Should Investors Be Concerned About China?

Economic growth is slowing faster than Chinese officials want and there is increasing anticipation for further rate cuts from the Peoples Bank of China 

J.P. Morgan Asset Management 22 April, 2015 | 3:58PM
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Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here, Kerry Craig, Global Market Strategist, J.P. Morgan Asset Management, asks if there is a bubble in China equities.

This year the year of the sheep according to the Chinese zodiac calendar and is associated with the characteristics of calmness and prosperity. Only one of those applies to Chinese equity markets at present and it’s not calmness.

The domestic stock market in China has gained nearly 100% in the last 12 months and valuations in the market are starting to look very lofty prompting calls of a market bubble. The demand for equities is so great from Chinese investors that enthusiasm is pouring over into the Hong Kong market. So can the momentum in Chinese equities be sustained or is this really a bubble on the brink?

First a few technicalities, the local Chinese market is known as the A share market, A shares are stocks in companies that can only be purchased by local Chinese investors or by foreign investors who have been given special access. For Chinese companies wishing to access international capital markets they may also list on the Hong Kong stock exchange and have a H-share or international share class.

The same company listed on both exchanges may trade at different prices because each can only be accessed by certain investors and because of this A-share stocks have historically been more expensive than the H share stocks.

Near the start of the year the Shanghai-Hong Kong Stock Connect programme was launched which allowed investors in China to invest in the H share stocks and investors in Hong Kong to invest in the A share class. However, the amount of money that could flow north and south was restricted as were the investors who could access it.

But as the A-share market hit a seven year high, the restrictions on who could use the Stock Connect programme were relaxed allowing Chinese mutual funds to partake in the programme.

The euphoria of Chinese investors at this development and being able to buy the cheaper H-share market is clearly evident in the surge of new investment accounts being opened in China, jumping from 1,670,000 against an average March value of 240,000. To some degree this enthusiasm is being propagated by the Chinese government who want investors to shift their focus from the increasingly expensive local market to an international one.

The market rally has been staggering the Hong Kong Hang Seng Index gained just over 10% in three days and is up 19% this year. This isn’t stopping the money flowing and the Stock Connect’s daily quota of $1.7 billion continues to be tested. This has to speculation about a possible bubble. The trouble with bubbles is that they are very hard to identify until they have popped.

Any asset or market index that rises this far this fast is ripe for large correction, and some near term consolidation or profit taking seems sensible. However, over a more medium term time frame the rally in the H-shares could continue.

The catch up in the Hong Kong market could run for a little longer as valuations in that market are lower than their Chinese counterparts. The Hang Seng is still trading at below its long run average and A-shares are still at a premium to H-shares, and until that gap closes demand will persist.

Bad News is Good News

Economic growth is slowing faster than perhaps Chinese officials want and there is increasing anticipation for further rate cuts from the Peoples Bank of China and fiscal stimulus measures from the government.

Finally, the market may be supported flows. The quota on the Stock Connect may be extended and given the difference in size between the A and H share markets there is still plenty of pressure forcing capital through that system. Meanwhile, some funds may be forced into buying Chinese equities if only to keep up with benchmarks. China accounts for 22% and 24% of the MSCI AC Asia Pacific ex Japan Index and the MSCI Emerging Market Index respectively. Any benchmark focused investor who has been underweight China may now be forced into buying shares.

Nevertheless, the question is after the arbitrage opportunities have faded investors will need to see evidence of significant improvement in China’s economic fundamentals and corporate earnings. Without this the rally could be very short term indeed and prove not to be the sheep with the golden fleece.

 

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J.P. Morgan Asset Management  is the investment arm of JPMorgan Chase & Co. and it is one of the largest active asset managers in the world.

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