How high can China equities go?

The lack of economic fundamentals behind frothy equity markets in China may not automatically mean the end is nigh, but rather investors should take care not to end up as the last one dancing when the lights are switched on.

A Chinese flag flies at Spring City Square in Jinan
Source: Bloomberg

There has been considerable interest in Chinese equities lately – and rightly so. The benchmark Shanghai Composite (SSEC) was propelled past 3,800 points to its highest close (31 March 2015) since March 2008.

Pure A-share indices were not spared from the upbeat mood either. FTSE China A50 remains poised to test psychological barrier at 12,500 and Shanghai Shenzhen CSI 300 Index stays in lockstep with SSEC, comfortably past 4,000.

The bullishness was driven by a union of factors. Government action, in particular monetary easing, coupled with perceptions of low valuations, fuelled the exuberance in Chinese shares. This is worrying because it signals an absence of solid fundamentals underpinning the recent stock rally.

Earlier gains in November and December last year were attributed to the surprise People’s Bank of China (PBOC) rate cut and the launch of the Hong Kong-Shanghai Stock Connect. Perceived bargains in equity was another reason cited for the bullishness.

At the end of 2013, the price-to-earnings ratio (P/E) of SSEC, A50 and CSI 300 indices were at 10.3, 7.3 and 10.6 respectively, compared to 12.1 (P/E) in the MSCI Emerging Markets Index (MSCI EM). Since then, the P/Es have shot up to nearly 18.0 (SSEC) and 17.2 (CSI 300) in late March 2015, while the A50 rose to 11.1. P/E for MSCI EM was steady around 12.0 in the same period.

The yuan did not appreciate in conjunction with greater demand for local equities. On the contrary, spot USD/CNY rebounded towards 6.2800 in early March 2015, helped by two PBOC rate reductions (Cumulative: 65 basis points) and a RRR cut. Offshore yuan (USD/CNH) mirrored the onshore movements.

One reason for the weak correlation between CNY and A-shares is the restriction placed on foreign investors. Only investors under the Qualified Foreign Institutional Investor (QFII) scheme may purchase A-shares. In other words, a huge chunk of the stock rally was driven by domestic demand.

Foolish optimism?

The optimistic view that the stock rally will be unbridled may be misplaced at best, and disastrous at worst. My view was echoed by China’s securities regulator’s warning to investors about market risks after the SSEC soared to levels seen before the 2008 financial meltdown.

It is not immediately apparent that investors may heed the advice, but there are plenty of reasons to do so. The most obvious reason will be a slowing Chinese economy, which is weighed by shrinking manufacturing activity, retreating industrial profits and falling housing prices. In the recent National People’s Congress, Premier Li Keqiang lowered the 2015 GDP target to 7.0% from the 7.5% target set for 2014.

This demonstrating the leadership’s awareness of China’s current growth challenges, partly a consequence of structural reforms. But for the moment, investors seem confident that stuttering growth will be supported by government measures. Premier Li’s commentary suggests the country has the tools to shore up growth should it underwhelm further reinforces bullish investor sentiment.

Lurking in the shadows

The lack of economic fundamentals driving equities is not the only concern I have. For one, reliance on headline valuations may mask expensive shares, owing to ‘cheaper’ financial and state-owned enterprises (SOE) counters.

Next, recent policy modifications relating to equity investment are also responsible for the rally. In September 2014, authorities cut trading fees for individuals and institutions by more than half while the futures exchange reduce margin requirements for equity-index contracts. Last month, China trimmed the banks’ reserve requirement ratio by 50 basis points to 19.5%. All of these are positive for trading volumes.

Perhaps of a greater concern are signs that the equity rally may have been linked to the demand from ‘shadow banks’. This means these institutions have shifted their funds away from lending to equity investment.

The ratio of total social financing over new bank loans, a proxy for new credit creation by shadow banking intermediaries, has been on a downtrend since the start of 2013. China’s trust firms reportedly were redirecting their cash into capital markets and Over The Counter (OTC) instruments as the authorities clamp down on ‘shadow lending’.

Put differently, these shadow banks are investing less in the growth of the nation through the conduit of loans, while increasing their exposure in the equity markets. An implication is government curbs have not exactly diminish shadow banking risk but merely transfer it to the capital markets.

Ratio of monthly total social financing to new bank loans
Source: PBOC, IG analysis

Near-term technical view favours buyers

The prevalent view is that China may loosen monetary policy further to hedge against a sharp deterioration in economic activity. This was bolstered by PBOC governor Zhou Xiaochuan’s remarks that the central bank has room to act if disinflation persists and that China’s growth slowdown might be too pronounced.

China’s monetary authorities also moved on easing mortgage policy to spur the flagging housing market. This would likely see speculators building additional long positions amid a consensus that the Fed rate hike may be later rather than sooner. However, without the justification of strong macroeconomic fundamentals and improved growth prospects, the situation may quickly turn tragic.

The short-term technical outlook for Chinese equities remains bullish. The A50 convincingly surged past 12,000 on 30 March 2015. On the charts, the 14-day RSI hovers around 70, signalling overbought conditions, but the 20-day simple moving average (SMA) shows a build-up in upward momentum.

This technical set up was more nuanced in the CSI 300 where price levels are well into overbought territory, with RSI seen above 80. Similarly, 20-day SMA is gaining traction, after cutting the 50-day SMA from under on 13 March 2015.

A sustained breach of the psychological 4,000 mark also point to more upside potential. In other words, near-term trend trading favours buying on dips, although it will be wise to keep an eye on price patterns to pinpoint exit opportunities.

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