China: A Crisis of Confidence?

Monica Defend (pictured), head of Global Asset Allocation Research at Pioneer Investment argues that Chinese authorities should be cautious to intervene in markets since the recent stock market crash might be part of a healthy adjustment. 

The tightening measures implemented by the Chinese authorities on margin financing, used by Chinese retail investors, may have curbed margin activity in recent weeks. Despite having fallen by more than a third from its peak levels, participation in domestic equity markets remains high. Investors, however, are struggling to grasp whether the Chinese government can contain market volatility. The massive portfolio outflows seen in recent weeks indicate that investors seem to be looking for any signs to exit the market.

A weaker-than-expected flash Chinese manufacturing Purchasing Managers’ Index (PMI) released by Markit on Friday, seems to have triggered the massive sell-off in the domestic Chinese equity market. Renewed concerns on capital outflows and Renminbi depreciation exacerbated the sell-off. Several onshore stocks have been suspended after falling 10%, the maximum allowed in a day. Hong Kong equity markets have also retreated, despite the stronger fundamentals driving this market, albeit the fall was more contained.

Our macroeconomic analyst was quick to point out that we should be cautious not to read too much into the recently negative news flow. The Markit survey for China has several limitations; it covers a narrow sample of industrial firms (420 versus 5000 in the Eurozone PMI) and is skewed towards smaller firms. This can hardly be representative of China’s manufacturing sector, which includes circa 360,000 industrial firms. Industrials may be facing downward pressure from falling export demand, but we believe this sector should have found a bottom, as we expect the global economy to recover in 2H 2015.

Furthermore, manufacturing adds to only a third of the Chinese economy. Property, infrastructure and service sectors contribute to the rest. The property sector has already shown solid signs of stabilisation, while services and consumption are holding up relatively well. Our proprietary China Coincident Indicator suggests that momentum may have cooled slightly since end Q2, but is stabilising. Recent data releases may not be upbeat, but are not the basis for panic. Meanwhile, data indicates that recent monthly capital outflows have been largely offset by fundamental inflows, including continued current account trade surpluses and direct investments.

In the absence of any meaningful change to our fundamental macro outlook for China, we believe that this correction points towards the technical factors at play. It appears we are facing a crisis of investors’ confidence in the Chinese government to sustain its domestic equity markets. As long as participation from retail investors remains high, the government may feel obliged to implement extraordinary measures to avoid a spill over into the domestic economy.

This would be a wrong move in our view. Despite the plunge through mid-July, the domestic A-shares market still appears expensive. We believe that these valuations are not justified against a slowing macroeconomic backdrop and subdued earnings growth. A healthy correction should send a positive signal to foreign investors, particularly those with an institutional mind-set, who seek companies with compelling fundamentals to drive share prices higher. Government manipulation to prop up markets is not sustainable and the authorities need to guide the markets gradually lower over the next 2-3 months in our view.

We expect further tightening on margin lending rules to reduce the participation of domestic investors. Increased institutional participation from international Sovereign Wealth Funds is a possibility. Cancellation of shares bought-back by companies would also be welcomed, but we assign a lower probability to such a catalyst. Most importantly, better visibility on earnings growth and higher dividends in 2016 may drive institutional investors back into the market.

We expect markets to remain volatile in the coming months but remain constructive. We reiterate that the opportunity lies in the offshore Hong Kong listed (H-Shares) equity market, where good quality companies are now trading at a 50% discount to the onshore (A-Shares) equity market. We are positive for the 2016 earnings outlook for several sectors within H-Shares including banks, telecommunications and technology. We continue to monitor the governments’ reform initiatives and the inclusion of the Chinese Renminbi in the basket of Special Drawing Right currencies by the IMF, which is anticipated for year-end.

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