Un­equal sell-off in Chi­nese stocks

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

While the world’s head­lines are con­cen­trat­ing on Greece, the real drama in fi­nan­cial mar­kets is hap­pen­ing much fur­ther to the East. Since its peak in mid-June, the Shang­hai Com­pos­ite In­dex has now fallen by al­most -30%, putting main­land Chi­nese shares in what is gen­er­ally ac­cepted to be bear mar­ket ter­ri­tory. In­tra-day volatil­ity has reached mind­blow­ing lev­els, with the in­dex swing­ing by more than 6% from peak to trough in each of the last four trad­ing days. Although what hap­pens in the Shang­hai mar­ket may not be di­rectly rel­e­vant to most in­ter­na­tional in­vestors, its fluc­tu­a­tions have pro­found im­pli­ca­tions for Hong Konglisted eq­ui­ties. As al­ways, how­ever, as­sess­ing ex­actly what is go­ing on in the main­land’s mar­kets is a tricky busi­ness.

Firstly, de­spite the cur­rent sell-off, China still stands out as the star per­former among the world’s large mar­kets this year. Over the year to date, the Shang­hai Com­pos­ite ranks fourth among all global in­dexes, with a US dol­lar to­tal re­turn of 24.5%. Among ma­jor de­vel­oped mar­kets, Hong Kong is sec­ond only to Ja­pan, with the Hang Seng In­dex re­turn­ing 14.4% and the H-share in­dex of lo­cally-listed main­land com­pa­nies on 10.6%.

Se­condly, the head­line sell-off of the Shang­hai in­dex dis­guises a sharply bi­fur­cated mar­ket. While the me­dian per­for­mance of the top 25th per­centile in Shang­hai has been flat since the peak of the mar­ket on June 12th, the me­dian stock among the bot­tom 25th per­centile is down -43%. The steep­ness of the declines for the worst-per­form­ing stocks re­flects a sig­nal fea­ture of the ear­lier rally: shares with a rel­a­tively small free float traded limit-up time and again over the last year as margined re­tail in­vestors piled in with bor­rowed money. Sim­i­larly, as the mar­ket has sold off, volatil­ity has been am­pli­fied on the down­side. With many stocks pop­u­lar with lever­aged in­vestors down by half, the chance of fur­ther falls rises as more in­vestors who bought in on mar­gin get flushed out.

Thirdly, the sell-off has not been driven by any gen­eral pol­icy tight­en­ing from the author­i­ties, who re­main broadly sup­port­ive of the mar­ket. True, the reg­u­la­tors have se­lec­tively tight­ened the rules on mar­gin trad­ing. Last week, the se­cu­ri­ties reg­u­la­tor said that in­vestors had been forced to sell stocks worth RMB 6.2 bln in two and a half days to sat­isfy col­lat­eral re­quire­ments. How­ever, at the same time the gov­ern­ment is try­ing to smooth the de-lever­ag­ing process via other chan­nels. Fol­low­ing last month’s in­ter­est rate and re­serve re­quire­ment ra­tio cuts, the author­i­ties an­nounced plans to cut the stamp duty on stock deals and to al­low the state pen­sion fund to in­vest in eq­ui­ties.

Can Bei­jing suc­ceed in de-risk­ing the sys­tem with­out caus­ing share prices to sink fur­ther “un­der their own weight”? We think it likely—and not only be­cause we ac­cept the so-called “fal­lacy” that it would be reck­less to “fight the PBOC and the Chi­nese gov­ern­ment”. Look­ing at the per­for­mance of China’s banks, they have barely fallen in the last few days de­spite the forced selling else­where. We re­cently de­tailed rea­sons why in­vestors should con­sider ro­tat­ing into Chi­nese banks. In ad­di­tion, we also ex­pect the risk pre­mium that has been at­tached to banks on fears of a dis­or­derly in­ter­est rate lib­er­al­i­sa­tion to di­min­ish. With de­posit rate lib­er­al­i­sa­tion al­most com­plete, there are few signs that com­pe­ti­tion to at­tract de­pos­i­tors is sig­nif­i­cantly driv­ing down net in­ter­est mar­gins, which means there is a great deal more con­fi­dence that Chi­nese banks will be able to main­tain a re­spectable re­turn on eq­uity go­ing for­ward. Fi­nally, the prop­erty mar­ket has sta­bilised, as­suag­ing in­vestors’ worst fears about bank as­set qual­ity.

Putting all this to­gether, it is likely that Chi­nese shares listed in Hong Kong, with their dis­pro­por­tion­ate weight­ing to the bank­ing sec­tor, should soon be­gin to at­tract more in­ter­est from in­vestors.

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