The Chinese Stock Market Cascade

The Chinese stock market has been experiencing significant turbulence, triggering the government to adopt a series of measures intended to support parts of the market, which, however, may have unwittingly exacerbated the cascade.

The Shanghai stock index has retreated 30% from its recent excited peak, to 3500 now.  This is approaching the levels seen in March 2015.  We believe that mid-2014 marked a new upward cycle for Chinese listed shares after a six year declining trend.  This we believe is being driven by the Chinese government’s reform agenda, the deregulation of interest rates and a relaxation of bank’s lending capacity and other changes like those to ownership that facilitates the movement of capital via the Hong Kong-Shanghai  connect.  The market is about 14% higher than at the start of the year and above our portfolio entry levels.  The highly speculative Shenzhen ChiNext market, which reached a capitalisation of US$ 470 billion has been the epicentre of speculation but in no way represents the sort of companies foreigners can or would necessarily buy.

Conspicuous has been the rapid rise in new trading account openings by individuals, the surge in margin usage and to some extent the notion that the Government saw an upward trend in the stock exchange as a way to mobilise savings to re-capitalise State Owned Enterprises (SOEs).  In this current squeeze, equity margin has shrunk from a peak of around CNY2.2 trillion to an estimated CNY1.6 trillion while funds secured unofficially are suggested to have fallen 70% to perhaps CNY0.5 trillion.  As a percentage of the country’s market cap, these combined numbers, CNY2.1 trillion represent 5.25% of the capitalisation of shares listed in China, still representing a high proportion of the free float.  While this usage of margin lending is clearly high versus other market extremes, it should be born in mind that Chinese domestic investors do not have an options market as exists in the West, stock shorting is not permitted and technically, investors are not permitted to day trade.

The disturbing feature is the Government’s apparent loss of poise.  Several measures have been rolled out in quick succession including the suspension of IPOs, easier margin regulations and direct market intervention.  By providing support to parts of the market, the Government may have unwittingly encouraged investors to liquidate while there is a propping buyer.

We take comfort from the business economics surrounding our holdings which have noticeably out- performed in this sell-off.  Will this market turbulence damage their growth prospects; not meaningfully we believe.  We had already factored in a weaker economy (more like 4% to 5% growth than the targeted 7%) and a sharp rise in non-performing bank loans.  None of these outcomes seem likely to surprise sophisticated investors.

The question we face today is when to add to positions.  Around our earlier entry levels would be ideal, but we can see concerns being raised as to how this rout may cause damage to an economy grappling with economic change.

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