Understanding the challenges of China
China equities are off to a rough start to the year with the CSI 300 and MSCI China indices respectively down by ~13% and ~9% as at 7 January.1
The recently introduced circuit breaker mechanisms within the A-share market have been singled out by many market participants as being the key driver behind the sell-off during the first 4 trading days of the year. We would argue that the sources of price fluctuations in the A-share market have not necessarily changed. Indeed, they continue to be determined by a combination of its underlying investor mix, their corresponding behaviours, and importantly, equity fundamentals/valuation.
On the other hand, the circuit breakers do appear to have exacerbated some of the herding mentality within the market, particularly when reacting to perceived negative market events. This would seem to explain the sudden acceleration of selling activity on both 4 January and 7 January when the circuit breakers were triggered, as investors hastily sought to position themselves in response to weaker PMI data/concerns on the lifting of share sale restrictions and an increase in the PBoC CNY/USD daily fixing, respectively – for fear that they would not be able to do so over the full course of the normal trading day. It did not take long for the selling activity to spill over to the H-share market in Hong Kong as broader de-risking activity picked up pace.
In response to the market turmoil, the China Securities Regulatory Commission (CSRC) announced on the evening of 7 January that the circuit breaker mechanisms would be temporarily suspended with immediate effect. Individual stock price movements will only be subject to the +/- 10% price limits which were in place prior to the introduction of the circuit breakers. The change in events is not completely surprising given that the CRSC had commented earlier in the week that the market needed time to adjust to the new mechanisms. At the same time, it noted that the circuit breakers themselves will continue to be refined based on the market situation.
With this announcement, we anticipate some degree of calm to be restored within markets. Aside from the acceleration of selling activity, one of the unintended consequences of the circuit breaker mechanism seems to be that it also prevents would-be-buyers from deploying capital. As market dynamics revert to the previous regime, contrarian investors focused on fundamentals are once again able to take advantage of dislocations created by shorter-term investors.
The above does not necessarily mean 2016 will not be without other challenges. As the PBoC seeks for the CNY to have more flexibility and market determination in its exchange rate, it will likely result in volatility being reflected in both FX and equity markets. Moreover, our expectation is that the Chinese government will likely seek to accelerate supply-side reforms to help address the issue around excess inventories on SOE corporate balance sheets. This may result in some short-term pain in certain overcapacity industries such as materials, basic metals and real estate. However, if successful, it will likely yield long-term economic benefits as stronger companies with more robust business models emerge.
This is not to say that there are no bright spots within the Chinese economy. We continue to identify opportunities within industries demonstrating healthy top and bottom-line growth. These include certain “sunshine” industries that comprise environmental services and alternative energy, health care, technology, equipment and machinery, to more conventional industries across consumption, insurance and utilities. Indeed, such a bifurcation in the economic structure of China provides an environment that is conducive to active management across both long/short and long-only investment approaches.
1Source: Bloomberg, as at 7 January 2016
Frank Yao is senior portfolio manager on the Neuberger Berman Greater China Equity Fund