The ups and downs of the Chinese stock market have captured financial headlines over recent weeks, after the meteoric rise of the Shanghai Composite gave way to a series of plunges and left investors asking whether they need to protect their portfolios against a spillover from the turmoil.
Between the middle of 2014 and June this year, Chinese stocks listed in Shanghai surged by around 180 per cent after the Shanghai-Hong Kong Stock Connect programme opened up access to mainland shares and the authorities encouraged retail investors to participate in the market. The Shenzhen Composite index of ‘new economy’ stocks saw even stronger gains.
However, as the graph below illustrates, both of the mainland markets have tumbled in value since, with the Shanghai Composite now down about 30 per cent from its peaks in early June. The reasons for the heady declines are unclear, but many have pointed to the rapid rise before the crash, the presence of so many ‘panicky’ investors using margin debt and the slowing economy.
Performance of indices since 1 Jul 2014
Source: FE Analytics
The Chinese authorities stepped in to arrest the slide, implementing measures such as cutting interest rates to a record low, ensuring there is sufficient liquidity, banning investors with large chunks of stock from selling over the coming months and ordering brokerages to buy. In addition, hundreds of companies suspended trading in their shares during the slump in a bid to keep it under control.
Despite this, the Shanghai Composite dropped another 8.5 per cent yesterday – after a period of relative calm – with analysts arguing that this suggests investors have lost faith in the Chinese government’s ability to slow the selling.
Nigel Green, chief executive of deVere Group, says investors need to consider ways to “China-proof” their portfolios given the continued uncertainty around its future direction and the likelihood that the authorities’ attempts to stabilise it will prove unsustainable over the long term.
“This latest crash is another chapter in the China slowdown story. The unfolding situation in China is likely to create volatility in the financial markets until the end of the year. With this in mind, investors should consider ‘China-proofing’ their portfolios to manage risk and benefit from the inevitable buying opportunities,” Green said.
“Whilst China’s slowdown is likely to be the big geopolitical driver of turbulence in coming months, I am confident there will be no hard landing as Chinese authorities have all the tools at their disposal to ensure it doesn’t happen. Indeed, the slowdown is on-trend. The economy is maturing and there’s a deliberate shift away from commodity-hungry infrastructure spending.”
“The expected volatility in financial markets triggered by China rebalancing its economy will present challenges and opportunities for investors, and due to China’s weight in the global economy, investors would be wise to bear this in mind when constructing and assessing their portfolios.”
However, Legal & General Investment Management equity strategist Lars Kreckel argues that investors do not need to be concerned of the Chinese stock market’s troubles spilling over into other regions, as it is an “isolated incident”.
He argues that there are a number of reasons for this, the first being that much of the volatility has come from China’s A-shares market – which is dominated by domestic investors. Few of these have access to international markets and are therefore unlikely to have much of an impact on global stocks.
Kreckel continued: “Secondly, foreign investors are also unlikely to become forced sellers of global equities as they did not participate in the rally.”
“This fundamental argument is backed up by empirics as there was virtually no correlation between the S&P 500 and Euro Stoxx and the Chinese market on the way up, and similarly little correlation on the way down.”
Performance of indices since 1 Jul 2014
Source: FE Analytics
Our data shows that over the past year, the Shanghai Composite has had a 0.21 correlation with the S&P 500, while its correlation to the Euro Stoxx is just 0.11.
The strategist’s final argument is that the Chinese market is still up around 90 per cent over one year, despite the brutal falls of recent weeks. While this means some Chinese investors are nursing short-term losses, they are still sitting on gains overall – which reduces the chances of the market rout causing problems in the real economy.
However, Kreckel warns that there are issues outside of China that investors would be better keeping their eyes on.
“What we do think should be a cause for concern is how markets react to the first Fed interest rate hike,” he said. “This could be in September, although December is a more likely point at which rates will move higher. There are historical precedents for this, and they point to a drop of 8 per cent in equity markets as a likely outcome.”
For investors with a long enough time horizon, some fund managers remain convinced that China offers some of the best opportunities for the Asia-Pacific region – especially given that they are exposed to Hong Kong-listed stocks.
Mark Williams, manager of the Liontrust Asia Income fund, has an overweight 27.5 per cent of assets in the country and has used the recent volatility to top up his holdings in stocks that have become more attractively valued.
The manager concedes that the Chinese government’s intervention in the market has proved concerning but does not overshadow the value opportunities that can now be seen in Hong Kong’s Hang Seng index.
“In our minds this marks a significant step backwards in China’s economic transition, an important element of which requires adoption of market pricing mechanisms. Whether due to hubris, fear or naivety, attempting to manipulate stock markets will do little to make them appeal to international investors – after all, who would invest in a market that effectively refuses to allow sales when the government does not want them?” Williams said.
“But does this longer term negative justify a 21 per cent fall for the Hang Seng China Enterprise Index (an index of Hong Kong listed H shares)? We would argue not. While the loss of some government credibility is a definite step back, it does not necessarily mark a total change of direction that now appears to be priced into some Hong Kong listed equities.”
“Hong Kong listed China shares trade at 8.2x forward earnings, with expectations of approximately 10 per cent earnings growth, an attractive combination which we find hard to achieve elsewhere. The immediate issues causing widespread concern lie in the A-share market, in which we do not invest and still see as expensive. For this reason, we are maintaining our Chinese exposure and selectively adding to holdings where we see unjustified weakness.”
Performance of fund vs sector since launch
Source: FE Analytics
