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China A-shares tanked recently. So what’s next?

Investment strategy

Chi LO
 

Investor concerns have rattled Chinese shares, but is the slump an entry point or does it mark the start of a more extensive correction? Chi Lo, senior economist Greater China, assesses the latest developments.

At the time of writing, the CSI 300 index, which maps the performance of the top 300 A-share stocks on the Shanghai and Shenzhen stock exchanges, was down by more than 20% from its peak on 24 January 2018, while the S&P500 was only 4% below its peak of the same week.

The trigger for the turn in the A-shares’ fortune was a combination of a slowdown in domestic growth momentum, when weak economic data started flowing in May, and a rise in Sino-US trade tensions. Although the growth slowdown had been expected since April, the market just piled this onto the prevailing worries about debt reduction, defaults and the squeeze on liquidity.

While the probability of a full-blown trade war remains low at this point, at around 10% in my view, the probability of a resolution is probably even lower. This means that there is more than an 80% probability of long drawn-out negotiations during which Chinese stocks will likely remain volatile.

 

Fears rise as growth momentum weakens further

 Since May, credit growth and macroeconomic indicators in China have weakened further from an already soft trend (for examples, see Charts 1 and 2). This in part reflects a self-inflicted slowdown via Beijing’s debt reduction policy, which has hit shadow financing especially hard (see Chart 3) – mostly affecting the private sector and thus impacting heavily on private investment incentive and market sentiment.

 

Exhibit 1: Adjusted credit flows slow

Chart 1: Adjusted credit flows

Note: TSF – equity + local government bond issuance, 3-month moving average.

Source: CEIC, BNP Paribas Asset Management (Asia), as of June 2018

 

Exhibit 2: Retail sales growth on a downward trend

Retail sales growth

Note: data series in 3-month moving average.

Source: CEIC, BNP Paribas Asset Management (Asia), as of June 2018

 

Exhibit 3: Debt reduction policy hits shadow bank lending

Exhibit 3

Note: 3-month moving average.

Source: CEIC, BNP Paribas Asset Management (Asia), as of June 2018

 

Fears have also been heightened by the increase in so-called pledged lending. Since 2016, many major shareholders in listed companies have pledged an estimated RMB 5 trillion of their A-share holdings (10% of total A-share market capitalisation) as collateral for bank loans. In a market sell-off, the banks would issue margin calls and start selling the shares as collateral if the borrowers cannot meet those calls. There would then be the risk a downward spiral in the stock market, and if liquidity were to dry up, massive suspensions would result, echoing the nightmare of the 2015 market crash.

 

Easing will help bonds more than equities

On the back of these fears, the People’s Bank of China (PBoC) has shifted its policy bias towards easing. It has cut the bank reserve requirement ratio twice since April this year, despite a rising interest-rate environment externally; and more easing is in the cards. It has also enlarged the collateral pool for its lending facilities by accepting lower-rating corporate bonds and pumped liquidity to prevent the 7-day repo rate from rising along with credit spread.

Barring an economic hard-landing, Beijing’s debt reduction policy has ruled out any massive reflation which would work against the point of reducing debt. The PBoC’s easing bias only aims at alleviating, not eliminating, the economic pains of structural changes and debt reduction. So, while the expected incremental easing will unlikely improve equity market sentiment much in the short-term, it will be bond positive.

Credit growth is expected to slow further, dragging on the cyclical growth momentum. Barring a full-scale trade war, the official 6.5% growth target for 2018 is still within reach, in my view (Q1 2018 growth was 6.9% annualised), as the impact of policy easing should filter through the system by Q4 2018. Under this scenario, the biggest beneficiary of monetary easing in the coming months is likely to be sovereign and high-grade bonds, with the 5-year Chinese government bond yield expected to fall further below the current 3.3%. Meanwhile, credit spreads are expected to widen until fears about defaults stabilise.

The market has been complacent about China’s growth slowdown while other risks in the system have been known for some time. The rise in Sino-US trade tension has shaken this complacency. From this perspective, the recent sharp decline in A-share performance is mostly driven by sentiment, which seems to be pricing in an economic hard-landing. This outcome is unlikely, in my view, because Beijing has the tools and financial resources to help prevent it from happening, not least aided by a relatively closed capital account and a financial system that is still largely influenced by the government.

 

What might support a market turnaround? 

  1. Stabilisation of GDP growth momentum
  2. Falling bond yields to ease the financing situation
  3. A revival of some legitimate shadow banking activities to help ease the liquidity squeeze on the SMEs/private sector
  4. Easing of Sino-US trade tensions

In terms of valuation, since the recent correction, the MSCI China index has been trading at 13x this year’s earnings, 10% below the start of the year; the trailing P/E ratio of the CSI 300 index is at 11.5x, which is not far above the levels seen in the deep market sell-offs in late 2015 and early 2016 when weak external demand, currency depreciation and capital outflows weighed heavily on market sentiment. Today’s economic and corporate fundamentals are better, corporate profitability is stronger, FX reserves are recovering, macroeconomic policy coordination is better and structural reform and debt-reduction drives are stronger.

From a longer-term structural perspective, the current market turmoil can be considered as an entry point for all the reasons we already know, such as A-shares’ inclusion in the MSCI, onshore bond inclusion in international indices, renminbi internationalisation, structural reform, debt reduction etc. The trick is to focus on low-debt, strong cash-flow companies within the structural reform catchment area. Meanwhile, the risk for short-term trading is volatility with a downside bias until market sentiment settles down.

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