China wobbling - can global party continue?
Brian Dennehy
“China’s bubble burst”?
This was the headline in The Independent on 23rd April 2008. The MSCI China index fell by 70% from peak (October 2007) to trough (October 2008). Another much watched China index, the Shanghai Composite, took just two years to rise 500% from 1000 to 6000, and in one year from October 2007 it lost a little over 70%.
Are we about to see a re-run?
The MSCI China index has more than doubled from its lows in October, and after falls in recent days (a fall of more than 5% in a day is common) investors are jittery.
Markets are driven by confidence, and the twin pillars of confidence now are the vast sums of cash injected into the global economy by Governments, and hopes of economic recovery. China has benefited from more cash than most, and economies awash with liquidity run the risk of markets driving much higher than the outlook can justify.
The stock market
The Chinese market, in common with many emerging markets, depends more on retail investors than more mature stock markets, which makes it twitchy and prone to over-reaction. For example, 57% of investors in the Shanghai index are retail investors, compared 20% in the US. Surveys in 2008 also suggested 65% of investors hold only between one and three shareholdings – further adding to investor risk and market volatility.
The Chinese stock markets are not cheap on fundamental criteria, but nor do they appear so expensive that you should panic. For example William Fong, manager of Baring China, suggests that the price earnings ratio based on next years earnings is acceptable now (at 14-15) but would look toppy nearer 17-18, suggesting 20% of upside from where we are now (on the MSCI China index).
To identify periods of extreme over-valuation, one of our favourite, and most successful, indicators since the 1980s has been the gap between any stock market index and its long term average – for example, for many indices moving 20% above that long term average is a good early warning sign, though each market is a bit different. By October 2007 the Chinese stock market was more than 50% above its long term average, which was extraordinary, and confirms our belief that this market is prone to over-reaction and that this will continue for years. Once it began to fall it did what we have observed many times over many years – it fell right back to the point from which the almost vertical trajectory began (plummeting 70% to get there).
Right now, following its recovery since November 2008, it is riding 40% above the long term average – extended by normal standards, but China is not normal. The falls in recent days could simply be a punctuation in a bull trend which has a few months to run, similar to 2007, and driven by excess liquidity – but our “gap” measurement gives a clear warning that the best has probably been seen, and you should stay very alert.
We are also being told that while global funds were piling into the Chinese market in July, domestic buying was limited. As is often the case, it appears foreign investors are late to the party.
The economy, short term
When someone pressed the “off” button for the global economy in October 2008, there was a collapse in Chinese export volumes, which had previously accounted for one-third of their success story, and there was also slump in domestic demand (as large numbers of local businesses and workers depended on healthy export demand).
On the face of it China either had to find a new export market for its products (which wouldn’t happen quickly) or encourage demand from within.
The latter has been key and their stimulus package is by far the largest of any country as a share of GDP. The country’s administrators have shown “remarkable dexterity” according to Douglas Turnbull, manager of Neptune China. As well as $585bn directed to infrastructure projects, key industries benefited from tax rebates, interest rates have been kept low, and there has been an unprecedented increase in bank lending. Healthcare reforms are also in the pipeline, a vital issue in the long run for generating much higher levels of consumer spending.
There is a savings rate of 50-60% in China, and the Government needs more of this to be spent. As a result they plan to introduce a social security net, with basic medical insurance being extended to 90% of the population by 2011. But it is not clear this will have a notable or quick impact. Time will tell.
In the meantime the Chinese economy is even more lop-sided than when it relied heavily on exports. In the first half of 2009 surging investment (particularly into infrastructure) accounted for 88% of Chinese GDP growth, double the norm; there are issues about the quality of Government-directed bank lending; and the Government has recently been concerned about its own stimulus package pushing up asset prices rather than bolstering the real economy.
There are certainly sufficient issues here to trigger a sharp pullback in the bull trend of the stock market.
The long view
Taking a long view there are grounds to believe the Chinese stock market is in its relative infancy; its weight in global terms is about 2% though China represents about 10% of global GDP.
If you compare Chinese stock market progress with the Japan market from 1959-1989, it does appear that the Chinese market has a long way to go. In 30 years of rapid economic growth, the Japanese stock market rose over 40 times.
As a more basic indicator of the economy’s potential consider that China has only 0.6km of railway per person, against 9.3km for car-loving America, we are told by Credit Suisse.
It is not a perfect picture. It is an ageing society as a result of the one child policy, and as well as supporting more pensioners there is a need to develop the healthcare system.
Yet the Chinese Government has shown determination and flexibility over an extended period. As one economist put it “Since 1978 I cannot think of any major mistakes that they have made economically”, perhaps making the Chinese authorities unique in a global context.
In conclusion on China investing:
- in the short term stay nervous by all means, it will keep you on your toes – but don’t panic
- do take profits, and consider leaving some money on the table if you’re brave
- long term investors should continue to accumulate through monthly savings; periods of falling prices will work in your favour
There is a separate and arguably more important issue - can the global stock market rally continue if the Chinese stock market collapses? We will cover this in another note shortly.
Date: 20.08.2009