News of the Chinese stock market decline continues to dominate headlines both financial and non-financial media with sensational attention-grabbing titles of a meltdown. The high levels of volatility seen in local Chinese equities has become a widely-discussed conversation topic as well, and investors may wonder about the prospects of the Chinese equity market moving forward. The benchmark local equity indices fell to approximately more than -8.0% on July 08, 2015 thereby spreading panic and fear over to the offshore equity market. In this article, we offer a quick update on the Chinese equity market amidst substantial volatility.
Local Equity Market Undergoing Correction
The spectacular and breath-taking surge in the local Chinese equity market (represented by indexes like the Shenzhen CSI 300 index as well as the Shanghai Composite index) began late in the fourth quarter last year, and since then, the local market has more than doubled in value in local currency terms. With the recent correction taking place, the Shanghai Composite index is up about 15.2% year-to-date in local currency terms, while the Shenzhen CSI 300 index is up 11.1% year-to-date (as of 7 July 2015). The decline from its peak recorded sometime in late May and early June to date is more than -30.0% and has been steep and swift. Just today, the sharpest peak-to-trough was more than -25.0% in intraday swings in the Chinese futures market!
Chart 1: Local Chinese Equity Market Since January 2011
The amount of leverage undertaken by speculators and investors in the local equity market has concerned Chinese government officials, and we have seen policy-makers stepping in previously to reduce leveraged trading activity via raising margin requirements in accounts, only for them to subsequently reverse their stand in an attempt to stem the haemorrhage in the domestic equity market. The talk about MSCI potentially including the Chinese A-Share market into the various relevant MSCI equity indexes has caused many investors to 'jump the gun' and hop into local equities in the hopes of a general surge in equity prices when fund managers would have to increase their exposure to the A-Share market. Volatility has reached staggering levels; as shown in Chart 2 below, with swings of a 5.0% to 10.0% range typically seen within an intra-day trading session!
Chart 2: Intraday Volatility Levels
Policy-Makers Attempt To Stabilise The Market
While policy-makers have also tried to reduce speculative activity in the A-Share market, they have also implemented measures over the past week in an attempt to stabilise the equity market. The People's Bank of China (PBOC) have been on an easing mode since late 4Q 14, and have continued slashing interest rates over 1H 15 as well as reducing reserve requirement ratios (RRRs) of banks in order to stimulate economic growth in China. These measures are seen as supportive of financial markets, and have helped to ease debt servicing costs for Chinese companies where disinflationary pressures in prices are present. Most recently, the China Securities Regulatory Commission (CSRC) temporarily suspended Initial Public Offerings (IPOs) of companies in order to stabilise the falling equity market. Additionally, a total of 21 brokerages in China pooled together to form a RMB 120 billion stabilisation fund, which seeks to buy into the equity market should prices go below undesirable levels, in effect serving as a 'private-sector put' on A-Shares.
Panic Has Also Spread To Offshore Equities
While all of the above is happening to the A-Share market, the risk aversion and panic has also spread to the offshore equity market. The HSML 100 index has fallen more than -20.0% from its peak in late April to present (as of 7 July 2015), making year-to-date gains in the red (in local currency terms).
Chart 3: Offshore Chinese Equity Market Since January 2011
Given the bloodletting in Chinese equities, investors may be wondering how our Chinese equity funds have held up during this recent correction in the market. Most of our Chinese equity funds are predominantly invested in the H-Share market, with many fund managers already cautious on A-Shares long before the recent plunge. Some of them have also pared back on their A-Share exposure in 1Q 15, citing concerns like rapid increases of valuation multiples as well as increasing speculative activity by local investors. Many of them have held up decently, while the FSMI China Equity Index is still up about 7.3% year-to-date! (as of 6 July 2015)
Chart 4: Selected Chinese Equity Funds Year-To-Date
Chinese H Shares Remain A Buy!
While sentiment has changed (from optimism to panic), fundamentals have not swung and changed as much. We advise investors not to read too heavily into the headlines, and to take a step back and look at the market from a wider perspective and with the long-term investment horizon in mind. The -20% correction has only made the offshore Chinese equity market cheaper by sporting more attractive valuations than before. Additionally, the A-Share market is still trading at a premium relative to its H-Share counterpart despite the recent rout in A-Shares, as shown in Chart 5 below.
Chart 5: H-Shares Still At Discount Relative To A-Shares
As of the time of writing, the HSML 100 index currently trades at an estimated PE ratio of 9.3X for 2015 and 8.3X for 2016, way below its fair PE ratio of 13.0X. We remain optimistic on the prospects of the Chinese equity market, with the H-Share market sporting one of the highest potential upside among the various markets under our coverage – we thus maintain our 5.0 Stars – “Very Attractive” rating on China.
Chart 6: Valuations Remain Compelling
In the near term, and certainly over the next few days or weeks, volatility is still expected to remain high. However, history has taught us that the best time to buy is when fear and panic grips markets while fundamentals remain stable – with panic and fear clearly evident and in abundant supply right now coupled with the investment thesis for Chinese equities remaining unchanged, the current correction in Chinese equities could prove to be an opportunity for those who dare!