Most investors cannot have missed the strong rally that Chinese stocks and funds have benefitted from over recent months but fund managers have warned that such a meteoric rise in markets will not continue into the long term.
Chinese equities have rallied since the second half of 2014 and chalked up a particularly impressive start to 2015 after authorities moved to liberalise the market through measures such as the Shanghai-Hong Kong Stock Connect programme, which allows private investors and fund managers in mainland China to trade in Hong Kong-listed stocks and vice versa.
Sentiment has also been bolstered by easing from the People’s Bank of China. Over the past six months, the central bank has cut interest rates three times in a bid to stabilise growth in the world’s second biggest economy.
According to FE Analytics, the Shanghai Stock Exchange A Share index – which covers stocks in mainland China – is up 31.40 per cent over 2015 to date while the offshore Hang Seng index has gained 17.54 per cent. The Shenzhen Stock Exchange Composite, meanwhile, is up a staggering 70.37 per cent in sterling terms this year.
These gains, despite a sell-off that marked the opening weeks of May, mean IA China/Greater China has been the best performing sector in the Investment Association universe with a 17.54 per cent average return.
Performance of sector and indices over 2013
Source: FE Analytics
However, these strong gains are prompting nervousness among some investors. One of these is Andrew Herberts, head of private investment management (UK) at Thomas Miller Investment, who points out that the Shenzhen Composite has been trading at more than 50 times earnings.
Herberts believes that the influx of domestic retail investors into the Chinese stock market is cause for concern. Mainland stock investors opened a recent 3.25m new accounts following a rule change allowing them to hold multiple trading accounts, while there has also been a sharp rise in margin debt – or money that is borrowed to buy equities.
“China’s stock market resemblance to that of Western markets in 1999 is partly the result of the vast growth in Chinese domestic investors, who seem to be fuelling a speculative bubble in Chinese equities,” he said.
“Inexperienced individual investors are investing in companies which they do not understand but are still making money. The situation is being compounded by the rise in amounts of risky retail margin trading, whereby investors borrow money from dealers rather than invest their own capital.”
Some commentators have been worried by the fact that the advance in Chinese equities is coming at a time when growth in the economy is slowing and the government attempts to reduce the economy’s reliance on investment and export-led growth through more of consumption-based model.
Maarten-Jan Bakkum, senior emerging market strategist at NN Investment Partners, says the Chinese authorities are finding it harder to maintain their track record in steering the economy through the slowdown. Meanwhile, the financial system looks vulnerable because of excessive lending and investment growth.
However, this does not mean domestic investors are likely to pull their money out of the market at the first sign of renewed economic weakness. Bakkum points out that many have “an unquestioning faith in the government” and its ability to safeguard the economy.
“The sharp increase in Chinese stock markets in recent months demonstrates that citizen confidence in the Chinese government is not at issue. Prices soar with every indication that there are more stimulus measures to come,” the strategist said.
“While foreign investors exit the market, Chinese investors seem to ignore the risks that are bigger by the day. A government that loses control over the economy and makes major policy mistakes is simply not part of the Chinese collective memory.”
Helen Zhu, head of China equities at BlackRock, argues that it is “just a matter of time” before China further loosens capital controls and increases the access to both the mainland A-share and the offshore H-share markets.
Currently access is limited through the mutual market access scheme under Shanghai-Hong Kong Stock Connect and the QFII/RQFII/QDII quota systems. These have strict limitations, such as only being open certain types of investor and having set lists of investible stocks.
“As China moves towards eventual capital account opening, we see continuous steps being made to remove these limitations. For example, more retail and institutional investors will be able to use the MMA over time, QFII/RQFII/QDII quotas are likely to be meaningfully upsized, the Shenzhen Stock Connect to come later this year will probably increase the list of investible stocks on both sides as well as the daily and cumulative trading volumes allowed,” Zhu said.
“Eventually, once capital account opening is complete, the A-share market will be completely open to global investors while domestic investors will also have full freedom to ‘go out’. The two pools of capital will be merged. We believe the reforms to move towards this long-term objective will continue to positively surprise in terms of timing and impact.”
But not all investors are convinced Chinese equities will continue their ascent. FE Alpha Manager James Thomson, who runs the Rathbone Global Opportunities fund, argues that all moves to open up the Chinese market seem to have done is “open a new avenue for speculation”.
He recently told FE Trustnet: “I heard one commentator speaking recently about how it is really encouraging that the gambler and speculator-types have access to the market, especially now that property seems to have been pushed out. That’s worrying to me.”
John Higgins, chief markets economist at Capital Economics, also warns that Chinese equities now look vulnerable to a correction. The consultancy predicts that the Shanghai Composite will end 2015 at 5,000 – up from its current 4,300 – before dropping to 4,000 in 2016.
“China’s stock market followed this pattern in 2009 – the Shanghai Composite rose some 80 per cent that year, as hopes grew that aggressive policy stimulus in response to the global financial crisis would help the economy to grow at double-digit rates again soon,” the economist said.
“By contrast, the stock market flailed in much of the following four years as it became increasingly clear that a structural slowdown was underway that would prevent this from occurring.”
Performance of index in local currency since 1 Jan 2009
Source: FE Analytics
Thomas Miller’s Herberts agrees that the market will eventually come crashing back to reality.
“Stock market bubbles like China’s have usually proven to be unsustainable, but can endure for surprisingly long periods of time. This market may run for another few years before the bubble bursts, especially if the country’s growth regains momentum, helping to justify current valuations,” he warned.
“It is likely that investors in China will be heavily brought back down to earth at some point but may well not get burnt just yet. Investors should consider any exposure they have to the area and keep in mind that when the bubble does burst, it will be widespread and not contained only within China.”
