Regardless
of your investment horizons in China, there's no avoiding the fact that its
equity markets suffered a major setback over the past month. Declining more
than 30 percent in just 17 sessions, the move was even more extreme than we had previously suspected in our most recent note on China in June (see Here). Is it a pulled hamstring from the quick sprint - or a heart attack
- remains the overarching question for investors and traders alike.
Granted,
"setback" is a matter of perspective, considering the magnitude of
the move over the past year which saw the Shanghai Composite reach a high on
June 12 of 5166 - more than 150 percent above it's close from a year earlier.
Taking into account that many of the most vocal bears on China were calling for
a crash when the index was flirting ~ 2000 last year, their triumphant refrains
over the past few weeks ring as hollow as their would-be returns - should they
have followed their own advice.
In
classic proof by assertion delivery, these very same pandas have now
moved their goalposts and downside targets on the Shanghai up to a hopeful
return to ~2000 - the same level previously believed would be the start of the
downside denouement for the index as well as the beginning of the end of the
great reckoning and rebalancing for China's economy.
Nevertheless,
misery loves company - and the breakdown in China's equity markets has captivated the comparative imaginations in the financial media, which was
largely already primed for disaster as the Shanghai Composite defied downside
expectations over the past year - much to the dismay of the hungry
pandas.
Greasing
the wheels of the story has been the heavy handed actions on the part of
Chinese authorities, who just last week suspended the sale of nearly half of
the A share listings after the index lost traction and more than a quarter of its value
since setting a high on June 12.
So - was it a pulled hamstring, a minor flesh wound or something much more
serious?
Although
some pundits and analysts find parallels with the severe US equity market
declines in 1929 or 2008, we believe it's a more benign consequence of China's extreme
outperformance, per se - closer to the likes of the severe retracement
decline in the Nikkei in May 2013, rather than an early indication suggestive of
much greater hardships ahead for China's equity markets and economy.
While
there's certainly enough causal concern for the perennial pandas to hang their
bearish outlooks from, we maintain our long-standing belief that the market -
as removed as it became from China's underlying economy, had traveled more than
enough road over the past decade to largely discount these conditions and
whittle down the actual bubble valuations reached at its peak in 2007.
Per
Meb Faber
- the ever erudite global market surveyor, China's CAPE ratio has returned to ~
15, significantly below its peak of 62 in October 2007 - and modestly above the
level (12) reached at its trough in December 2013. Despite the greater
cynicisms held towards China's equity markets and its regulating authorities
today, we view them - just as the Party clearly does - as a prospective wealth
transmission mechanism, as its economy matures and transitions from being
driven primarily by construction and production enterprise - to greater
domestic consumption.
Prospective, because although the media has remained fixated on how many
retail accounts were opened in China over the past year, retail traders represent just 4 percent of the total population and stocks currently
account for less than 15 percent of all household assets. While in the
short-term a continued market decline may lead to painful losses for the
retail-come-lately crowd, total margin positions are equal to only 3 percent of
total household bank deposits. Seemingly lost in translation is the
paradoxical fact that although the Chinese are widely viewed as avid
speculators - they are among the worlds greatest savers with a stash of cash
worth nearly 50 percent of
China's GDP. Comparatively speaking, the US holds less than half -
coming in last year ~ 17 percent of its GDP.
Although
certainly more nuanced when you consider the significant income disparity
that exists throughout China, the greater takeaway - with respect to the
current correction and future prospects for their markets - is that a majority
of the population has yet to materially invest or feel the broader wealth
effect from either side of the tape. The reality is that China's equity markets
are quite young by global standards, resuming trading only 25 years ago after
being closed for decades by the Communist revolution. Often viewed as the
speculative wild west of emerging markets, they will increasingly exert a
broader reach if the government succeeds at transitioning the
economy to a more mature footing - without a prolonged economic contraction and
market meltdown.
Here
lies the crux of China's variant perspectives today.
What
the pandas are largely betting against - again, is that the new
reforms brought forth by President Xi Jinping in 2013 is broadly failing - and
that real structural economic improvements will only take place after a painful
cyclical slowdown is digested. From their perspective, what the equity market
crash exposes is the dangerous topical and speculative nature now prevalent in
China, which had largely diverged from its dour economic underpinnings.
Moreover, any attempts to conspicuously support or stabilize their equity markets
is an act of futility, as market forces will inevitably exert a much greater
influence in the face of economic weakness.
From
our perspective, what these pandas fail to concede is that 1) China isn't a
western economy - it is still very much a hybrid system where the state holds
disproportionate influence over the private sector, and 2) they have the
resources and deep pockets to instigate support where they see fit.
Although
western ideals of free-market capitalism will invariably denounce China's heavy-handed
efforts of late; the validity of their economic data or the efficacies of Xi
Jinping's new governance platform - the same criticisms in varying
circumstances have been made since they initially embarked on their historic
reforms nearly four decades ago.
Admittedly,
it's still too early to determine whether China can successfully titrate the
next steps and maintain its relatively high level of economic growth, while
reforming its economy; we do, however, defer to their long track record of
exceeding catastrophic expectations - which to a large degree has been
sustained by China's uniquely powerful monetary and fiscal policy flexibility.
Over
the past few years we've followed a comparative blueprint for the Shanghai
Composite: the S&P 500's consolidation breakout from the secular low in
1982. And although the index got ahead of itself and filled out the proportions
of the pattern quicker than expected, the retracement from the performance
extreme has now tested and bounced hard from the breakout level this past March. All
things considered, we maintain our expectations that a secular move higher for
the index is still underway, from the consolidation breakout last year.
In hindsight, the breakdown in the Shanghai now resembles the initial break
in the Nikkei in May 2013 - subsequent to the rollout of Abenomics in Japan in
the fall of 2012. During that period, the Nikkei rallied nearly 90 percent in
less than 7 months, on the back of broad stimulus initiatives - before
eventually retracing 20 percent over just 16 sessions.
While
the short-term plight of China's equity markets is just an ancillary concern to their broader
reforms platform, by the Party's own public endorsement over the past year,
their stability is critical to wider participation and
support. Considering that similar skepticism was levied against the Fed's
extensive intervention in the markets during and subsequent to the financial
crisis or the Bank of Japan's enormous efforts over the past three years to
break its own deflationary quagmire - In an era where central banks have
increasingly played an overtly visible role in jockeying participants to the
field, we certainly don't underestimate the even greater capacity in China
to step in and shore up their own markets from what we
perceive is a more short-term consequence of extreme outperformance. In our
opinion, betting against that here is more of a fools wager - by hanging on to
a preconceived notion that China will eventually have its hard landing or 1929
market decline.
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For further reading on our thoughts on China this year, see:
