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Some investors are concerned that, as China emerges from the Covid-19 pandemic, stock prices may have risen too far, too fast.
The MSCI China A-Shares Onshore Index has risen 19% this year as of July 30, and the MSCI China Index has advanced 13%. Some are wondering if the world’s second-largest economy may be set for a repeat of its 2015 stock market crash, when Chinese equities lost nearly half of their value.
These investors are voicing concerns about what they see as signs of trouble ahead, including a spike in trading volumes driven by individual investors back to 2015 levels; an increase in the premium paid for domestic A-shares over Hong Kong-traded equities (a proxy for retail investor exuberance) to 30%, its highest in years; and worries that Chinese monetary policy may encourage excessive margin leverage.
Read: Here are the big winners among U.S. stocks during a sizzling August
While these metrics are certainly worth tracking, we believe this bull market is unlikely to end in similar fashion to the boom-bust cycle of 2015 for six reasons:
• Corporate earnings and the Chinese economy are relatively strong: Corporate earnings through the end of July have generally proved to be resilient. We now expect positive low single-digit earnings growth in 2020 with a stronger rebound in 2021. While expectations are lower than was the case at the start of the year, the recovery in China is well ahead of the rest of the world, leaving it relatively better positioned for a V-shaped recovery that most other leading nations.
This is evident in the strong returns in specific China A-share sectors during the first six months of 2020. Unlike the U.S., where returns have been mainly driven by mega-cap tech and tech-related consumer discretionary companies, health care has been by far the best performer, with technology, consumer staple and communication services companies also posting strong gains.
• Investor optimism is grounded in reasonable policy expectations: While daily turnover in A-shares hit records ($244 billion traded on July 14) and stocks favored by individual investors have led the market so far this year, the rally is underpinned by reasonable expectations of monetary policy support and the impression of a strong state ‘’put.”
In addition, China’s so far relative modest fiscal stimulus in response to the pandemic is well below the double-digit outlays of U.S. and Europe, leaving room for expansive, targeted further support later this year.
• International capital flows provide a strong tailwind: As index provider MSCI increases the China weighting in its key indices, international investors are increasing China allocations. This year, international investors bought $21 billion of China A-shares by mid-July compared to $15 billion during the same period last year. We expect flows to continue for the foreseeable future as MCSI increases the China weighting in its widely used MSCI All Country World Index from the current level of 5% in the coming years.
• Margin leverage is elevated but not critical: It is true that margin leverage is high, but it remains considerably below 2015 peaks. Five years ago, margin trading balance reached 2.3 trillion renminbi, or 18% of daily turnover, well above July 2020 levels of 1.4 trillion renminbi and 13%. We believe regulators would clampdown on margin financing before allowing a retest of 2015 highs. However, should that occur, we believe investors should expect the market reaction would amount to more of a speed bump than a crash.
• U.S.-China trade tensions are largely background noise: We view rising tensions between Washington and Beijing as a natural derivative of the very different political and social structures in the world’s two largest economies. This could increase equity market volatility but is unlikely to derail the long-term opportunity in China. Notably, the past two years of rising trade tensions did not restrain the comparative performance of Chinese equities, especially A-shares.
In fact, trade tensions have been a catalyst to accelerate Beijing’s efforts to become self-sufficient in areas such as energy supply and semiconductor fabrication. The impact of Beijing’s directed investment and stimulus aimed at improving semiconductor and integrated chip self-reliance has helped several semiconductor and integrated-chip firms trading as A-shares to post gains of more than 40% year-to-date through July 31.
• Capital markets are maturing: During the 2015 crash, a large number of companies suspended trading of their stocks to avoid a share price free fall. As a result of subsequent regulatory changes, the number of suspended stocks has since steadily trended lower. At the same time, the quality and the quantity of public Chinese firms have improved and, over the past five years, almost 1,100 new China A-share companies have listed publicly. Regulators are encouraging more open and innovative capital markets.
For example, the establishment of the Science and Technology Innovation Board on the Shanghai Stock Exchange in June last year is encouraging more initial public offerings. Already, 140 companies in such high tech sectors as semiconductor manufacturing, artificial intelligence and biotech have listed on the STAR board, raising $31 billion.
Now, online payment and financial services firm Ant Group plans to list on both Hong Kong’s H-share market and the STAR board rather than listing in the U.S. as an American Depositary Receipt, further demonstrating the growing attractiveness of domestic Chinese markets. The deal is expected to value Ant at $200 billion to $300 billion, and could be the largest-ever Chinese initial offering. Using capital markets to fund innovative, strategically important policy objectives is part of China’s strategic plan to develop domestic capabilities in key global industries from semiconductors to aircraft and electric vehicles.
Beyond short-term market considerations, the outlook for Chinese equities will be shaped by the way the economy is being transformed. Beijing is pinning hopes for the next stage of economic development via making significant investments in the infrastructure that will pave the way to be a leader in next-generation technologies. For example, current policy initiatives include a $2.1 trillion investment over five years in key technologies — 5G, the industrial internet, transportation/rail, data centers, artificial intelligence, ultra-high voltage electricity transmission and new energy vehicles.
Whatever happens in Chinese equity markets in the short term, if Beijing’s policy actions and bets on innovation pay off as we expect they will, long-term investors in Chinese equities stand to benefit.
Anthony Wong, CFA, is a Hong Kong/China portfolio manager, and Shannon Zheng, CFA, is a product specialist, both at Allianz Global Investors in Hong Kong.
