Participation in the Chinese stock market is driven mainly by retail investors, who have pushed prices up to extreme levels on borrowed money (ie. leveraged). Any exposure to Chinese equities we currently have in our portfolios is mainly through a diversified Asia ex Japan allocation. However this Chinese exposure is to the H-share market, which is trading near historical discounts to the A-share counterparts. Whilst our Risk Matrix flagged a warning in late June, it did not deteriorate enough to warrant a complete reduction in risky assets. However, we are closely watching to execute any necessary equity reduction when the time comes.
China has now replaced Greece, Oil, Russia and ________ (fill in the blank) with whatever you were worried about, as the top worry for many investors. We acknowledge that whilst the stock market rout in Shanghai gives us some cause for concern in terms of possible contagion to regional Asian markets, nothing has fundamentally changed from our last update. China is still coming to terms with an economic restructuring which has and will continue to impact global growth. The large Emerging Market economies and commodity producers will feel the pain for quite some time to come. Whereas the US, Japanese and European economies continue to report positive data which provides supporting reasons for investing in these regions.
Bet the House
One has to understand the structure of the local Chinese market as the reason for the sell-off. In the past, foreign investors who desired an allocation to Chinese companies could only access the Hong-Kong listed entities (H-shares). To buy into the RMB denominated A-shares in Shanghai, the Chinese government issued Qualified Foreign Institutional Investor licenses (“QFII”) selectively to large managers or institutions. As such, the onshore A-share market was the domain of retail Chinese investors, of whom made up more than 80% of trading volume. It was only in Nov 2014 when the Shanghai-Hong Kong Stock Connect scheme was launched, investors in Hong Kong and Shanghai were then able to trade on each other’s exchange. The slowdown of the Chinese property sector had also shifted local investor interest to the stock market (Fig 1).
Fig 1: Phenomenal Rise In New Brokerage Accounts From Mid-2014. More Than 80% of Investors in A-share are Retail.
Not only were local investors interested in making money from the stock market, they wanted to turbo-charge their earnings using leverage. Brokerage houses and banks were only too happy to lend to these investors given that the loan book growth suffered a slowdown as a result of the weak property sector. The rise in margin debt was in tandem with the number of stock accounts opened (Fig 2 & 3).
Fig 2: Astronomical Rise in Chinese Margin Debt Makes It Higher Than the US from a Debt/GDP Ratio
Fig 3: Record Growth in Margin Debt from the Middle of 2014
The performance of the A-share margin has a very high correlation to margin financing levels, which implies that the rise in the Shanghai Composite was driven mainly by retail investors, borrowing money to gamble and trying to make as much as they could (Fig 4). Fundamentally, when a market is driven by sentiment and where valuations do not matter to the investors holding on to the assets, then a large sell-off like what we have seen over the past two weeks is expected.
Fig 4: The Performance Of the A-share Market Has a Very Close Relationship to Margin Trading
Impact and Portfolio Positions
Fortunately, the wealth effect of the stock market rout does not have such a large bearing on the local investor as stocks only form less than 15% of an individual’s assets (Fig 5). In addition, whilst the stock market has fallen more than 30% from its peak, the majority of the investors are still in the black, given that the index has risen approximately 2.5 times from the middle of 2014. The majority of our portfolios hold some Asian positions, with any Chinese holdings limited only to the H-share listings of Chinese companies. Compared to their A-share counterparts, H-shares now trade at a significant discount (Fig 6). We are comfortable with the companies in our funds as they are well-run, cash flow generating corporations and we do not advocate cutting until our Risk Matrix signals a possible risk-off event.
Fig 5: Stock Holdings of an Average Chinese Household Do Not Form a Significant Portion of their Assets
Fig 6: A-Shares Now Trade at a Significant Premium to their H-Share Counterpart
Risk Matrix Signal
As for the Risk Matrix, it flashed an amber signal on 25 June, which we then executed some equity reductions for a limited number of strategies. We remain on watch in the event it turns red, which is when we will significantly reduce our equity positions for all our portfolios.
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