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What Investors Should Know About China’s Stock Market Rally

What Investors Should Know About China’s Stock Market Rally by Weili Jasmine Huang, Columbia Threadneedle Investments

  • China’s government owns a significant share of companies which they need to unwind, and this is going to hang over the stock market in the months and years to come.
  • We expect China’s economy will slow as it transforms from an industrial, manufacturing economy to a consumption-driven, service-focused market.
  • Companies that can take advantage of economic and demographic changes while contending with environmental and social issues will survive and flourish.

Q: Is government intervention in China’s stock market a positive or a negative?

A: After a long run-up, the Chinese stock markets experienced a huge correction, largely in part to the Chinese government’s crackdown on margin trading. Additionally, the government purchased almost 10% of the market in order to keep it from bottoming out. Now that leaves the government of China owning significant percentages of companies – there’s no way they can exit these holdings in a short time frame without defeating their original intent of supporting stock prices. However, it’s obvious that they need to unwind these positions at some point, and this is going to hang over the market like a dark cloud in the months and years to come.

Q: Does the recent rally in China’s stock market look sustainable?

A: To begin with, only one of China’s two stock markets has rebounded 20% this year, and that’s the market available mostly to Chinese investors and some institutional investors, known as the “A shares” market. The other stock market, called the “H shares” market, is based in Hong Kong, and is open to offshore investors. The H shares market has rebounded just 10% since this summer’s lows. While directionally, the performance is similar this year, the returns of these two markets can differ dramatically.

While both markets have rebounded, I view this as a countertrend, not a sustainable rally, especially for the onshore market. Both Chinese stock markets will continue to remain range-bound as they have been for the past five years, and I don’t see that changing anytime soon. However, for onshore investors, the ride will be much bumpier as this market has been quite volatile as of late. For example, the A shares market was up 150%, then corrected by 40%, and is now up 20% from the lows.

Q: Where do you see the greatest headwinds for China’s stock market?

A: There are things working against the Chinese market that make further government stimulus necessary. China’s GDP will continue to slow. This year, it is reported to be at 7%, but the government has publicly lowered its target GDP to 6.5% for the next five years. We’re thinking that this could trend down to as low as 6%, and that’s going to put added pressure on the already precarious equity markets.

The other factor putting pressure on the markets is the Chinese currency, known as the renminbi. In recent months, the renminbi topped record highs, prompting the government to devalue it suddenly in August as RMB’s pegging to the U.S. dollar made it appreciate substantially against its trade-weighted currencies. The suddenness of this devaluation, however, had a backlash effect, causing not only the Chinese equity markets but markets across the globe to reel.

Many feel that the renminbi remains too strong, and the specter of further currency devaluations casts a shadow over the markets, sparking added uncertainty and volatility – two things equity investors dislike.

Q: What can the Chinese government do to stimulate the economy?

A: Currently, the government is stimulating and supporting the economy in several ways – it has loosened its monetary policy by lowering interest rates, reduced the cash reserve requirement for banks, and started a program of physical spending by investing in infrastructure projects.

Consumption is playing an increasingly important role for the economy. The government is trying to get Chinese consumers to buy more, so they lowered the auto purchase tax by half, cut the down payment on mortgages from 30% to 20%. This helped stimulate the economy and the market to rebound.

We expect the Chinese government to continue attempts to stimulate the economy, but it won’t be for the purpose of driving growth. Rather, they are going to try to cushion the slowdown with their fiscal policies.

They can continue to cut interest rates and lower the reserve requirement ratio, known as the “RRR,” which is essentially the percentage of cash that banks need to have on deposit with the central bank. Both these actions put more money into the economy.

The Chinese government also has room to do more physical spending as the current physical budget deficit is just 2%. This spending helps to support the social welfare and consumption parts of the economy as well.

Q: What are some of the major risks that investors need to consider?

A: Macroeconomic trends are the key drivers for the performance of the equity markets. If we see growth decline, or unemployment levels climb, then those are worrisome signs for another potential collapse.

Right now, there is overcapacity on the mining, coal and energy sectors. If this overcapacity continues, which we feel is likely, there will be layoffs. Unemployed workers translate to lower consumption – if you’re not working, you’re not spending.

The Chinese currency is always a concern – if there were a subsequent substantial currency devaluation, then we are going to see a repeat of what happened in August when the Chinese market fell precipitously.

Lastly, we remain troubled that Chinese government now holds a big stake of the domestic, onshore market. At some point, they will begin to sell, and that will put downward pressure on prices.

Q: What is your outlook for China’s economy and where do you see opportunity?

A: Our expectation is that China’s economy will slow as it undertakes a major transformation from an industrial, manufacturing economy to a consumption-driven, service-focused market. This transition has already started, but it will take years to come to fruition. While there will be pain – there is in every transition – this change is necessary for China to have a sustainable economic model in the years to come.

Consumption is now more than 50% of China’s GDP and the service sector is playing an increasingly important role in driving employment and income growth for China’s families.

In order for China to move from the “Old Economy” (investment-driven) to the “New Economy” (consumption and services-driven), the government needs to continue to reform. They need to close down and restructure plants operating in overcapacity industries such as energy and mining. They need to support the new economy by allowing more privatization of companies. Additionally, they need to provide more of a social safety net to the Chinese people.

As the economy begins to morph, new innovative players have risen to the forefront. Those companies that can take advantage of economic and demographic changes while contending with environmental and social issues will survive and flourish. Hence, we favor sectors such as information technology, healthcare and the like.

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