Can China’s positive equity momentum be sustained?
China’s offshore and onshore equity markets have been on a strong run in the year-to-date, outperforming other major markets.
This strength has not been driven by improving economic growth, but rather a combination of the policy outlook and financial market liberalisation measures.
Following the latest announcement to cut the reserve requirement ratio for banks by 100 basis points (with an extra 100 basis points for small rural institutions), the People’s Bank of China is certainly delivering significant stimulus to the real economy. Further easing measures are expected later this year, and while credit conditions have eased over the past few months, China’s economy continues to trend lower, highlighted by the latest GDP data in the first quarter of 2015.
But policy support alone cannot fully explain the current rally, nor is it likely to sustain the positive momentum over the longer term. In our view, the single biggest driver for the sharp jump in the Hang Sang Index and the MSCI China in April is financial markets liberalisation, which represents a significant tailwind to the long-term performance of China’s equity markets.
Financial controls were relaxed in April 2015 to allow domestic financial institutions to freely access Hong Kong’s stocks. These reforms followed measures in November 2014 to allow easier foreign access to the domestic stock markets (HK-SH Stock Connect); a move strongly welcomed by both foreign and domestic investors, sending the onshore (‘A’ share) CSI300 Index to a record high. Prior to the reforms in November, China’s financial markets were all but closed with strict capital controls, despite China being the manufacturing hub of the world over the past two decades.
Importantly, the offshore (‘H’ share) Chinese equity rally has been wholly supported by domestic buying. While foreign flows have been negative in the year-to-date, domestic flows from China into Hong Kong notably spiked in April, following anaemic levels over the past year. Indeed, both the A-share and H-share markets have seen record trading volumes as a result of market liberalisation.
We believe that domestic buying of the offshore market should be self-sustaining – a phenomenon not to be underestimated. Chinese households continue to hold the majority of their financial assets in cash (60-70%) compared, for example, to 40% cash holdings of Korean and Taiwanese households’ financial assets. Moreover, the Chinese government is actively encouraging investors to diversify their assets into equities away from over-heated sectors, such as property, with more financial market liberalisation measures likely to be announced as part of a broader package of reforms to rebalance the economy.
The ‘A’ share market was trading at a premium to the ‘H’ share market as a consequence of the reforms implemented last November, which stimulated overseas investment flows. However, over the last few weeks that premium has eroded. Nevertheless, equity market valuations remain attractive. Both the offshore and onshore markets continue to trade either below or near to the long-term average (over the past ten years).
Despite the significant equity moves, we believe that that the positive momentum in China’s equity markets can continue over the longer term, notwithstanding there will be probably be periods of volatility. We have been overweight in Chinese equity since the end of 2014 and although we recognise that China’s economy is weakening, we expect the authorities to deliver appropriate policy measures to avoid a hard landing. More importantly, though, the government’s reform efforts are gaining momentum and should continue to support domestic buying. Investor surveys indicate that overseas investors are generally underweight in China, which again provides more scope for a continuation of the positive trend.
Jade Fu is investment manager at Heartwood Investment Management