Chinese A-shares on a roller coaster
Far away from Europe and the Greek drama, the Chinese A-shares market went through a massive correction in recent weeks, sweeping away in value the equivalent of three Greek GDPs. The authorities came to the rescue, and as we speak, the market seems to have stabilised. So what are the implications for global markets and how do we look upon China and the potential of its market?
Chinese A-shares on a roller coaster
To set the scene; most overseas investors currently invest in China through Hong Kong-listed Chinese equities, while the A-shares, consisting of Chinese companies’ stocks listed in Shanghai and Shenzhen, and denominated in RMB, are still absent in most global or regional portfolios because they are excluded from indices. This is the reason why this strong correction has had little impact on global markets.
On the back of strong liquidity, reform momentum and a surge of interest among domestic retail investors (also boosted by easy access to margin financing), the A-shares market had staged an impressive rally from November last year, up to its peak mid-June 2015, before going through the 30% correction. We do not expect the downturn to have any implications on Chinese consumption. 95% of Chinese do not own stocks, and stock investments represent 6% of households’ assets.
Important rescue measures
The authorities stepped in with an unprecedented series of supportive measures in order to stabilise the market. The fear that the market was on the brink of collapse led to intensified intervention following the unsuccessful first round of rescue attempts. Many of these measures, such as pushing brokers, fund management companies and large shareholders to commit to long-term investments, are positive, as they address the lack of institutional capital; one of the main shortcomings of this market where 85% of the trading is done by momentum-driven retail investors.
We welcome this, as well as a critical evaluation of margin financing practice and IPO rules. Margin debt is a new concept in China, and its sharp increase among unsophisticated investors has worried us. Multiple IPOs, often underpriced to guarantee their success at launch, have drained liquidity as the cash subscribed needs to be deposited by participants. We have avoided those.
But there are other, less positive considerations. Firstly, the government had initially set the healthy development of equity markets as a priority, as it in turn would allow for more equity issuance needed to deleverage the debt-ridden economy. The stock market is also an important source of financing for companies that have limited access to bank loans, and a more positive market will make more capital available to them. The ambitious task of reforming state-owned enterprises (SOEs), through privatisation, restructuring, or even share incentives programs for the management of listed SOEs, also partly depends on the stock markets. The opening up of capital markets is a cornerstone of the RMB internationalisation. We still believe in the strong reform momentum, but time will tell if the current storm will lead to less use of stock market-based tools to achieve these results.
Secondly, the authorities also allowed thousands of companies to use loosely-defined rules to suspend trading. This undermines the efforts of the Chinese government to establish a convincing platform for an equity capital market, which they are trying to open up and promote. In our view, restoring confidence for the long term should be a priority for the government. Our base case scenario remains that A-shares’ inclusion in MSCI indices will start next year, and in the long run it implies a potential doubling up of China in the emerging market index.
Right exposure to China
At East Capital, we started researching the A-share market back in 2012, and have invested since 2013. Earlier this year, our daily-traded and open-ended UCITS fund was the first Luxembourg fund to get regulatory approval to invest up to 100% in A-shares through Stock Connect. We find this market interesting because we like the breadth of sectors that benefit from the rebalancing of the Chinese economy towards a consumer-led model, which include services, healthcare, and consumer stocks. And we like the span of entrepreneur-driven companies and upcoming global leaders. The market is still poorly researched; local investors and brokers spend little time understanding the value drivers, risks and corporate governance, and the quality of companies differs a lot. That is where our approach can make a difference, and the outperformance of our strategy through the correction is the best evidence of this, as we had stayed away from the segments of the markets that have rallied a lot but without any improvement in earnings or fundamental reason.
Looking forward, we believe we are correctly positioned for when investors start to look at and invest in more higher-quality companies trading at reasonable valuations, and when long-only institutional investors enter the market. And despite this summer roller coaster, we still believe this will happen earlier than most of our peers seem to believe.
