On Thursday, mainland Chinese shares managed to squeeze out modest gains even as the HSBC Manufacturing PMI printed in contraction territory [7] at 49.2, missing expectations and hitting its lowest level in a year. Of course, as we observed earlier [8], in an upside down world where NIRP means savers subsidize borrowers’ mortgages, bad news is good news, especially in China where each negative data point incrementally increases the odds that the PBoC will ease further (rate cut up next, then another RRR cut and then who knows, maybe we’ll get Chinese LTROs [9]), and so we suppose it’s only natural that stocks rise as signs of economic malaise multiply.
That said, on Wednesday we highlighted the fact that China faces competing mandates [10]. On the one hand, the country needs to deleverage as it’s currently trapped beneath some $28 trillion in debt, but on the other hand, supporting the economy at a time when pressure from a strong dollar and a move towards a service-based economy (not to mention an industrial production-sapping war on pollution) are hampering economic growth means keeping liquidity flowing.
This means that Beijing will often appear to be adopting inconsistent policies. For example, Reuters recently reported that the PBoC will streamline the process for ABS issuance meaning banks will be able to offload credit risk to investors and free up their balance sheets to make more loans (i.e. create more debt). Meanwhile, China is cracking down on margin lending in an effort to decrease the amount of risk embedded in the country’s leverage fueled equity rally. For their part, UBS believes China may have to go far further in terms of regulation if it hopes to cool a rally that’s being fed by the creation of more than 1.5 million new stock trading accounts every week. Here’s more via Bloomberg [11]:
As UBS Group AG strategist Lu Wenjie sees it, policy makers may add to existing interventions as soon as later this year. The Shanghai Composite Index’s 121 percent surge over the past 15 months isn’t justified by earnings prospects in an economy growing at the slowest pace since 2009, according to Lu.
“It’s absolutely possible we’ll see some draconian measures from the regulators,” he said in an interview in Hong Kong. “The pace of stock rally is too fast.”
While authorities have already placed curbs on margin trading and made it easier for short sellers to wager that stocks will fall, the measures have so far done little to slow the Shanghai.
Valuations: The price-to-earnings ratio of the Shanghai gauge has more than doubled from its low to 21.7 times earnings. That compares with an increase of 44 percent to 23.7 a decade ago.
Speaking of UBS strategist Lu Wenjie, in a recent note, the analyst says that although the bank isn’t yet ready to remove an overweight recommendation of Chinese equities (no one wants to step in front of a freight train driven by millions of semi-literate day traders), UBS isn’t under any illusion that the rally in Shanghai isn’t in part driven by the always dangerous intersection between Keynes’ “animal spirits” and a flood of liquidity.
Via UBS:
We've been overweight Chinese equities within APAC since mid-November. Recently however, economic data have continued to soften. Meanwhile, the A share equity rally looks to have spilled into the H share market. Can this equity rally keep going, especially if the economy remains weak?
We think so. Let's be clear, though. This rally is not being driven by improved growth expectations. The economy remains soft. Tao Wang, our head of China economics, thinks the weaker economy is likely to lead to further easing. We are expecting further rate cuts of 50bps: 25bps in Q2 and the rest some time in H2. Given the rise in credit in recent years, this would suggest a meaningful reduction in interest burden, which we think should continue to be powerful for the equity market.
In our view, the driver of this market is clearly liquidity. Easier monetary conditions seem to have supported the rally in the A share market. In recent weeks, this has spilled into the H share market. Generally, we believe what causes liquidity rallies to end is when policy shifts. That seems some way off to us – especially if our view of further rate cuts plays out.
What has become trickier, in our view – especially for fundamental investors – is that this liquidity has become entwined with what John Maynard Keynes identified as "animal spirits". Animal spirits are almost always harder to read. Historically in China, whether in the property market or A share market, the government has considered measures to temper animal spirits when they may be regarded as getting out of hand. While there has been some noise around leverage, we haven't seen much – yet – that would suggest the authorities are deeply uncomfortable with the direction of the equity market.
In our view, the challenge with almost all retail-driven liquidity rallies (like this one) is that they generally don't abide by the more fundamental rules we follow…
In our view, however, the dominant driver of this rally is not those 'fundamentals'. It is liquidity, interacting with animal spirits. Here, easier policy doesn't seem over yet; and while there have been some comments from regulators about the A share rally, we think they look unlikely to curtail retail investor interest just yet.
Presented once again with little comment other than to say that this is the one chart you need to show anyone who tells you Chinese equities are not in a bubble:
[12]
