At the time of writing, the CSI 300 index, which maps the performance of the top 300 A-shares 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 added this to the prevailing investor worries over 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 shares 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 exhibits 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 exhibit 3) – mostly affecting the private sector and thus affecting the private incentive to invest as well as market sentiment.
Exhibit 1: Adjusted credit flows slowNote: TSF - equity + local government bond issuance, 3-month moving average. Source: CEIC, BNP Paribas Asset Management, as at July 2018
Exhibit 2: Retail sales growth on a downward trendNote: data series in 3-month moving averages. Source: CEIC, BNP Paribas Asset Management (Asia), as at July 2018
Investor 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 the 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 a risk of a downward spiral in the stock market, and if liquidity were to dry up, massive trading 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-rated corporate bonds and pumped in additional 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 - this would work against debt reduction. 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 beneficiaries of monetary easing in the coming months are 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 market 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. However, the rise in Sino-US trade tensions 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 is unlikely, in my view, because Beijing has the tools and financial resources to help prevent it, not least aided by the country's relatively closed capital account and a financial system that is still largely influenced by the government.
What might support a turnaround in Chinese shares?
- Stabilisation of GDP growth momentum
- Falling bond yields to ease the financing situation
- A revival of some legitimate shadow banking activities to help ease the liquidity squeeze on the SME/private sector
- Easing of Sino-US trade tensions
In terms of valuation, since the recent correction, the MSCI China index has been trading at 13x 2018 earnings, which is 10% below the ratio at 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, currency 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 Chinese shares 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. For investors, 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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