property prices, and construction companies will feel the brunt – rather than banks, since the market is too small to impact the credit system meaningfully.”

China’s mortgage loan to GDP is only 15% compared with between 80% and 110% in the US and UK in the middle of the financial crisis. Lou says investors should avoid property stocks. But the MSCI China Index is unlikely to fall into bear market territory in the event of a collapse in the real estate market, since property stocks make up only 4% of the benchmark.

“We have entered a new situation: a bubble – or at least stretched valuations – in the property market, but not in the Chinese equity market,” says Cheung at CLSA. He says unless the government takes decisive measures to stabilize the property market: “I don’t think we will see that significant an amount of new capital committed to Chinese stocks.”

Brake time

The other monster in the closet is tighter monetary policy. Says Mark Mobius, executive chairman at Franklin Templeton Investment: “If the government puts on the brakes, you will see a crash in the Chinese market. But the government does not want a slowdown in growth – so we won’t see this happening.”

Since late 2008, the People’s Bank of China (PBoC) has flooded the market with liquidity, leading to massive money supply growth. But tighter bank lending standards and a higher cost of capital will increase corporate financing costs and reduce consumption, which could drag equities down in the short term.

“The fear for Chinese equities is not about GDP or corporate earnings growth, it’s monetary tightening, the pace of monetary tightening and the risk of policy errors,” says Cheung.

But Fe at Martin Currie says credit conditions this year will still be relatively loose. In the 2010 fiscal year, the government’s full year lending quota is Rmb7.5 trillion. This represents a 20% new loans to GDP ratio – lower than the 31.5% last year – but above the average 14.6% between 2001 and 2008.

“Although the supply of credit is lower than last year’s high base, strong corporate and household balance sheets should support equity investments,” says Jing Ulrich, chairman of China Equities at JP Morgan.

In addition, real interest rates are likely to remain in negative territory – Fe predicts this will average -0.5% this year – in the likely absence of aggressive rate hikes and creeping price pressures. “This threat of wealth erosion should encourage a higher allocation of funds toward equity markets,” says Ulrich.

“In the short term, I see volatility as the government adjusts monetary policy – but we are moving towards a structural bull market that will last at least the next three to five years,” says Ke.

Investors are treading carefully. Higher credit costs relative to 2009, property price volatility and a slight slowdown in government spending are the market hazards. “But if you are too disciplined now, you are likely to miss out on the oncoming rally that will start in the second half of the year,” says Lou at Morgan Stanley.

Strong corporate earnings and a potential appreciation of the renminbi should offset the impact of higher credit costs and drive the equity market higher, he says. As markets are now in the later stages of the liquidity cycle, Lou recommends investors step up exposure to companies that show healthy levels of earnings growth and are supported by domestic consumption. He is underweight banks, properties and material processors and overweight consumers, telecoms, insurance and energy.

Those who argue that the Chinese equity market is financially uncorrelated with the global market place, because of its smaller market share and the relatively low share of savings in Chinese shares, may yet be in for a surprise: how the market reacts to the withdrawal of domestic stimulus measures could once again be the bellwether for how western financial markets ultimately react to the unwinding of Keynesian policies elsewhere.

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