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LGT Beacon: Stock market earthquake in China

August 5, 2015

In recent weeks, China has experienced a stock market earthquake. While the domestic A-share market was suffering the most, the H-share market in Hong Kong which is freely accessible for international investors has also reported ample losses. However, other emerging markets let alone the global bull market have been only marginally shaken by the Chinese earthquake.

With losses of over 30% within a single month the Chinese mainland stock exchanges has dominated headlines in the financial press recently. Some market reports spread excessive panic, calling the recent market turmoil the beginning of the end of the Chinese economic miracle and warn about the spill over effects to global financial markets. However, it should not be forgotten that with a price increase of almost twelve percent the Chinese CSI 300 Index still belongs to the strongest stock markets globally this year despite the recent setbacks.

The myth of the wealth effect

The sudden market collapse was not the result of mounting economic concerns. The structural slowdown of China’s economy has been looming quite some time yet. However, this has not prevented the stock market to more than double within a year. The rally was driven by monetary easing, reforms and stock market speculation (as indicated by the increase in margin debt). Only the regulator’s announcement to limit the amount brokerages can lend for stock trading has ended the bull market and triggered a market tumble. Nevertheless, the fear that the real economy might be adversely affected by the stock market tumble seems exaggerated. The role of public stock markets for corporate financing or private investment is simply too small in China. Less than 10% of China’s total household savings are invested in equities. Thus, the argument that the wealth effect (which states that consumers spend less when their wealth decreases) will hit the real economy hard is not convincing. Accordingly, the growth forecasts for China had also not been upgraded in the first half of the year despite a spectacular stock market rally and the supposedly positive wealth effect.

China has still a lot of fire power

The Chinese government oversaw several steps to stem the selling frenzy, but the first measures have fizzled relatively quickly. How-ever, the institutions have enough fire power (also through unconventional measures) to provide the financial system with liquidity in the case of market distress due to defaults of margin debt. Critical analysts see the state intervention as a renunciation of the reform plans regarding the market liberalization. However, even in the supposedly liberal financial markets in Europe or the US market interventions are common. Of course, there the reasoning with price stability seems more traditional, but quantitative easing is manipulating long-term interest rates and hence indirectly also stock prices.

China’s stock market is an isolated bear cage

Most foreign investors are more concerned about the spill-over effects since their access to the mainland stock market is very limited. It is not surprising, that the so-called H-shares (which are freely tradable at the Hong Kong stock exchange) are adversely affected by the mainland stock slump. After all, these stocks are often issued by the same Chinese companies that also issue A-shares. However, the high trade barriers between the Hong Kong and the mainland exchanges prevent pure arbitrage opportunities. The mainland investors react more sensitively to Chinese economic policy. Accordingly, A-shares rallied much more during the last year when monetary easing was implemented. On the other hand, H-shares have suffered less from recent setbacks. Unlike the real economy, the Chinese stock markets is not of significant importance for global markets yet. Foreign participation on the mainland stock market is marginal, suggesting contagion through this channel is unlikely. Under the realistic assumption that the price decline does not lead to a financial crisis or an abrupt economic downturn in China, the spill-over effect to the rest of the world is very limited with the exception of the Hong Kong based H-shares. And the latter offer attractive valuations since they are still traded with a discount of 38% versus A-shares.

Read about the resulting investment positioning changes in our portfolios in the LGT Beacon below. To subscribe to a weekly newsletter, click on "Abo".
Note: The next LGT Beacon will be published on 12 August 2015.

LGT Beacon 08/05/2015 (pdf)

From: LGT Beacon Abo