Chinese Equities are a Problem

In my opinion, the massive stock selling in China, which has garnered much less media attention than the Greek drama is the more serious situation. The People’s Bank of China have cut rates and lowered bank reserve requirements to provide support for the stock market that can’t seem to catch a bid.

For the past year, folks have been trading Chinese markets like day traders and the volatility is astonishing for a stock index. Both the Shanghai and Shenzhen stock exchanges more than doubled in a less than a year and both are now off their highs and in bear market territory in a blink of an eye. This precipitous sell-off is cause for concern and the speculative “risk-off” trading demeanor does have the potential to spread to other markets. That said, the Chinese regulators are throwing everything at the market in order to prove a floor.  Aside from the rates cuts and lowered reserve requirements, “The securities regulator relaxed rules on margin financing, making it easier for investors to borrow cash to buy shares and reducing pressure on brokers to call in collateral. The government announced that state pension funds would allocate more cash to the stockmarket. Official media, playing the cheerleader as ever, talked up blue-chip stocks. It did not work: rather than boosting confidence, the series of moves carried a whiff of desperation. The market tumbled nearly 10% on Thursday and Friday.”

But wait, there’s more. According to a Bloomberg report via Business Insider, “According to a Bloomberg report on Saturday, officials are suspending Initial Public Offerings (IPOs) – as many as 28 on the Shanghai and Shenzhen stock exchanges – to deal with the tumble in stocks. Stopping new companies from going public in IPOs may reduce the flow of cash from existing stocks, Bloomberg notes. There was no information on how long this ban would last.”

That should be enough to quell market jitters right?

Another recent report out of Business Insider, “China's top 21 securities brokerages said on Saturday that they would collectively invest at least 120 billion yuan ($19.3 billion to help stabilize the country's stock markets after a slump of nearly 30 percent since mid-June.”

Surely stepping up efforts to support the world’s second largest economy’s stock market from cratering is a noble effort. If the growth in China falters then there will be global repercussions and that could be the spark that ignites the coming market correction.

Now this morning in Business Insider I read, “But now Chinese companies have decided to take matters into their own hands and they just found a better and easier solution — suspend the company's stocks from being traded at all. According to China's official financial news outlet The Securities Times, picked up by the Financial Times and Reuters, more than 200 companies just suspended their shares. This brings the total amount of shares suspended to 651 since June 29, which is worth 23% of the 2,808 companies listed on the Shanghai and Shenzhen exchanges.”

Added to that, “According to Xinhua, a daily trading limit for the CSI 500 index will be effective from Tuesday, the latest action by China’s financial regulators to prevent more losses. Overnight China’s financial futures exchange said it would limit investors’ daily purchases of CSI 500 index futures to 1,200 lots for rise and fall.”

That makes sense. When trying to stop the stock market from selling-off…stop all the market participants from selling. Of all the central banking financial engineering that we have seen over the past several years, the actions taking place in China is the most astonishing display of moral hazard yet. The attempts to shackle the invisible hand are on full display and it is this humble investors opinion that all these efforts will fail. It would be an excellent lesson in macroeconomics if the world’s second largest economy didn’t face economic, financial and social upheaval.   

That said, we believe China offers wonderful long-term investment prospects. Admittedly it cannot sustain the published 7% to 8% economic growth over the long-term but a more moderate 3% to 4% for the Chinese economy is still impressive and worth looking at through all this near-term volatility and market turmoil.

For full disclosure, as part of our 3Q14 Global Equity Program rebalancing, we added the iShares China ETF (MCHI) to our managed accounts program near $46 per share. While the position is still up 15%, we are starting to question its value-add prospects to the portfolio. The position is very small relative to the program portfolio but it may not make the cut at the next rebalancing. When looking at the daily and weekly charts we find the ETF is sitting near critical levels and may be near-term over sold.

Bottom Line: The near-term prospects may provide a bounce in the ETF but ultimately we believe there is little centralized regulation can do to stem a market correction. More importantly is the long-term concerns on the economic and financial stability in China. As such a key driver of global economic growth, a major economic, financial and social upheaval in China is enough to start the correction in U.S. equities that so many are talking about.

 

 

 

 

Joseph S. Kalinowski, CFA

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