On Friday, Shanghai-listed shares rose to their highest levels [14] since 2008.
The inexorable, self-feeding rally in Chinese stocks has recently been characterized by wild intraday swings. Take Thursday for instance, when a move by Golden Sun Securities to curb margin trading triggered panic selling, sending shares lower by more than 5% before the momentum abruptly shifted, and just like that, a straight-line, limit-up frenzied buying spree helped benchmark indices close green on the session.
This volatlity is spilling over into Hong Kong, which has in turn prompted officials to consider implementing a "cooling off period", designed to calm traders down after the types of violent swings that are becoming commonplace as the rally continues. Here's more via Bloomberg [16]:
The manic trading that makes China the world’s most volatile stock market is seeping across the border into Hong Kong.
Swings in the 10 Hong Kong shares most traded by mainland investors over the city’s exchange link more than tripled in April, increasing at almost twice the rate as the benchmark Hang Seng Index. Last month, volatility in the most-active link shares, including Hanergy Thin Film Power Group Ltd. and Evergrande Real Estate Group Ltd., was little changed on average even as fluctuations in the Hang Seng shrank 30 percent.
Chinese investors are gaining unprecedented freedom to bring their own brand of trading to overseas markets as the government eases capital controls to promote international use of the yuan.
The seven-month-old exchange link with Hong Kong lets them buy a net 10.5 billion yuan ($1.4 billion) of shares in the former British colony each day. Authorities will soon let some wealthy individuals buy international shares and other assets under the so-called QDII2 program, China’s Securities Times reported last week.
In Hong Kong, “I have people telling me now that they’re concerned about this volatility,” said Herald van der Linde, the head of Asia-Pacific equity strategy at HSBC Holdings Plc. “It becomes a little bit more like mainland China.”
Hong Kong’s bourse is considering changes to its trading rules that would give investors a “cooling-off period,” limiting trades to a fixed range for five minutes whenever a stock price spikes more than 10 percent. The exchange currently has no limits on intraday swings and mainland bourses cap daily moves at 10 percent.
China’s world-beating rally has been driven by a dangerous combination of margin debt and unprecedented growth in new stock trading accounts.
Shares have also gotten a boost from the relaxation of trading restrictions and indeed, the quota on the Shanghai-Hong Kong connect is set to be abolished later this year, once a similar link is established between Hong Kong and the Shenzhen Comp.
Still other factors have added fuel to the fire, including a new “mutual fund recognition [17]” scheme that will facilitate cross-border mutual fund flows and, importantly, the inclusion [18] of Chinese A shares in two transitional FTSE Russell indices, one of which will serve as the new benchmark for Vanguard’s $69 billion EM Index fund.
As you can see from the above, there are plenty of catalysts to drive shares ever higher, making the situation still more precarious with each passing day of trading.
Back in March, BNP gave up [20] on trying to predict what happens when record margin debt collides head-on with millions of newly-minted, semi-literate day traders. “What happens next,” the bank wrote, “is clearly an unknown-unknown.”
Despite the uncertainty inherent in trying to call blow-off tops, BNP is out with a new note on China’s equity “bubble trouble.”
Via BNP:
China’s A-share markets continue to climb into the stratosphere. At the time of writing, the Shanghai Composite was up by around 52% YTD and more than 140% y/y. The even frothier (though much smaller) Shenzhen Composite has soared by more than 115% YTD and 185% y/y. Chinese equities remain the best-performing asset on the planet by a wide margin. The scale and speed of these gains scream ‘speculative bubble’. The workhorse definition of a bubble is large and sustained asset-price movements that are unexplainable by fundamentals. For stock markets, ‘fundamentals’ are, of course, earnings. It is noticeable that the A-share surge has coincided with both steady downward revisions to GDP growth and flat to falling profits
Equity margin debt has soared by almost 3% of GDP since the A-share market began its dizzying run-up last summer. Now pushing towards 3.5% of GDP, China’s outstanding margin debt exceeds that of the US, which itself has hit record highs (Chart 3). In classic bubble fashion, the pace of increase in margin debt has also accelerated. Over the last two months, margin debt has expanded at an annualised clip of 6% of GDP.
Bubbles ultimately burst: they expand continuously, then pop. The extreme reliance on leverage of this A-share run further foreshadows this inevitability.. As the increased supply of margin debt has been the key driver, market sensitivity to any restriction in its continued growth would cause an abrupt and most likely cascading price reaction.
And just as we said on Thursday, the inclusion of mainland shares in global EM benchmark indices could indeed prolong the bubble.
How long the bubble can continue to inflate is the key question – but necessarily unanswerable. Inherently irrational, bubbles usually last longer than expected. Recent academic literature has emphasised the strong growth in global financial assets and associated buying power of institutional asset managers. Momentum buying reinforced by market-capitalisation benchmark weightings could further inflate the bubble. In particular, imminent decisions on the inclusion of A-shares in global equity indices might see strong institutional buying buttress the retail mania for a time. Still, the exponential trends in turnover, margin debt and increasingly valuations imply that a climax is now unlikely to be too far away. The Shenzhen Composite’s P/E ratio is now over 66x (with a median P/E of 108x), compared with the 75.8x P/E at the 2008 bubble peak.
Recall also, that when the PBoC implemented its second YTD RRR cut in April we said the following [22] about the country’s equity bubble:
In other words, the Chinese market may be "red hot", but please don't stop making it even redder. Because as long as China is unable to halt its housing hard-landing, it will gladly take an equity bubble in lieu of a housing bubble if that helps preserve the people's wealth (the problem being that in China only 25% of household assets are in financial products - 75% is in real estate, something which as we showed before is inverted in the US).
This is echoed by BNP:
The good news is that the inevitable bursting of the bubble is unlikely to have too pronounced a macroeconomic impact. Equity bubbles are less pernicious than credit and housing bubbles, where fixed liability and long duration ensure a much longer-lasting fallout. The bad news, of course, is that China is already labouring under the influence of an epic housing and credit market bubble, which has only just begun to deflate. A desire to mitigate the impact of that bubble is a key reason why the Chinese authorities have been so prepared to cheerlead and sustain the A-share surge through regulatory support. Clearly, a sharp pull-back in equity prices would partially reverse the aggressive loosening of financial conditions in the last few months that is showing signs of helping stabilise the economy in the near term.
As suggested above, there are quite a few incentives for Beijing to do everything in its power to keep the music playing for as long as possible. Economc growth is decelerating, the government's move to rein in shadow banking [23] has curtailed credit creation, the real estate bubble is bursting, and the country's economy is weighed down by $28 trillion in debt [24], making credit expansion efforts extraordinarily risky especially considering the alarming rate [25] at which NPLs are rising.
In other words, China needs a distraction. The country needs its equity bubble.
And while BNP may be correct to suggest that a Chinese stock market crash may not trigger an macro-catastrophe, investors would still be wise to remember that the more spectacular the boom, the more painful the inevitable bust.



