Summary Conclusion
China’s financial market’s problems are home grown. As such weakness caused in other markets, especially China shares listed in Hong Kong, is unjustified. China will take time to fix broken systems; but that shouldn’t blind investors to the opportunities fumbling is producing.
Preamble
Complete understanding, of any market, isn’t possible; the knowledge would be a philosopher’s stone. For all that we must try and form an understanding of, perhaps not the whole shebang but, at least as much as it is possible to get to grips with of China’s financial markets. The events of last week were unexpected and sent shock waves around the world. We should try now to get a bead on them and, in so doing, consider some possible consequences.
Note To CSRC: It’s The Currency, Stupids!
Before I go on it’s important to note last week’s stock market turmoil was not a bottom-up event. Nothing that occurred was in response to news that could seriously and/or suddenly affect the earnings power of corporate China. Last week’s moves were about that hardest of variables investors have to deal with; sentiment.
For some reason there was a collapse of investor nerve not only on Monday, January 4th but again on Thursday, January 7th. Sure, there was a weak Caixin/Markit PMI on Monday highlighting sluggish manufacturing growth, and another on Tuesday with similar downbeat news on the service sector; but these would have been unlikely to send morale so off a cliff? Last summer’s selling moratorium for large shareholders was due to unlock on Friday 8th; but this was hardly new information. Finally, the circuit breaker rules had been well telegraphed and I saw no comment ahead of Monday’s implementation to suggest these would be any kind of problem?
No, only one thing was happening that could have caused such a confidence-vacuum prior to Monday’s problems, and remained ongoing throughout the week; the Rmb was weakening, again.
Form
Scars are still fresh from last August when a managed 3% depreciation of the Rmb took place between August 10th and August 12th. The Shanghai Stock Exchange Composite Index then fell 25% from its 3, 928 August 10th close to a low, on August 26th, of 2, 927. A Pavlovian association therefore in the minds of investors, between currency and stock market weakness, can be forgiven.
Déjà Vu All Over Again
Throughout December the Rmb was falling and by the end of the month it had fallen nearly 2%. A stock market reaction was thus due with only issues of timing and magnitude moot.
As last week progressed the Rmb weakened further fanning a brush-fire of speculation as to why the government might be either managing or allowing it? This produced what, with 20-20 hindsight, was the obvious reaction that led to the second close of markets on Thursday.
Same-Same; But Very Different
The difference between the Rmb move last summer and the recent fall is an important one and explains why the market reaction was so violent. Unlike last August when the Rmb adjustment was planned the most recent move was not. This took the administration to a place the Party doubtless hates, and will never admit exists; Outer-Controlia.
If there was any doubt remarks from the Central Bank last Thursday ended it. Videlicet? “Some speculative forces are trying to reap gains from playing the renminbi..”. [Those trading activities] “..have nothing to do with [China’s] real economy..” [And have only caused] “..abnormal fluctuations..”, and “Faced with such speculative forces..” [The Central bank] “..has the ability to keep the yuan stable at a reasonable equilibrium.” [?!]
In English? We tried a little float, it’s scared the bejesus out of y’all, we’ll try and fix it. Oops. Oh and er, sorry?
The Sixty Four Thousand Yuan Question
Can it all now be ‘fixed’? There are two ‘its’ here. First, the currency; yes, that can be fixed.
A bit of background. Foreign exchange reserves fell last December by U$108bn, a record. They’ve also been falling steadily since peaking at U$3.99trn in June 2014 and fell for 13 of the subsequent 15-months; but the reserve pile is still U$3.33trn and was in need of a bit of a run-down anyhow. Why are operators shunning the Rmb in favor of the dollar? Grassy-Knollists have theories; but the main reason, I’d figure, is the simple and obvious one that explains why the world is accumulating dollars. Their value has risen, and is perceived to be still doing so.
How is the currency ‘fixed’? A three pronged solution is probably in the works. Strong words behind the scenes with SOEs with unnecessary or suspiciously large foreign currency balances, more direct intervention or its explicit threat and a clarification of how the new basket-float system is to be managed henceforth (announced in an editorial on the PBOC website on Friday, December 11th this new regime may be ground-zero for the convulsions since?).
That ought to put a floor on the currency and deal with the most urgent sentimental problem.
‘Fixing’ The Stock Market
‘Fix’ can have two meanings; to repair, or, to unfairly influence an outcome.
A repair is out of the question in the time required to restore spirits so the game will have to be fixed in terms of the other definition. This will be especially hard. The tumbrel is believed to be rolling around for CSRC chief Mr. Xiao Gang but his decapitation, should it take place, won’t fool anybody. China’s domestic stock markets are broken and this point is now so obvious I don’t need to digress into details here.
Moreover, their proper functioning seems to be so at odds with present policy, which has been to stress and progress tighter central control, a major initiative to cure ills seems most unlikely.
So? More restrictions on dealing, more public funds applied to prop-up already expensive stocks and more witch-hunts for those chimeric ‘speculative forces’. In all, a pretty yuk-tastic cocktail.
What Now? For the A-Share Markets..
These are likely to be heavily sedated by the cocktail described above. The authorities can have one of two things. A doped market with the appearance of stability but where volumes crater as investors, large and small, vote with their feet on the lack of transparency and fair play. Or, a lively one that clears, at lower levels, but from where sincere reform could produce lasting improvement to justify higher valuations.
Sadly, they’ll most likely pursue the first option. Good luck all; but that’s not a market that’ll merit serious consideration for a long time.
Hong Kong Sanity
Hong Kong, along it should be noted with the world’s other major stock markets, suffered collateral damage last week from China’s failure; but none of what ails China’s stock markets is found here.
Our jurisdiction has a clear exchange rate policy; we’re hard pegged, that’s it. Our IPO queue isn’t a product of political fiat; you meet our rules, you list, period. We don’t tolerate zombiecos (we give them too much room perhaps?); we delist all the time. We don’t tell large investors what they can and cannot do with their investments; are you kidding!? The Hong Kong Stock Exchange and our Securities and Futures Commission are largely open, transparent and accountable stewards. They could always do better but the fact remains they run a pretty respectable gig [To remind; we ran the biggest IPO show in the world here last year]. The Hong Kong stock market may be in China but it is, to date, refreshingly not of it.
What Now? For China Stocks Listed in Hong Kong..
Unlike northern cousins stocks in Hong Kong were cheap going into the New Year and, as a result of last week’s ructions, got a lot cheaper. How cheap? Depends whom you ask but my valuation North-Star is the earnings multiple of the Hang Seng China Enterprises Index (HSCEI). In mid-December the forward PER for the HSCEI was 6.6x, as of last Friday it had fallen to 6.2x, close to as low as it’s ever been.
Cheap is neither the necessary nor sufficient condition that tempts investors so predicting a sudden snap-back from present levels for Hong Kong stocks would be foolish. However, on any long-term consideration of value, Hong Kong listed China stocks are now unequivocally attractive.
In Conclusion
The fundamental reasons for investing in China stocks, earnings growth, valuation and uniqueness of opportunity haven’t altered in the last couple of weeks. The number of acceptable market places for capturing those opportunities though has reduced in number; perhaps to now just one?
The Keystone-Cop operators in China responsible for the confidence-crisis last week are unlikely to be replaced or alter behavior any time soon. Be that as it may, it’s important to remind ourselves the black-holes of policy, planning, intention and execution that’ve got investors so discombobulated recently are domestic problems.
China’s planners’ shortcomings therefore, as much as they affect asset prices outside the mainland, are presenting not threats to investors, but opportunities.