Insights On China’s Stock Market by Clough China Fund
Chinese stocks are in the midst of a severe correction after surging for the better part of the last year. We want to provide our investors with an updated outlook and some perspective on the current developments in Chinese equity markets.
Bull Market Had Solid Underpinnings
After a prolonged period of weak returns, Chinese stocks began to rally in the middle of 2014. This new bull market was not a random event but rather one driven by improving fundamentals helped by significant economic and social reforms. The reforms included the high profile anti-corruption campaign which was designed to improve Beijing’s standing with the people and cut down waste and inefficiencies in the state dominated economy. The rapid pace of opening China’s financial markets surprised many and gave support to the notion that the economic rebalancing towards a consumption and services led economy, which was already gaining traction, was on solid footing. The “New China” growth model was finally embraced by investors and Western-style capital markets emerged to help fund the private sector, which has generally been underserved by the state sponsored banking system.
As we moved into the Spring, Shanghai’s bull market turned into a boom and overconfident investors accelerated their share purchases with borrowed money. The best performing stocks were small to mid-sized companies characterized by “thin floats” (i.e., small percentages of the shares held by non-insiders) as demand for the shares pushed prices sky high. These companies are listed on both the Shanghai and Shenzhen bourses. By some calculations, outstanding margin balances were high, but just 3 – 4% of the overall market capitalization in China. However, when considering less regulated margin borrowings such as “umbrella trusts” and the thin floats, margin on tradable shares was as much as 15%. This was simply too high when the leverage was concentrated in overvalued and technically extended areas of the market.
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Leveraged Equity Positions Need to Clear
Regulators made several attempts to lean into the wind of this speculative activity via so-called verbal intervention characterized by official state warnings of stock market risks in the domestic media. They also tightened margin borrowings with specific attempts at cracking down on the less regulated umbrella trusts. Ultimately the surge exhausted itself and we saw a much anticipated “correction” of stock prices on the Shanghai stock exchange.
Leverage is now coming out of the Shanghai stock market and it’s not pretty. The small to mid-sized companies who saw their stocks surge are plummeting the most. Indeed, many shares have been temporarily suspended from trading or are essentially locked and not trading due to the 10% limit down function that exists in the domestic markets. It’s a fluid situation but at times this week we have seen 60 – 80% of the listed shares effectively not trading resulting in a poorly functioning, jammed market. Fortunately, outstanding margin borrowings have now declined by nearly 30% according to China policy researchers at NSBO Beijing.
With the Shanghai market freezing up, we have seen contagion into the offshore China markets, particularly in Hong Kong, but also in US-listed Chinese companies. When domestic investors aren’t able to sell investments to generate cash to repay margin borrowings, they look to markets that are trading and Hong Kong began to sell off in concert with domestic markets. This despite the fact that Hong Kong never had the equity boom the mainland experienced. While the Hong Kong market is mature and dominated by institutional investors, the fear of contagion has served to be self-fulfilling.
Our fund has not been immune to the selloff, particularly as it extended into Hong Kong. We have had modest holdings in China’s domestic A-Share market with the vast bulk of our exposure in higher quality, cheaper Hong Kong-listed Chinese companies. The biggest risk investor’s face is not volatility but rather the loss of permanent capital. Some of the leveraged investors in China’s domestic market are facing permanent capital losses, but we do not think the technical pressure from their selling has impaired the value of our holdings, despite the declines related to contagion. When market conditions normalize, we believe the value of our portfolio will recover strongly.
What a Bottom Might Look Like
In the last week we have seen significant supportive policy actions intended to help stabilize the market. The government moved to postpone all pending Initial Public Offerings (IPOs) which will reduce the equity supply in the market. The public pension funds have also lined up to dramatically increase their equity holdings in the coming weeks. Insurance companies were given further latitude to build equity allocations to blue chip Chinese stocks. Further, the brokerage community committed to buy equities, a pledge which was encouraged and supported via credit lines by the CSRC (China Securities Regulatory Commission) and CSFC (China Securities Finance Corp). The brokerage firms also agreed to not sell existing holdings unless the Shanghai Composite traded meaningfully higher to 4,500. The CSRC has also prohibited significant holders (> 5% shareholders) and corporate executives from selling shares for the next six months. Indeed, some insiders are even being asked to repurchase shares they have divested in recent months.
We suspect that even more market stabilizing policies will emerge and China has ample tools to ensure liquidity for both the economy and the financial markets. Further interest rate cuts and reductions in the required reserve ratio (RRR) for banks are highly likely, further lowering debt service costs and loosening bank lending to the benefit of the broad economy.
The cumulative impact of the recent policy moves is likely to prove helpful in the coming weeks. We are also beginning to see corporations voluntarily buy their shares in the market. Stock buyback announcements may be the most effective way of rebuilding investor confidence. We suspect these announcements and lower stock prices themselves will cure the problems now that valuations have come so much lower. We may see even more of this in Hong Kong-listed companies. As this transpires we will see fewer and fewer suspended shares in Shanghai and markets will begin functioning properly again.
Valuations Are Cheaper
Valuations across the board in China have cheapened dramatically, even in Shanghai which is now trading at 13.5x expected earnings over the next year. At its peak, the Shanghai Composite traded at only 18.5x earnings, hardly a bubble like valuation to begin with. MSCI China, the Fund’s benchmark index, is trading at less than 9.5x expected 2015 earnings which is a 45% discount to US stocks and an 18% discount to the MSCI Emerging Markets index according to Deutsche Bank. The benchmark has a 2.6% dividend yield.
The correction in Shanghai, while severe, shouldn’t have a significant impact on the growth outlook in China. Retail investors are a large investor group in China and represent 80% or more of trading volume according to the CSRC. However, they own less than 20% of the value of the market, with the bulk of equity ownership concentrated in institutional hands such as government agencies, sovereign wealth funds and insurance companies and with corporate insiders like founders and management teams. According to Gave-kal, there are likely less than 30 million households with significant direct equity ownership and most of those investors are high net worth individuals with significant assets outside of equities. While some are suffering significant losses, it will be in no way debilitating for a country with 1.4 billion people.
We have argued that investors should consider allocating to China with a long-term view and multi-year time horizon and our view has not changed on that front. We won’t attempt to call the timing or level of a market bottom, though prices have gotten much more attractive. It’s likely that the sharp correction, much of it caused by technical unwinding of leveraged investors, is nearing exhaustion and volatility will decline.
We believe the economic outlook in China remains bright and New China themes continue to offer great promise for investors. The recent events will likely chasten mainland risk takers and a more sober environment will emerge with savings directed towards institutional investment products such as life insurance and mutual fund products. China’s capital markets will mature and will continue to absorb a greater percentage of the countries still massive savings.
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