The worst-ever start to a year for China’s stock market has seen bourses across Asia slide into bear market territory. The benchmark Shanghai Composite Index dived by 22 percent in January, amid slowing Chinese economic growth, growing capital outflows and waning confidence in the authorities over failed circuit breakers.
Longer term, however, the news might not all be bad for Chinese stock investors. According to Nikko Asset Management senior portfolio manager Eng Teck Tan, China’s stock market volatility reflects its dominance by retail investors – a situation that may change with growing institutional investment, potentially including from overseas. Tan also suggests investors focus on China’s “new economy” Shenzhen bourse instead of the “old economy” Shanghai exchange to better capture the gains from China’s transforming economy.
The Diplomat’s Anthony Fensom spoke to Singapore-based Tan about his views on Chinese stocks and what investors might expect in 2016.
The Chinese authorities have been criticized over their market controls, such as the 7 percent circuit breakers and various rules aimed at preventing selling. What’s your view on the impact of these?
Circuit breakers are not new – they’re in Asia everywhere; it’s just that they’re rarely triggered. For example, Taiwan has a circuit breaker at 10 percent, South Korea at 15 percent and in Thailand, it’s up to 30 percent, so the controls are not new. What’s more critical for China is the communication that it gave to foreign investors and the lack of consultation.
Also in China, the free float [portion of shares held by public investors] is relatively small so having a circuit breaker tends to create a lot of intensity on both ends, whether up or down.
There has been plenty of discussion about the impact of individual Chinese investors using margin loans – is this a reason for the volatility?
Margin loans exaggerate the situation, but the real reason for the volatility is there are too many retail investors. Taiwan is a good example – before it opened up to the world in 1998 it was equally volatile, with margin loans and retail investors making up 80 to 90 percent of the market, similar to China right now, with few institutional investors.
Once China opens up its market, if the MSCI includes China in its indices in June, it will end up like Taiwan with far less volatility, and the institutional investors will discipline the market to a large extent. Margin loans have come down more than 60 percent since their peak at over 2 trillion yuan ($300 billion).
Shanghai was in a bear market for years and was ignored, but suddenly it seems to have become a major driver of Asian markets. Why has this changed?
Ownership of Chinese stocks is less than 2 percent for global investors, and within China itself there’s a minimal wealth impact as they invest less than 10 percent of their wealth in the stock market; most of it is in property, fixed deposits, and things like that.
People are more concerned about the economy, which is undergoing this massive transition. China has never had a big focus on services and consumption. When you’re doing fixed asset investment, it’s easy to control – you just build a bridge or airport and create a huge multiplier effect, you create huge demand for steel, cement…but how do you control people on the street consuming services? You can’t tell them to all go and watch a movie.
In my view it’s hard to change this structural move toward consumption – as the Chinese get richer, they want different things, they no longer want to work as hard as before and no longer want just simple things like food and clothing. They’re moving to bigger houses and cars, going on overseas trips, going to the cinema to get experiences, all sorts of things. These are things you can’t change.
The nervousness comes from the fact that 60 percent of the economy has been from fixed asset investment and the Chinese government is slowing that down very quickly. They know if they don’t, in another 10 to 15 years they could end up like the Asian financial crisis with too much investment in unproductive assets.
Imagine a mathematical formula where you have 40 percent of the economy growing at about 10 to 15 percent, but you have 60 percent at almost no growth or very low single digits, that will easily bring down growth to 6 or 5 or 4 percent. It’s still a good growth number globally, but people are still used to China growing by around 8 to 12 percent so 6 percent looks quite bad from that perspective. But in the longer run it might be healthier for the global economy.
You suggest foreign investors focus on Shenzhen instead of Shanghai?
There are a few different exchanges in the Chinese market, including H-shares listed in Hong Kong, while the Shanghai Stock Exchange and the Shenzhen Stock Exchange are referred to as A-shares. Historically, state-owned companies, the old economy of China dependent on fixed asset investment for the past 25 to 30 years, are generally listed in Shanghai as it’s the oldest exchange and has a lot of the bigger companies. Mining companies, oil companies, banks and insurers tend to be on the Shanghai exchange.
Whereas in Shenzhen, it tends to be what we call “new economy” – areas historically more accessible to private companies, like technology, export sectors, automation, manufacturing, healthcare, some internet companies and things like that.
Now there’s this massive transition in China toward more services and the consumer economy. Most of those companies tend to be listed in Shenzhen. Generally the split between state-owned and new economy in Shanghai is probably like 70/30 and the reverse is true for Shenzhen.
So this is why we think that going forward, because of this transition and because the services part of the economy, the non-manufacturing PMI is still growing healthily, the services sector will have better growth prospects in Shenzhen.
Why are H-shares trading at such a massive discount of around 50 percent to A-shares?
There are a few reasons why the A-shares are trading at a premium – the main thing is that in China, it’s a closed capital account and there are exchange controls. China has one of the highest savings rates in the world, approaching close to 45 to 50 percent. As it stands, China has between $7 to $13 trillion in savings, depending on whether you include the government, corporates and individuals. But because it’s a closed capital account, people can’t bring it overseas to invest.
For example, as an Australian if you don’t like the Australian market you can go and invest in the U.S., but in China they don’t have that option. Generally people invest in four things: cash, property, fixed income, although it’s relatively small and dominated by insurers, and the last one is the stock market. Because of that the A-shares trade at a huge premium, as the H-shares are bought by overseas investors who can go elsewhere, so H-shares are currently trading at about 8.5 times [forward price/equity ratio], which is really cheap.
Foreign shares trading at a discount to the local shares is not something new – it’s happened before in Singapore, Malaysia, and Taiwan, when their capital accounts were relatively closed. At some point the discount will narrow, but the most important thing is the capital account – eventually the ability of foreigners to invest in Shanghai and Shenzhen will improve.
Even with the Hong Kong-Shanghai Connect scheme there are still restrictions, and with the Shanghai and Shenzhen stock exchanges not in international benchmarks, investors tend not to invest in them. This will continue until these factors are resolved, which is probably another couple of years away.
Looking ahead this year, which sectors should perform well and which will disappoint?
For traditional industries like materials, it’s not going to be a good recovery. There might be some spurts when the oil price bottoms, but there’s still too much excess capacity. There’s also concern about supply side stocks with overcapacity issues. You have to be more wary about some of the financials, which could potentially disappoint as well.
The growth areas of the economy are already relatively expensive, at about 15 to 20 times [PE] compared to about 8 to 10 times for the old economy. Some of the higher value-added manufacturers will continue to do relatively well, along with healthcare and automation stocks, while we are also very positive on consumption with respect to services, such as cinemas and tourism.
It doesn’t only have to relate to China – the influence of Chinese tourism on countries like Japan, Korea and Thailand will also do very well. Only 4 percent of Chinese actually have passports – it’s over 80 percent in Australia, 90 percent in Singapore, 50 percent in the U.S…..so it doesn’t only have to be the Chinese stock market but other countries that can benefit.
How will the Shanghai and Shenzhen bourses perform this year?
We think Shanghai will post single-digit gains – the only good news is the fact that a lot of stocks are very cheap, the market is trading at around 11 to 12 times PE, the lowest it’s been probably since the Global Financial Crisis. Supply side reform will impact Shanghai much more.
Shenzhen is relatively expensive at 22 times, but we think it will outperform Shanghai, probably by around 1.5 to 2 times. Earnings growth is still phenomenal, in the 20s, so that will give investors more comfort.
Most foreign investors have exposure to H-shares that have similarities to Shanghai, which is dominated by the old economy. Whereas the Shenzhen-Hong Kong Connect scheme likely happening this year will give foreign investors exposure to the different kinds of stocks you can find in China, and this will have an impact on Shenzhen as well, so we expect Shenzhen can do between 15 to 20 percent growth.