The pros and cons of a bull mar­ket

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

In sharp con­trast to their ap­proach in 2007, Chi­nese gov­ern­ment of­fi­cials are ac­tively en­cour­ag­ing the cur­rent bull mar­ket in on­shore eq­ui­ties, re­peat­edly say­ing that ris­ing share prices are a good thing for China. We agree that there are def­i­nite eco­nomic ad­van­tages to the runup in stocks, but it is also worth keep­ing an eye on the risks.

The most di­rect ben­e­fit of the bull mar­ket is that it has al­ready lifted China’s eco­nomic growth rate. While the of­fi­cial year-on-year growth rate of China’s gross do­mes­tic prod­uct slowed to 7% in the first quar­ter, ter­tiary in­dus­tries grew at a rel­a­tively ro­bust 7.9% pace. Most re­mark­ably, the growth of the fi­nan­cial ser­vices sec­tor ac­cel­er­ated to 15%.

At slightly less than 10% of GDP, the fi­nan­cial sec­tor has typ­i­cally ac­counted for 0.6-0.8pp of real GDP growth in re­cent years. By our es­ti­mates, that con­tri­bu­tion dou­bled to 1.4pp in the first quar­ter of 2015, largely be­cause the bull mar­ket fu­eled higher earn­ings at non-bank fi­nan­cials such as bro­ker­ages. With­out the run-up in stocks, it is un­likely the econ­omy would have hit Bei­jing’s growth tar­get (the jump in the fi­nance sec­tor’s con­tri­bu­tion to growth also helps ex­plain why cor­re­la­tions be­tween GDP growth and other eco­nomic in­di­ca­tors broke down in 1Q).

There is also a po­ten­tial ben­e­fit from the wealth ef­fect. In the­ory, when the value of house­hold as­sets goes up, con­sumers feel wealth­ier and spend more. But in ag­gre­gate Chi­nese house­holds have only limited ex­po­sure to the eq­uity mar­ket. Our best es­ti­mate is that re­tail in­vestor stock hold­ings are worth about RMB 13 trln. In com­par­i­son, wealth-man­age­ment prod­ucts are worth some RMB 15 trln, while house­hold bank de­posits amount to RMB 54 trln. How­ever, by far the big­gest house­hold as­set is hous­ing. We es­ti­mate the ur­ban hous­ing stock is worth about RMB 149 trln at cur­rent mar­ket prices.

This im­plies that house­holds hold only around 5% of their to­tal as­sets in the stock mar­ket. Since there was lit­tle ev­i­dence of a wealth ef­fect on con­sump­tion dur­ing the long up­swing in hous­ing prices, we doubt whether the rel­a­tively small in­crease in house­hold as­sets caused by the eq­uity bull mar­ket will have a no­tice­able im­pact.

The eco­nomic ben­e­fit that has been talked about most— in­clud­ing by Peo­ple’s Bank of China gover­nor Zhou Xiaochuan—is the ef­fect of the bull mar­ket on eq­uity cap­i­tal mar­kets. Com­pany val­u­a­tions im­prove in a ris­ing mar­ket, and both IPOs and sec­ondary place­ments get much eas­ier. As a re­sult, cor­po­rate debt/eq­uity ra­tios fall and the econ­omy be­comes—or should be­come—less de­pen­dent on debt fi­nanc­ing, which mod­er­ates over­all eco­nomic risk. A bull mar­ket will also al­low Bei­jing to sell the shares of sta­te­owned en­ter­prises at higher prices, much as it did in 2007, which should fa­cil­i­tate SOE re­form.

The eq­uity cap­i­tal mar­ket ac­tiv­ity has in­deed picked up since 2014. The amount of cap­i­tal raised has risen for five quar­ters in a row as the reg­u­la­tors have given the green light to more deals as the mar­ket has climbed. De­spite the re­cent in­crease, how­ever, eq­uity fi­nanc­ing re­mains rel­a­tively small, at less than 5% of to­tal so­cial fi­nanc­ing, com­pared with 20% at its peak in 2007. What’s more, most of the com­pa­nies of­fer­ing new shares to­day are pri­vate firms whose bal­ance sheets are gen­er­ally in good shape. For eq­uity fi­nanc­ing to have a mean­ing­ful im­pact on the wider econ­omy, far more com­pa­nies—and more heav­ily-in­debted com­pa­nies—will have to come to the mar­ket.

Of course, while a bull mar­ket in stocks is wel­come, not all the im­pli­ca­tions are pos­i­tive. The most ob­vi­ous risk is the ef­fect of ris­ing mar­gin debt. From RMB 400 bln a year ago, to­tal mar­gin debt has quadru­pled to RMB 1.8 trln, equal to some 3% of to­day’s eq­uity mar­ket cap­i­tal­i­sa­tion. To fund their loans to stock in­vestors, bro­kers have bor­rowed from the in­ter­bank mar­ket. If the stock mar­ket sud­denly re­verses and in­vestors de­fault on their mar­gin debts, the contagion ef­fect will be much greater than in pre­vi­ous cy­cles, since the bank­ing sys­tem is now more ex­posed to the bro­ker­age in­dus­try. If any bro­kers get into trou­ble, banks may end up tak­ing losses as well.

A sec­ondary but nonethe­less sig­nif­i­cant risk is that the com­bi­na­tion of a slow­ing econ­omy and a ris­ing eq­uity mar­ket may en­cour­age com­pa­nies to di­vert cap­i­tal into stock mar­ket spec­u­la­tion. As the econ­omy has slowed, cor­po­rate earn­ings have de­te­ri­o­rated, es­pe­cially in heavy industrial sec­tors. With com­pa­nies strug­gling to make money from their core busi­nesses, in­vest­ment gains from a ris­ing eq­uity mar­ket will ac­count for a greater share of to­tal prof­its, po­ten­tially prompt­ing com­pa­nies to in­crease their ex­po­sure to the stock mar­ket. Con­se­quently cor­po­rate prof­its will be­come even more de­pen­dent on the stock mar­ket, in­creas­ing the volatil­ity of earn­ings. If mar­ket’s trend re­verses and the econ­omy re­mains weak, earn­ings will suf­fer a dou­ble blow.

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