The new year has started with China dominating the headlines once more, after a sharp drop in the country’s domestic A-shares market prompted declines in global equity markets.
The CSI 300 index plummeted 7 per cent on Monday, causing trading in Shanghai and Shenzhen to be suspended for the day thanks to ‘circuit breakers’ unveiled in September that are designed to halt a market rout.
Global indices tanked on the back of the weak session with the FTSE 100 suffering its worst start to the new year in 16 years by closing 2.39 per cent down. Across the pond, the S&P 500, Dow Jones and Nasdaq ended the session down, as did European indices and a number of commodities.
Of course, 2015 was marked strong falls in the Chinese stock market sparking turmoil across the investment universe. Following their rocketing performance in latter half of 2014 and the opening months of 2015, Chinese equities went into freefall – although intervention by the authorities meant the asset class did make a small positive return for the year.
Performance of indices over 2yrs
Source: FE Analytics
The recent rout was eased by the People’s Bank of China and its decision to pump Rmb130bn (£13.6bn) of liquidity into the market. The country’s financial regulators have extended indefinitely the ban on share sales by some institutional investors, a ban that was brought in to try and control last year’s sell-off.
However, Russ Koesterich, global chief investment strategist at BlackRock, warns of the “unpleasant truth” that 2016 is starting with many of the same challenges held back 2015 – such as elevated valuations in markets and depressed commodity prices.
“And international events may still trigger volatility, as we saw over the weekend with a major sell-off in China, a sign that the country still represents a systemic risk,” he added.
The view that China will continue to go through a volatile run is shared by many in the investment research community. Bank of America Merrill Lynch (BofA ML), for example, has one of the more extreme forecasts out there after tipping a 27 per cent fall in the benchmark Shanghai Composite index.
David Cui, head of China equity strategy at the investment bank, is bearish on the outlook for China and warns that the rapid expansion of debt that has taken place over a relatively short period of time will have significant consequences.
“Historically, any country that grew debt this fast inevitably ran into financial-system problems, including currency devaluation, banking recap, and high inflation, and we do not expect China to be an exception,” Cui wrote in recent note.
“We believe that the government had maintained system stability over the past few years by allowing various implicit guarantees to get firmly entrenched, which has made the financial system fragile.”
Given the fact that China is the world’s second largest economy, any problems in its financial system bring the risk of fresh turmoil to its immediate region and the global stage.
Kamel Mellahi, a professor of strategic management at Warwick Business School, is another expect Chinese equities to have a difficult future.
However, he notes that the authorities’ main focus is the rebalancing of the economy away from a dependence on infrastructure and low-cost exports towards the service sector, high-end manufacturing and domestic consumption.
“The Chinese stock markets are set for choppy waters and share prices will continue to see-saw as China seeks to recalibrate its economy. Retail investors, which account for a large portion of stock market trade in China, are not in it for the long haul and are prone to panic. It is to be expected that they react to short-term blips about the health of the Chinese economy,” he said.
“This stampede-type sell-off is often driven by a herd mentality but the concerns that triggered it in the first place were very strong. The fundamental reasons that triggered the sell-off are the continued shrinking of manufacturing activities and the expected lifting of the ban, introduced during last summer to halt the stock market rout, on share sales by major investors.”
“One does expect the Chinese government to intervene strongly and publicly to prop up share prices. This will undermine its pledge to let market mechanisms have more influence, but perhaps more importantly, it has a much bigger fish to fry. It’s keeping its eyes on the management of economic reforms to rebalance its economy.”
Ross Teverson, manager of the Jupiter China fund, points out that investors who taking exposure to China through stocks listed in Hong Kong and Taiwan rather than Shanghai and Shenzhen have a degree of insulation from falls in the A share market.
For example, while the MSCI China index was down 2.49 per cent in 2015 the average member of the IA China/Greater China posted a small positive return of 0.83 per cent. Thanks to the above, Jupiter China was up 5.53 per cent over the year.
Performance of fund vs sector and index in 2015
Source: FE Analytics
While the manager is generally positive on the investment case for Chinese equities – arguing that a focus on company fundamentals allows interesting opportunities to be found – he concedes that the ride from here is likely to be far from smooth.
In fact, he warns that the measures brought in by the government to calm the market could occasionally have the opposite effect.
“In our opinion, the recent market movements were the result of a coming together of a number of factors: the negative PMI data point came at a time when there has been growing awareness that the lock-up of a lot of large A share investors is coming to an end later this week, and those negatives in combination with the absence of any new easing measures from the government have clearly spooked domestic investors,” Teverson said.
“In our opinion, the attempts to control market volatility, such as the circuit breakers that have been put in place and the measures making it relatively easy for individual companies’ shares to be suspended, while aimed at reducing market volatility, can actually have the effect of increasing volatility at certain times.”
