2015, Mid-Year Market Outlook - CHINA & Asia

PART THREE

Market Drivers: An In-Depth View

with June 30th update on Shanghai stock market correction.

For Asia Pacific Region

Realities: OVERVIEW


The ‘Asia of Today’ is better positioned than in 2008, or 1997, though the growth momentum varies from country to country: 

Japan’s economy has finally turned a curve and produces respectable returns. North Asia benefits from tech boom that is still a major driver globally. India undertakes challenging new reforms proposed by the new pro-business government under President Narendra Modi. South East Asia exhibits mixed fortunes, as a multitude of different challenges impact on these economies. 

The key to growth and investment momentum is a flourishing Middle Class consuming boisterously. This has led to an upsurge in house prices, which is often the top priority asset for investors.  Many governments count on this local demand to offset falling demand from abroad. 

Low oil prices make life easier for oil consuming countries, but they hurt producers. More expensive imports hit the trade balances of countries like Malaysia, and loss of income from oil weakens the Malaysian Ringgit. Inflation, notably in food prices, has become a growing worry in emerging economies.

Three Main “Asian Players” in 2014


  1. China, aims to “slow” economy to 7% in 2015. The slowdown scares foreign governments but its leaders are quite happy – and on the ball.
  2. India’s economy is growing at 5.5% per annum [February 2015], but it wants more, - with lower inflation.  
  3. Japan: in 2014, its GDP grew a slow 0.5%. Hurt by sales tax hike, sales dropped initially, but confidence is returning. The data in 2015 suggests that the economy is improving still, company earnings are strong, and liabilities are in check, though not declining.



China – it’s happening now!!

The realities of China are an almost legendary story:
1.35 billion people, a consumer market worth trillions of $$$, growing according to a predictable, planned economy, offering a long term vision that can be relied on. Its leadership is home-grown, navigates difficult times rather efficiently, while learning rapidly, not just from past mistakes. 

China has acquired a strong sense of achievement, growing power and influence on the world stage. With this came improved business acumen, corporate knowhow and fiscal skills, transparency & corporate governance, as they adopt and work toward Western standards.

Chinese leaders focus on economic, political & social reforms, an efficient banking system, and tidy credit facilities.  We have heard and seen the challenges it faces with respect to its climate and environmental issues. But we also learn that China takes on the most ambitious targets to clean up its records (last climate conference in Kyoto, December 2014).

There are some extra,very powerful factors, driving China's growth: 

  • Its affluent Middle Class, well known for consuming the majority of luxury goods from Europe, creating its own trends, and largely offsetting slack foreign demand. 
  • It also manages to assert its influence politically, economically, and militarily, in Asia, Africa, and South America, establishing, even redrawing boundaries, literally.  In this way it can secure resources & energy for its economy, while becoming a rich and generous benefactor to emerging nations, and even Europe. 
  • In April 2015, China announced the creation of the Asia Infrastructure Investment Bank (AIIB), involving 52 founding countries in Asia and Europe to rival the World Bank’s activities. Here we see China marking territory on a different, but equally important level for investors. 


The Chinese Reform Program

A new reform process began in 2013, under the new leader Li Keqiang, and is targeted for completion in 2020. One of the main sticky points is the prevalence of corruption. 

This is what Li Kequiang said in a speech, following his appointment:
 “When a snake bites his hand, the Chinese warrior will cut it off to save his body.” a metaphor paraphrasing a Chinese proverb. 
“It’s going to be tough.., painful…” 

Another crucial aim of the reforms is to tackle shadow credit culture. To prevent short term turmoil the government introduced new bank reforms and cut interest rates several times.  Still, it initially led to an (orchestrated?) credit squeeze, which hit property sales, finally cooling down the overheated property market. Industrial production levels decreased and lavish spending habits came under the scrutiny by the politburo as the anti-corruption drive began to bite.

The OECD published an article, “Structural reforms for inclusive growth” commenting on the Chinese reform efforts. Here are some quotes:
“Manage rural-to-urban migration in context of an ageing population”; “Urban and rural regions are expected to grow simultaneously and in equal measures”, to avoid social unrest. It also acknowledged that “Battling pollution is harder in a fast growing economy”.

Equal Incomes for all in China?

The “Gini coefficient”, an income equality indicator, measuring income inequality among the population, is “on the mend”, according to OECD. In response, China’s leadership reiterated that achieving equal income distribution among its people “a long-term goal”, it plans to achieve.

 “Shanghai – Hong Kong Connect”

Connecting Shanghai and Hong Kong ,
source: Google Maps
Announced in spring 2014, and launched on November 17, 2014, this new measure is arguably the most exciting event for foreign investors so far, courtesy of the Chinese leadership . By issuing RQFII, which stands for “Renmimbi Qualifying Foreign Institutional Investor” quota, foreign investors and institutions can directly buy the so-called ‘A’ shares, which are traded on the stock exchange of Shanghai, the SSE Composite.  Though the access remains limited (it is a set quota, not a free for all…), the benefits for the stock investors of the SSE Composite have been swift and highly exciting. 

Demand remains high as global indices across the world are amended to include many new China shares in their allocation.  Consequently, many institutions will be obliged to acquire China shares to be in line with the new allocation rules of the indices.

Chinese Mainland Investors are also benefitting: they can buy an extended range of investable assets through the Hang Seng (the Hong Kong Stock Exchange).  I believe that it will be a perfect conduit for the issuance of Chinese corporate bonds as upgrades will almost certainly follow. Over the medium term, it could also influence certain asset classes on a global basis. 

The Shanghai-Hong Kong Effect on Stocks

Since April ‘14, the Shanghai index rallied 60% (February 2014). Hang Seng did not! Following the announcement, the SSE experienced an early arbitrary value adjustment, which was missed by most foreign China funds, simply because they did not have any RQFII quota. Indeed, new RQFIIs can’t come soon enough! In the meantime, shares of Taiwan companies and overseas China stocks benefitted (and continue to do so), as investors pile in in anticipation.


Shanghai Index Chart, from 2009 to 2015


After the GLC, the SSE rallied enormously, reaching a peak in August 2009. Although economic growth remained strong, Shanghai stock values continued their downward trend for more than 4 years!

The RED trendline shows the strong momentum and only after successfully breaking it in 2014 did the markets turn up.  It was as if the flood gates were opened. 

... rising more than 60% in 7 months, but volumes started to drop from December 2014 onwards.  

Shanghai Index Chart over almost 2 years:
 UPDATE June 29th
In recent days, the SSE corrected sharply, yet – orderly. The index low today (June 29th, 2015) is almost the same as in May 2015. (see orange circle on the right.)

The big rally started in April 2013, reaching an interim peak in May 2014, mildly and briefly correcting. (See orrange circle in the middle). Thereafter it rose to reach a peak in mid-June! 

EVEN AT THIS EXTENDED STAGE, THE JUNE PEAK is still well below 2007 peak levels. So far, the index retraced 78.6% of the fall, measured from the all-time high of 6124, in October 2007, to 1800 in October 2008. The 76.8% Fibonacci level is famous for reversals if the advance stalls! And it did.


SSE COMPOSITE CORRECTION SINCE MID-JUNE

The SSE corrected in an impulsive move accompanied by huge volumes. It retraced almost half the initial advance (50% Fibonacci level - see the fat red linefrom April 2014. This is an ambiguous level for future moves: if you are in, stay in, if you are out, wait for a clear move...

In the last few months, the Shanghai Stock Exchange trading system buckled: It was unable to record all the trades! In other words, the exchange is not ready to trade the kind of volumes investors are going to produce in the future. It is in dire need to update its system (Reuters report of April 15, 2015). "Recent volumes in the SSE now surpass the volumes traded daily at the New York Stock Exchange and the NASDAQ." 

I am tempted to say that the recent correction does not show the whole picture. While looking for greater insight I received mail from APS.

Comments by APS CIO

The CIO of APS Asset Management, Singapore, Wong Kok Hoi, shared some precious details about the rally and the reasons for the present correction. His comments are classified as "for professional advisors only". That is what happens. Just don't let the public know... at least, that is what regulators insist on!

He describes the main drivers for the original rally as 

  • (i) economic reforms, corporate restructuring, deregulation, lower business costs thanks to tough anti-graft measures, 
  • (ii) declining interest rates and 
  • (iii) ample liquidity.
He also states that the above drivers remain in place! 


As for the correction..

  • ".. indiscriminate selling", but "biggest losses in mid- to micro caps". "the bear market is here for small caps and for the rest of 2015." (I would not be quite so bold as to write this asset class off completely, but I acknowledge the emphasis on larger caps, going forward.)
  • "the [Chinese] government worried that unless the animal spirit of retail investors is tempered to some degree, this bull market would really spin out of control."  
So they interfered? How?
  • "...on Jan 19, the SSE COMP fell -7.7% DoD on rumours that the CSRC [China Securities Regulatory Commission] had issued sterner regulation pertaining to the size and duration of margin financing.
  • "Leverage amplifies price movements".  Curbing margin trading exacerbates price volatility.
  • "... CSRC and CBRC have stepped up checks on brokerages and banks"
That explains the trigger, - but the size of the June correction?
  • "Most of the selling came from forced margin selling!" 
That means, as the first stop loss is triggered, the selling pressure builds, and so the stop loss below is breached, and the next one below that, etc. each time accelerating into a downward spiral, until there are no more stop loss orders, - and no buyers left in the market. No buyers? Well, someone is going to be left with the assets that sold off rather hastily... 
  • The CIO's account of PE Ratios for small caps far exceeded that of large caps, hence the added selling focus on the small cap sector. 

So are we done yet with the correction? 

The CIO is anything but bearish: 
  • "Monetary and fiscal policy [remain] supportive." [four cuts in interest rates over the last nine months]
  • "...structural reforms are put into place and begin to bear fruit"
  • "..., we expect a multi-year rerating to occur", meaning, company earnings will improve based on fundamental factors rather than speculative exuberance. 
Fund managers may be accused of doing a marketing spiel so that you and I, the punters will buy.  But this information is not directed at the man in the street.  And my own research very much supports his views, which is why I happily endorse his concluding comments. 


Final Word on the Correction

The idea that this is the start of a more painful, longer lasting correction is misplaced. The band wagon may have been rolling for some time, but many investors have yet to get on. More buyers, enticed by the promise of good fortune, will restart the enthusiasm. Soon, the second round of rally will start.  When it does, make sure, you are buying the right fund, with the right mix of ‘A’ / ‘H’ and other China shares. There are many more choices opening up.

Chinese Fund Performance

Most of the China funds registered outside of Mainland China, have yet to participate in the great surge engulfing the SSE. This is clearly visible in the performances they produced during that rally. 

Source: fundsupermart Singapore.
60% return in the Shanghai index translates into just 20% in China funds, registered in Singapore. That is a poor result, considering the opportunities.

I said in January, ...more upside potential for funds with access to Chinese mainland equities, medium term. However, the first impulsive rise - sharp and swift - may be over by the time, fund managers obtain their RQFII quotas and will start buying.  

It so happened. The peak came a couple of weeks ago, and since then the index has corrected by some 22%! How much did the funds lose? 

Well, the peak in fund values (SGD values!) was actually in late May. Since then it corrected about -10%. One could argue, what they did not gain on the up, they did not lose to the downside either.  But it certainly proves my point that China fund managers have yet to fully engage with the SSE Composite.  The correction may prove to be the right opportunity to do so. 

This you must accept: a lot of preparation and system upgrades are needed before the process of buying and selling in the new environment is perfected. Have patience (with your fund managers).

China’s Drawback Factors

Political errors in China are relatively seldom, and their vision far exceeds that of typical European or American politicians who tend to think from one election to the next only. We might see resistance for China’s military exploits, and any policy that seems to affront the “West”. But that will be resistance based on ideology and emotional dogmatism. Investors will be swayed by emotion more than sticking to the long-term growth story.

The most recent correction in the Chinese shares (and the SSE in particular) can partly be attributed to the huge profits investors may have accumulated since 2014. But it may also have to do with foreign investors worrying about – GREECE.  Strange that a small nation should hold the world stock markets to ransom, if only in the minds of some very big pocket investors.

China in 2015 - Expectations Summary

  • For too long (2010 to 2014, Mainland China equity prices had suffered a bear market, while in US and other markets, the bulls had been in charge. But they are now “catching up” to the rest of the world.
  • Rerating of banks and bonds a boon to Chinese equities. 
  • Buying fever spills over into Asia & beyond (that has yet to transpire…)

Bottom Line Advantages

  • A planned economy matters in terms of targeting an economic outcome, though the stock markets can drum a different beat.
  • A centralised command of economy, society and reforms is frowned on in many parts of the world, but one big advantage is that the results are more predictable. And thus, benefits will soon follow! 
  • China still is the world’s largest manufacturer: Local consumers make up shortfall in overseas demand. It also progressed to outsourcing production to lower labour cost countries like Vietnam. 
  • The Chinese government has ample foreign reserves, giving it plenty of scope to weather economic slowdowns, even storms. The one thing they want to avoid at all cost is the often predicted “hard landing” of its economy. 


updates in RED, June 29, 2015.

Click here for updates on India, 
Click here for updates on Japan
Click here for updates on Korea, Taiwan and South East Asia.

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