Economy, Talking Point

Red investors

First, talk of a bubble. Now a bear market. What’s going on?

Red investors

Downer: an investor contemplates his portfolio

It’s a subject worthy of Adam Smith, JM Keynes and Milton Friedman: how is it possible to have a bubble at the same time as a bear market? It may sound contradictory, but China appears to have both at the moment.

As reported in WiC57, some think the Chinese economy is a giant bubble waiting to pop.

But ‘unpopped’ bubbles are usually joined at the hip to bull markets. Yet China is now officially in a bear market – if you look at stock prices, at least. Shares in Shanghai are some of the worst performers globally, down almost a fifth since the start of the year. If the Chinese are suffering a crisis of confidence in their own companies, perhaps we should all be worried…

Is the Greek debt debacle to blame?

Not really. The EU is China’s biggest export market but trade volumes to Greece make up a very small proportion of goods sold (although Xinhua was making the point this week that anxiety will grow if the debt crisis spreads further within Europe).

Of course, exporters haven’t been too happy to see the yuan climb more than 10% against the euro since November. But monthly exports to Europe have actually kept pace well, showing year-on-year growth each month over the same time period.

Better to look closer to home…

Yes. The stock market slowdown is reflecting domestic conditions, particularly the change in tone being set out by the Beijing leadership since the start of the year. Pronouncements on credit tightening (after last year’s loan binge), the raising of banking reserve requirements and the introduction of a host of measures to cool the property sector all have investors sniffing the wind a lot more cautiously. Many have decided to spend some time on the sidelines as a result.

That may be wise, as further tightening measures could be on the cards. Figures released this week confirmed that the economy grew 11.9% in the first quarter – the fastest pace in almost three years, and indicative of overheating. Property prices jumped 12.8%, another major hike. Banks lent out Rmb774 billion ($113.3 billion) in April, more than in March, and in line with some of last year’s bonanza months. And consumer prices rose 2.8% in April from a year earlier, the fastest pace in 18 months.

Of course, the recent policy announcements may need a month or two more to bite, and April’s data might just be the high tide of the current cycle. But research out this week from Qu Hongbin, chief economist at HSBC, makes clear that the current numbers indicate an economy “still in the hot zone”. Further tightening is predicted as a result, including another hike of up to 150bps in bank reserve requirements. Interest rates – so far untouched – will have to go up too, HSBC thinks. Expect at least a 27 basis point increase before the end of the second quarter.

Does the state of the property market tend to drive stock prices?

There are different views here. One is that investor outlook gets a boost from real estate booms, and that stock prices often benefit. The problem with this is that both the Shenzhen and Shanghai indices have been in decline for months, even as property prices careered upwards.

But clearly the various steps announced to counter speculators over the last month (see WiC57) have had a chastening effect. There is a sense that Beijing has acted far more decisively this time around (with “unprecedented austerity measures”, says HSBC). And with 300 listed firms boasting property businesses – and making up around a third of market capitalisation –it’s not hard to connect the dots: when real estate developers struggle, so too will the overall market. For example, when Shanghai Securities News reported last week that developer Evergrande Real Estate Group would slash apartment prices that was viewed as the trigger for a 4% slump on the Shanghai Composite the same day.

Still, that is not the same as saying that further property weakness will lead to share price disintegration across the board. Yes, it might take the edge off some consumer confidence. But China’s property market is not a highly leveraged one, and most household balance sheets will be able to handle a decline in house prices. Retail sales growth shows no signs of flagging yet. The 2007/8 property slowdown didn’t show up noticeably in consumer spending data, either.

It is true too that a fall in house prices will have an impact on economic growth in general (feeding into the construction and financial services industries, as well as hitting the producers of many of the household items purchased by new owners). But Qu Hongbin is hopeful that other sectors of the economy will be able to take up some of the slack. He cites the notoriously robust entrepreneurs of Wenzhou as an example. Many closed down their shoe factories to speculate on real estate. But if the sector slows, Qu thinks that they will probably redirect capital back into manufacturing.

So why are investors still heading for the exits?

Another cloud on the horizon is new stock issuance, with around $80 billion of activity expected in the coming months. The domestic banks will get most of the new funds (to replenish reserves after their lending spree). Front of the queue is the Agricultural Bank of China, which is expecting to raise at least $30 billion in IPO proceeds.

All in, the new issuance is something of a deluge – at close to five times daily turnover on the Shanghai exchange this week. The worry is that all of this new supply could dampen prices in general, even if Beijing ends up twisting the arms of some of its larger state-owned enterprises to buy big chunks of it. It’s a concern that may be fuelling rumours that the proposed launch of an ‘international board’ in Shanghai (to support listings for a select group of foreign firms) will also be delayed. Policymakers are said to be worried that too much retail money could depart Chinese companies for the foreign firms.

So for the moment, sentiment remains weak. One way of highlighting this is to look at the differences in share prices of mainland Chinese companies traded in both Shanghai and Hong Kong. Although their underlying performance is identical, traditionally the ‘A’ shares in Shanghai have sold at a premium to their ‘H’ share peers in Hong Kong. The upside has averaged 40% during the past three years. Currently the gap is down to 6%. Why should there be a gap in price at all? One reason WiC has cited previously is a lack of alternative investment opportunities (so perhaps stocks might pick up if property has to go on the back burner for a while?). But the other is stock picking psychology. Put simply, Chinese investors are usually momentum-driven. That leads to rapid surges and declines in market prices, as investors respond to the prevailing interpretation of changes in government policy (see WiC17), as well as to the wider bandwagon effect (see WiC6).

Between late 2007 and mid-2008, for instance, local bourses fell 65% from their peak value. Last year they were global leaders again, departing the doldrums months before markets elsewhere. Currently they are frontrunners yet again, although this time in a downward direction. Analysts elsewhere will be hoping that there is no deeper symbolism; and that where China rushes first, other markets won’t follow.

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