Chinese A shares: mind another correction

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Aidan Yao , senior Asia economist at AXA investment Managers comments on the outlook for Chinese A shares. 

Key points:

 China’s A-share market has experienced a significant correction in recent days, falling by more than 10% from the peak, amid concerns about elevated valuations.

 After voicing caution in late April, we have now officially revised our tactical call on A shares to “negative” and reiterate our recommendation on downside protection.

 The parabolic rally of the market in the last nine months reflects a substantial valuation re-rating driven by liquidity, leverage, and elevated expectations about future reforms.

 Given that many of the previously supportive factors are either diminishing (monetary easing and leverage) or moving against the market (corporate earnings and increased equity issuances), we think downside risks for A shares are accumulating rapidly.

 In light of the declines already occurred, we would not be surprised to see the total market correction reaching 15~20%, along with a surge in volatility. This will likely be followed by a period of range-bounding market, as sentiment consolidates.

Despite the change in the tactical call, we remain positive on Chinese equities over the long run. This is predicated on our constructive view on the Chinese economy, continuous financial deepening, and an official desire to develop and integrate China’s capital market into the world.

Caution: near-term hiccups in A shares
Last September, we published a note “News on Chinese equities”,1 which marked a major turning point in our view on China’s A shares from underweight to overweight. Since then, A shares have rallied between 110% and 140% across different indices, surpassing our wildest expectations. Given the parabolic rally in such a short time, driven mostly by valuation re-rating, we felt that the market had moved too far ahead of itself. Hence, we voiced caution at the end of April and advocated the need for downside protection.

Over the past two months, although the market has continued to march higher, the speed has slowed. At the same time, volatility has risen and the market has experienced a number of sizable drawdowns . The growing divergence between equity prices and macro fundamentals has made us increasingly uneasy with the continuous rally, fuelled by rising valuations and leverage. We therefore think it appropriate to change our A-share call to “negative” on a tactical basis, and reinforce our recommendation on downside protection.

Longer term, we remain constructive on Chinese equities, predicated on our positive view on the Chinese economy and structural economic reforms. We think the bull market has further to run, provided the authorities are successful in rebalancing the economy, furthering financial deepening, 3 and developing the capital market. In other words, the change in the tactical call does not alter our long-term positive view on Chinese equities. To explain how we have shifted our near-term position, we look back on the reasons that made us turn bullish on Ashares last September, and assess how they have changed since then

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