Banking & Finance, Talking Point

Is it different this time?

Bullishness on Chinese stocks rises as MSCI ups its index allocation


Buy orders flooding in: local investors check out stock information in Shanghai

Politics isn’t supposed to be a place to get rich but China’s lawmakers seem to be doing well enough, with 93 dollar-denominated billionaires in the legislative and advisory branches of the government, according to calculations from the Hurun Report, the rich list provider.

That was actually a drop in billionaire attendees, many of whom took a pummelling from the slump in the local stock markets last year. But it’s still a wealthier crowd than the United States Congress, which could only muster 203 millionaires last year.

The backdrop for the tycoons turning up at this week’s Two Sessions in Beijing (see this week’s ‘Economy’ section) is a much brighter start to the year, with the stock markets going on a tremendous tear.

At the start of this week, the SSE Composite, an index of all the stocks traded in Shanghai, was up 23% from early January and it has been similar on the second exchange in Shenzhen. Together, China’s bourses have retaken the title of the world’s second largest market from Japan.

All of this has been happening at a time when China has been fighting a trade war with its biggest rival and persisting with a long-running campaign to curtail credit, which has been particularly bruising for the private sector, one of the most productive parts of the economy.

This week Li Keqiang, the Chinese premier, announced lower growth targets too. How does that square with talk that the A-share market’s bull run has more room to run?

A rebound, not a re-rating?

Amid the congratulatory mood some analysts have been calling for a sense of context. They see the surge in share prices as more of a turnaround than a triumph, following the woeful performance of the Chinese markets last year, when Shanghai was the worst performing of the world’s largest bourses, dropping by a quarter.

Here there are similarities with a Talking Point from almost 10 years ago, when WiC reported how markets were in feasting mode, but only after a punishing period of famine (see WiC6).

The background this time is that stocks fell too far and too fast last year on fears about the impact of the trade war with the United States, as well as anxiety that China’s economy was slowing. Now the bourses are booming because a trade deal with Washington is thought to be close and fears about a harder landing have largely subsided. Signs that borrowing costs are coming down, which typically bodes well for stocks, have added to expectations that companies are going to perform better.

It’s still worth keeping things in perspective: despite their dizzying climb over the last two months China’s stock markets are still down in dollar terms on the start of 2018 – Shanghai by a tenth and Shenzhen by almost a fifth.

Back to boom-and-bust?

The run-up in prices has seen a return of familiar headlines, especially warnings that Chinese stocks are back to the cycle of boom-and-bust that has characterised much of their recent past.

Commentators have been searching for similarities with earlier instances of investor euphoria, especially the bull markets of 2006/7 and 2014/15, and one of the findings in the Securities Times was that the same suspects have been leading the charge, including Anhui Quanchai, a maker of diesel engines, which was one of the best performing stocks over January and February.

Despite have a market cap of slightly over Rmb5 billion ($744.2 million), the daily turnover in Quanchai’s shares has often been 50% higher than PetroChina’s (the oil giant is worth nearly Rmb1.35 trillion), which isn’t bad for an aging state-owned enterprise that isn’t followed by a single analyst. What’s also revealing is that Quanchai has a record of these kinds of run-ups, jumping as much as 300% during previous booms, before reversing course during the subsequent bust.

Cases like these foster fears that the current bull run is being fuelled by fervour from retail investors who don’t want to miss out on momentum stocks, and not by more fundamental analysis.

Twelve out of the 30 top-performing stocks from February are set to report losses for their most recent financial year, for instance, with some of the lossmakers more than doubling in price over the last month. There are cases in which companies that have defaulted on their bonds are outperforming more convincing candidates as well.

The question is whether these trends are revealing of the kind of psychology that WiC has discussed in the past, especially among retail investors, who hold more sway on Chinese bourses than smaller shareholders in more mature markets. These retail punters hunt in herds, chasing investment themes and so-called ‘concept stocks’, and triggering dramatic swings in share prices. Recent beneficiaries include companies linked to 5G technology and firms from the brokerage sector. In a more extreme example in January there was even a rally for stocks with a name in common with Yi Huiman, who had just been announced as the new head of the China Securities Regulatory Commission (CSRC), the stock market watchdog.

Investors are getting encouragement from the government?

Another trend for many of China’s stock-pickers is that they tend to pay more attention to the prevailing direction of government policy, and not worry too much about profit and loss at a company level.

During the last boom we wrote about how investors had been responding to months of encouragement from the state-owned media to get into the stock market. Again, there are more than a few similarities with the descriptions cited in our Talking Point of late 2014, which highlighted how ‘super bull’ fever was gripping investors (see WiC264).

The mood turned dramatically when the bubble burst and the authorities started to strong-arm the speculators, blaming them for a disastrous plunge in share prices. What followed was a lengthy period in which regulators went into a deeply cautious mode.

The tone changed again last month, Chinese media outlets agreed, after Chinese leader Xi Jinping appeared to have given a thumbs-up to the stock market. “Finance is a core competitiveness of a country, financial security is an important part of national security,” Xi told a meeting of senior Party cadres last month.

Many investors saw Xi’s remarks as a rallying cry for a bull market in the context of the ongoing trade war, Hong Kong Economic Times noted, as US President Donald Trump also sees the health of the stock market as a proxy for confidence in his policies.

The mood also improved when Yi was appointed CSRC boss (see WiC439). This was soon being heralded as a signal that shares would get their fizz back and Yi got straight into this spirit at his first press conference last week, telling investors to “revere the market, and respect and follow market patterns”.

He even agreed with a description of his new job as being like “standing at the mouth of a volcano”, which some investors construed as a message that stocks would carry on sizzling and less as an indicator of the danger his new role might do to his political career.

What about evidence that this bull market is different?

There are other arguments that the stock market surge is different to the boom of four years ago, especially that there hasn’t been the same explosion of margin lending, when investors borrowed billions to fuel the share-buying spree (see WiC290).

Caixin magazine counselled a little caution this week, saying that margin debt, or the value of shares bought with borrowed money, had reached Rmb796 billion by market close last Friday, an increase of 12% since the start of February, but the CSRC is promising to be vigilant, telling brokerages to maintain their monitoring of abnormal trades.

Elsewhere in the press there are warnings that regulators must do more to track unlicenced lenders – who offer leverage of as much as ten-to-one on speculators’ shares – because this isn’t being captured in the official data.

Visibility is much better for investment from foreign institutions, which have been returning in numbers after the chastening experience of last year. Much of this investment is coming through the ‘northbound’ channel of Hong Kong’s Stock Connect, which accounted for net buying from abroad of more than Rmb120 billion in the first two months of this year.

In part, that’s a response to the increased appetite for Chinese stocks since index provider MSCI included A-shares in its benchmarks for the first time last summer.

Late last month MSCI cheered investors further when it said it would be boosting the proportion of large-cap A-shares in its benchmarks. A group of mid-cap stocks is also going to be added in November in news that is seen as positive because it will force index funds to add to their positions.

Bruce Pang, an equity strategist for HSBC, says the revisions will attract at least $10 billion of investment from passive funds, and that related buying from active managers could take total foreign inflows past $70 billion this year.

Just the start for the benchmarks?

Pang is predicting at least $600 billion of foreign investment will find its way into the Chinese markets over the next 5-10 years because of MSCI inclusion. But the flows could be much larger if more A-shares are added to the benchmarks in the years ahead, bringing them closer to their true proportion of the international equity markets.

The revisions to the MSCI Emerging Markets Index this year will bring an increase in A-shares from 0.7% to 3.3% of the benchmark, for instance, but that’s still less than a tenth of their true weighting in market capitalisation terms.

Existing investors will want further changes to the weightings in the belief that it will buoy share prices, while policymakers will welcome more professional, long-term investors in the hope that it will reduce the role of the retail investor base and make markets less volatile.

Critics counter that reweightings of the benchmarks could be counterproductive if they pull foreign investment into Chinese stocks simply because of their status in the indices, and not because the shares are getting more attractive in their own right.

Asset managers also have reason to be cautious: Chinese stocks have been underperformers relative to developed markets over the longer term, despite the superlative growth of the country’s economy.

It is also putting pressure on regulators to deliver improvements in areas like corporate governance, as well as greater consistency in the rules and regulations of the stock exchanges themselves. After all, indices are only guidelines and portfolio managers can modify their mandates and choose not to follow the benchmarks if investment returns turn out to be too unpredictable. Steven Sun, head of research at HSBC Qianhai Securities, is hopeful that meaningful changes are imminent, citing the launch of the Science and Technology Innovation Board in Shanghai, which will see the listing of high-profile companies in key sectors like high-end manufacturing, new energy and biomedicine.

Designed to encourage high-tech firms to go public the Nasdaq-style exchange could be the “boldest reform so far in China’s capital market”, Sun predicts, because it will pioneer rule changes that bring the bourse closer to international norms.

(New York and Hong Kong accounted for nearly 70% of the money raised through Chinese IPOs last year, Reuters said this week.)

CSRC boss Yi Huiman made the same point as Sun last week, describing the new exchange as a means for transforming China’s equity markets in general, and there’s a strong sense that the regulator is fast-tracking the plans, formalising them only a day after it had wrapped up a public review of the draft proposals.

There was more urgency this week, when the Shanghai stock exchange said preparations have entered a “sprint” stage and that technical readiness should be reached by May.

So there’s more room for the market to run?

Analysts will be watching the new board in Shanghai for signs that regulators are serious about making changes, i.e. bestowing on it a new system that limits the powers of officials to control the timing of listings and also allows ‘pre-profit’ firms to go public.

In the meantime there is a strong case that share prices won’t run out of steam just yet. Market cycles in China are generally much shorter than the US but the current upswing is only about a quarter of the way through a typical run. Companies are trading below their long-term averages too, especially outside the tech counters and consumer stocks that fund managers have been favouring.

Despite optimism for the shorter-term, the longer-term horizon is harder to predict, with a bleaker mood taking hold of many of China’s privately-owned businesses. Companies like these account for well over half of the country’s economy and they generate an even greater share of its urban jobs. Yet many firms are frustrated about their prospects, especially that taxes are too high and that the state banks won’t give them loans.

The deeper concern is that government policy has tilted too far in the direction of state enterprises, protecting their position in the economy. Entrepreneurs complain that their own rights are less respected, something we reported on yet again last week (see WiC442).

Sentiment like this could turn out to be significant, says Shuli Ren, a columnist at Bloomberg, because the founders of these firms are some of the largest groups of shareholders in the markets, outnumbering institutional investors and retail punters. Watching what these insiders are doing is important, she says, and they were net sellers of more than Rmb4 billion of shares in the three weeks to February 23. Nearly 80 more companies filed disclosures on sales by insiders in the final week of the month.

If the selling accelerates it says something meaningful about some of China’s most important wealth creators and how they feel about their futures. And it might put a brake on the bull market as well.

“If you were a lucky entrepreneur at a ChiNext-listed company, wouldn’t you maximise this rare bull window and sell, too?” Ren postulates.

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