Easing in China

In China, there is little doubt that we are witnessing portfolio rebalancing from institutional and most prominently retail investors. Household asset allocation has been trending in favour of a higher weighting towards equities since hitting a trough of 5.7% of total assets in 2005. With the exception of a huge spike to 27% in 2007, we have seen a steady climb each year to currently stand around 17%.

China

Household allocations towards cash and bonds have always generally been low, but it’s the weightings towards investments in property and to a greater extent deposits that are being reduced in favour of equities.

Investment in deposits have traditionally held a 60% weighting of the Chinese household portfolio. But I feel this figure will be closer to and even below 50% in 2016.

This is a cultural shift, driven by a realisation that Chinese equities were cheap but also premised on a belief that Beijing views a higher stock market as having significant benefits for the real economy.

It must be said that this is not the first time a central bank or government has impacted a stock market through implementing a range of market friendly policy initiatives. The Federal Reserve, Bank of Japan and now European Central Bank have all targeted an increase in base money and balance sheet expansion, in turn much of the excess liquidity made its way into the stock market.

The common shared belief; a higher stock market boosts the real wealth effect, increasing discretionary spending and pushing the economy closer to ‘escape velocity’, or its full potential. Fed styled quantitative easing is not currently occurring in China and is unlikely given the People’s Bank of China (PBoC) can’t directly monetize government debt. There are, however, qualitative measures being undertaken that are really helping the equity market.

Putting some of the other initiatives into context, since Q4 of 2014 we have seen three cuts to the benchmark lending rate, a 150 basis point reduction to the level of reserve banks have to hold (reserve ratio requirement or RRR), various liquidity initiatives and a reduction in the level of down payments for first and second home buyers.

Also adding to confidence and as part of the reform towards local government debt, the Ministry of Finance has offered local governments the opportunity to swap a portion of existing debt maturing this year into longer dated maturities.

This debt swap should save local governments around RMB40-50 billion a year in interest payments and has removed some of the concern surrounding the sizeable debt loads of local governments.

It is a widely held view that further easing measures will be seen. We could even see a cut to banks RRR in the coming weeks given the recent money and credit data and the subdued monetary base growth. A lower RRR would increase the money multiplier, with commercial banks able to increase lending and help the PBoC achieve its M2 money supply target of 12% growth.

The explosive moves in equities really started in July 2014, with the Shanghai Composite and the CSI 300 having rallied 114% and 119% respectively since. We have seen a dynamic expansion in valuations with the Shanghai Composite’s consensus forward price-to earnings ratio increasing from what was a cheap 7.9 times to currently stand at 17.32 times.

The explosive moves have really become much more pronounced since March and it’s interesting to see just that over 20 million new A-share accounts have been opened in that time. What’s more, many of these new investors are young enough that they won’t have been too negatively affected by the 72% crash in the Shanghai Composite, seen between 2007 and 2008.

These are huge figures though and they really complement the view that we are seeing a household portfolio rebalancing and there almost seems to be a fear of missing out, with a growing view that equities are going higher.

The authorities have even allowed individuals to have 20 separate A-share accounts, providing greater flexibility to investors on where they trade. This level of account opening also suggests there is a wall of capital that has not yet fully been invested in the market, complemented by talk that nearly $20 billion currently sits in Chinese bank accounts. So, in theory this supports the notion that pullbacks should be limited.

Some investors have also looked at using margin financing to increase their exposure. Margin financing really started in March 2010, but has grown in popularity of late and there is talk that a number of securities firms are struggling with the requests for margin financing from investors.

Purchases of stock using margin financing as a percentage of turnover has pushed up to around 16%, which is a historically elevated level and helped by some innovations from brokers, who have designed various products to help high-net worth individuals achieve greater leverage ratios.

Greater regulation does seem to be picking up around margin financing, with the regulator actually banning the issuance of umbrella trusts (products that allow individuals the ability to lever up by two times). This feeds into the idea that while Beijing wants higher stock prices, more importantly officials want a healthy capital market, which will involve the dampening of excessive speculation.

The moves to allow mutual funds full access to H-share listed stocks through the Shanghai/Hong Kong ‘southbound’ connect was clearly one method of keeping equities supported. But importantly this should help channel capital into a market that has been trading on a growing valuation discount to A-share listed firms.

There is speculation that we could shortly see lower barriers for mainland retail investors to take part in the Stock Connect, although margin financing is currently not permitted to buy H-shares through this channel.

This will give a more diverse range of retail investors (i.e. not just high net worth individuals) even more opportunity, especially when 95% of stocks on the H-shares market trade on a P/E discount to their corresponding A-shares listed valuation. The H-shares index currently trades in 9.7 time’s forward earnings, so I would expect reasonable outperformance here over the coming 12 to 24 months.

It is also worth highlighting that some 44% of Shanghai Composite stocks trade on a current price to earnings multiple of 50 and above. So providing increased opportunity, amid tighter regulation should be seen as a longer-term positive, although as we also saw on 19 January and 17 April talk of increased regulation in margin financing does increase short-term volatility. Still, these pullbacks seem to be used as an opportunity to accumulate.

 

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