The Path Forward For Chinese Equities

China: Deceleration and Equities

In short, there is nothing to suggest that Chinese stocks are in a bubble. Even when Chinese stocks peaked in May and June of 2015, they didn’t look alarmingly expensive.

Chinese stocks opened 2016 with a tumble after a tumultuous 2015, which saw the FTSE China A50 Index trade in a range swinging from 8,450 to 15,100 points. Much of the volatility in China has to do with a changing macroeconomic environment: China’s economy is slowing, export growth is weak, commodity prices are collapsing, the People’s Bank of China (PBOC) is lowering interest rates and the country’s currency policy is changing. We will look at each of these factors as well as various valuation measures and discuss what they might mean for the Chinese equity market in 2016 and beyond.

A Slowing Economy

China’s economy grew “only” 6.9% in the quarter ended September 30, 2015.  By the standards of most countries, this is an enviable pace, but for China it represents a significant slowdown from the 10% pace that the country has enjoyed for much of the past few decades (Figure 1). 

We expect China’s growth to decelerate further to 5.5% during the second half of this decade before falling to around 3% annually in the 2020s.

Not only has real GDP growth cooled, nominal GDP is also growing much more slowly than in the past.  Nominal GDP, which doesn’t adjust for the rate of inflation, is a much underappreciated measure of economic health.  It represents the sum total of cash flows available to service debt, equity shareholders and to fill government coffers.  China’s nominal GDP has been decelerating even faster than its real GDP as a result of declining inflation (Figure 2).

Figure 1: Both Real and Nominal GDP Growth is Slowing.

Figure 2: Inflation Has Been on a Downtrend Since 2011.

In many respects, declining inflation is a good thing.  It permits the central bank to ease monetary policy. The combination of lower inflation and slower real growth, however, can make life difficult for debtors.  This is a problem because China’s private sector is awash in debt.  In fact, China’s private sector debt levels are much higher than those in most other emerging market countries and are more akin to those seen in Western Europe, U.S, Canada and Japan (Figures 3 and 4).  Having high levels of private sector debt isn’t necessarily a problem if one of the following two conditions is present:

  1. Nominal (and preferably real) GDP is growing quickly: there will always be more money to service interest and principal repayments on existing debt.
  2. Interest rates are extremely low: this is the case in Western Europe, Canada, Japan and U.S. but not (yet) the case in China, where the cost of borrowing is still relatively high.

Figure 3: China’s Private Sector More Highly Leveraged Than its Emerging Market Peers.

Figure 4: High Levels of Private Sector Debt are Manageable if Interest Rates are Very Low.

China’s equity market appears to be especially sensitive to credit concerns.  This is probably because financial stocks represent 69% of the weighting of the index, dwarfing any other sector.  Financial stocks have a similar weighting in the Hang Seng Index, which correlates highly with the FTSE China A50.  By contrast, financial stocks have a much lower weighting in the tech-heavy S&P 500® and in the FTSE 100 (Figure 5).  Any development that calls into question the credit worthiness of China’s private sector is likely to upset the equity market.

Figure 5: The FTSE China A50 is Heavily Weighted to Financials.

Sector/Market Index FTSE China A50 Heng Seng S&P 500® FTSE 100 U.K.
Financials 69.08% 57.88% 16.48% 23.36%
Industrials 13.42% 6.81% 10.05% 6.84%
Consumer Discretionary 6.10% 2.69% 12.89% 11.04%
Energy 3.02% 6.00% 6.50% 12.15%
Consumer Staples 2.69% 2.47% 10.06% 18.35%
Utilities 1.99% 5.02% 2.99% 4.53%
Telecom 1.43% 8.32% 2.43% 6.41%
IT 0.99% 10.81% 20.69% 1.51%
Materials 0.80% 0.00% 2.76% 5.46%
Health Care 0.47% 0.00% 15.15% 10.34%

* Source: Bloomberg Professional (XIN9I, HSI, SPX and UKX)

Currency

High debt levels are probably contributing to slower growth in China but are not the only one.  Another major factor is an overvalued currency.  For many years China has tied its currency to the value of the U.S. dollar (USD).  When USD was weak during the period from 2002 to 2011, China allowed the Renminbi (RMB) to appreciate by roughly one third.  This made sense at the time as it allowed China to contain inflationary pressures while not damaging competitiveness.  Since 2011, however, a stronger USD has lifted the RMB along with it, degrading China’s competitiveness (Figures 6 and 7).  

Figure 6: Euro (EUR) and Yen (JPY) Have Fallen Sharply Against the Renminbi and Dollar (USD).

Figure 7: Emerging Market Currencies Have Plunged Versus the Renminbi.

This is a big problem for China since its economy is strongly dependent on exports and has relatively weak internal demand, especially on the consumer side.  In fact, much of China’s expansion was driven by investment, both private and public, that transformed the country into a global export powerhouse.  Now, however, export growth is stagnating (Figure 8) and China is beginning a delicate transition to a more consumer-led economy.  We expect that the equity market will be very sensitive to export growth as well as to information that indicates how the transition from an investment and export-led economy to a consumer-led economy is proceeding.

Now that the RMB has become a global reserve currency with International Monetary Fund (IMF) special drawing rights, China is moving to a currency basket and is expected to loosen controls on RMB trading.  If RMB weakens, it will likely boost the equity market.

Figure 8: Exports are Stagnant but Imports are Plunging, Which Adds Back to GDP.

Commodities

Given the breadth and scale of the collapse in commodity prices and the perceived role of China in bringing that about, some have even questioned if China’s economy might be in a much steeper slowdown than the official GDP numbers suggest.  We don’t think so, for two reasons:

  1. The collapse in commodity prices isn’t explained entirely by China.  To a large extent, it reflects the boom in supplies of a wide range of products, including agricultural goods, energy and metals.
  2. GDP is the sum of government, consumer and investment spending plus exports less imports. While China’s investments and exports have been slowing, imports are collapsing (Figure 8) and this adds back to GDP.  In fact, the collapse in energy prices alone probably added about 1% to GDP.  The collapse in imports is mainly a price effect related to lower commodity prices and not primarily a reflection on the weakness of Chinese domestic demand.

The effect of lower commodity prices on Chinese equities is somewhat counterintuitive: while many people blame softer growth in China for the collapse in commodity prices, lower energy prices in particular, is actually good news for China and probably, on balance, good news for Chinese equities.  To some extent, weaker demand for Chinese goods in commodity-producing countries will be bad for China’s growth, but this should be outweighed by domestic gains as well as gains in other commodity-importing markets that buy Chinese goods such as the United States, European Union and Japan. 

Interest Rates

In the face of an overvalued currency and high levels of private sector debt, the PBOC has been steadily reducing interest rates (Figure 9).  On balance, lower interest rates should be supportive for Chinese stocks as they will make debt burdens more manageable while encouraging growth in consumer spending and stability in investment spending.  Higher rates in the U.S. won’t necessarily be bad for Chinese stocks either, especially if higher U.S. rates coincide with a weaker exchange rate for the RMB.  

China announced on the first business day of 2016 that it would be moving away from using the reserve requirement ratio as its main monetary policy tool.  Rather, reserve requirements will be used mainly to ensure the stability and solvency of the banking system while interest rates will gain a more prominent role in the management of monetary policy. We expect that China’s rates will most likely fall. 

Figure 9: PBOC is Likely to Ease Policy Further and Focus More on Rates than Reserve Requirements.

Valuations

At the start of 2016, Chinese equities don’t look particularly expensive compared to their international counterparts.  While there is no perfect measure of valuation, using a variety of measures such as price earnings, price/sales, price/book, and dividend yields shows Chinese stocks have valuation levels that appear to be fairly unexceptional when viewed against both emerging market and developed market indices (Figure 9).  By most measures China’s stocks fall in the middle of the range for valuations (Figure 10).

Figure 10: Equity Valuation Measures

Market P/E Current Year Estimate P/E Next Year Estimate Price to Sales Price to Book Dividend Yield
China 13.8 12.72 1.23 1.6 2.07
Hong Kong 10.7 9.68 1.63 1.1 3.71
India 17.95 15 2.14 2.66 1.62
Japan 14.95 13.73 0.74 1.27 1.87
Singapore 12.23 11.44 1.21 1.08 4.16
U.K. 15.27 13.3 1.18 1.71 4.27
U.S. 16.44 14.58 1.76 2.54 2.25

* Source: Bloomberg Professional (WPE page as of 12/31/2015)

In short, there is nothing to suggest that Chinese stocks are in a bubble.  Even when Chinese stocks peaked in May and June of 2015, they didn’t look alarmingly expensive.  If there was a bubble in Chinese stocks it was probably back in 2007 and early 2008, not in 2015 and 2016 (Figure 11).  As such, while we fully expect Chinese stocks to remain volatile and cannot rule out substantial further downside, we think that if Chinese stocks sell off a great deal further they will eventually be seen as a bargain.  Overall, we suspect that the bearishness expressed by many commentators regarding Chinese stocks has probably gone too far and that over the next five to ten years Chinese stocks are likely to achieve average or perhaps somewhat above average returns. This, of course, doesn’t rule out the short-to-intermediate term possibility of a retest of the August low of around 8,500 points on the FTSE China A50 or even a retest of its 2014 lows around 6,300 points. 

Figure 11:

Regression Model

A simple and admittedly not very sophisticated regression model largely confirms our intuitions regarding what influences Chinese stocks.  Our model seeks to explain the monthly return of the FTSE China A50 Index from December 2010 to December 2015 using six variables: changes in the S&P 500®, West Texas Intermediate oil prices, Fed Funds, Copper prices, JPYUSD and the PBOC’s policy lending rate.  Together, these inputs explain only about 29% of the variation in the index – leaving the rest unexplained (Figure 12).

Figure 12:

  Coefficients Standard Error t Stat P-value*
Intercept 0.00 0.01 0.30 76.6%
S&P 500® -0.14 0.40 -0.35 72.6%
WTI -0.23 0.13 -1.83 7.3%
Fed Funds -14.96 41.19 -0.36 71.8%
Copper 0.71 0.19 3.73 0.0%
Yen Future -0.81 0.46 -1.78 8.1%
China Rates 0.00 0.09 -0.04 96.8%
CNH -0.15 1.32 -0.11 91.1%

Source: Bloomberg for Raw Data, CME Group Economics Research Calculations

*P-Value represents the probability of getting such strong results randomly given the number of degrees of freedom. Lower P-Value => a stronger result.

A few things here are of interest: during the five-year period in question, Chinese stocks tended to benefit from lower oil prices.  Copper prices and Chinese equities moved in line, but this is likely Chinese equities moving copper rather than the other way around.  The same can be said of the FTSE China A50 future and the Japanese Yen future.  Lower Chinese stocks may put further downward pressure on the Japanese currency.  U.S. and Chinese interest rates exert a weak influence BUT Chinese interest rates are only after-the-fact moves in policy rates and do not reflect market expectations.

Going forward, we expect that a weaker Chinese currency will most likely be positive for stocks as will any further easing of monetary policy.

Lastly, what is most interesting and perhaps ultimately most important to equity investors both in China and elsewhere is the lack of correlation between the S&P 500® and the FTSE China A50 Index.  What this implies is that Chinese stocks are potentially a very good diversifier for investors in the U.S. and elsewhere and that Chinese investors would also likely benefit from diversifying abroad.  

 

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only.  The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions.  This report and the information herein should not be considered investment advice or the results of actual market experience.

About the Author

Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.

View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.

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