In last month’s Equity Insight we warned of the risks of the Chinese equity bubble imploding but we have to admit it all played out more quickly than even we thought.
Despite the severe correction, many of the concerns we had a month ago have not gone away completely (see figure 1). Valuations, as an example, remain stretched in some parts of the market and just as the building of a bubble can take prices far beyond fair value, a bursting bubble can easily see prices overshoot in the opposite direction. With forced selling driving much of the price action, calling a trough is a dangerous game we would rather avoid playing.
Now that the bubble has burst, the more important question from a global investor’s perspective becomes whether the sell-off in Chinese equities can have wider implications for other assets around the world. In short, we think contagion beyond China’s borders is unlikely. A shares are dominated by domestic retail investors, who account for around 25% of A share market cap ownership, the majority of increased leverage and more than 80% of trading volumes. While painful for these investors, the fact that they have extremely limited access to overseas equity markets suggests the potential for liquid foreign shares being sold to meet domestic margin calls is very limited.
Foreign investors are equally unlikely to become forced sellers of international equities as they never meaningfully participated in the Chinese bubble in the first place. Access to A share markets has been extremely limited and, even with the new Stock Connect programme, northbound flows have only accounted for around 1% of Shanghai A share trading volumes. Another argument against contagion is that there has never been any correlation of Chinese equities with markets outside China; what happened in Chinese equities stayed in Chinese equities. The correlation of the Shanghai Composite with the S&P 500 — but also of regional markets across Asia — has been zero on the way up and stayed zero on the way down (see figure 2). This behaviour is consistent with the fundamental arguments above.
Global investors do hold investment in the Chinese offshore bond markets. Prices in that market are somewhat weaker since the start of the stock market sell-off but nothing dramatic. At the moment, the contagion outside China is visible in some China-related trades like the Australian dollar and commodity-related assets and currencies. The correction in some of these asset prices, like oil, has been considerable but not only due to China and there is no sign of general market stress or outright panic in our view.
It’s also worth remembering that, despite the 33% drop since mid June, Shanghai A shares are only back to where they were in mid March and remain 80% above year ago levels. With leverage having increased in the later stages of the rally, many investors will have large net losses but there will also be some investors who remain materially better off than they were a year ago.
The impact of the fall in equity prices on Chinese economic growth is unlikely to be very large. The historical correlation between the stock market and the economy is weak. While the share of Chinese households who own equity has been rising, it is still a lot lower than in major advanced economies. Household balance sheets remain strong and the savings ratio is high, providing scope to limit the impact of asset price shocks on consumer spending. The scale of funding to the real economy accounted for by equity issuance is very small in comparison to credit flows. Confidence effects could be significant given the pace of the recent falls, but the Chinese authorities retain significant policy levers to support growth.
The rapid expansion in credit since 2008 has left China’s economy vulnerable to deleveraging pressures and investors need to be aware of the systemic risks that these bring. Extreme equity price volatility does not help the authorities’ capacity to manage these deleveraging pressures and avoid a hard landing. But, at the moment, we think that the deflation of the stock market excesses doesn’t substantially impact the other parts of the economy.
There is, of course, always a possibility that we are wrong. One of the bears’ concerns is that the lack of market response to the government’s intervention to support equity prices shows investors are losing faith in the government ‘put’ that has implicitly supported asset prices across China. This would be a profound change to the reaction function of Chinese investors.
But this is only one interpretation of the events of the past few days and, in our view, not the most likely. It seems more likely to us that in the midst of an imploding bubble the power of forced selling, deleveraging and margin calls has been far more powerful than the government’s initially hesitant attempts to stabilise the market. Given the track record of policymakers across the world in recent years, it seems premature and possibly dangerous to jump to the conclusion that this time is different.
More generally speaking, we do see China’s rapid expansion of credit as a potential area of global systemic risk. Hence the situation needs to be monitored very carefully as a potential tail risk event. This monitoring has become more intense as the stock market development makes the situation in China by definition more uncertain and fragile. Should a credit crisis emerge in China that would impair the banking sector to an extent that is no longer manageable by the central government – for instance as a result of defaults because of stock speculation – we would expect a serious impact on global risk assets and in investors’ portfolios. We would look for stress in the banking sector and in the housing market to understand whether this stock market deflation has ramifications in other parts of the economy. So far we do not see signs of elevated stress.
So, while we remain focused on the risks and possible avenues of contagion for other global assets, our base case is that the implosion of the bubble in parts of the Chinese equity market will not spill over into global asset markets. We have not materially changed our positions in response to events in Chinese equities. While any indiscriminate forced selling will ultimately create interesting opportunities, many of the risks highlighted in last month’s Equity Insight remain, so we would avoid the temptation to pick a trough and avoid catching a falling knife.