We are witnessing the emergence of a new consumption culture. The proportion of the population born after the Deng Xiaoping era has just reached the tipping point: it accounted for more than half of the population in 2015. Their ranks should grow to two-thirds in five years and their consumption behaviour is reshaping China’s political, economic, business and social landscapes. This generation, born in the 1980s and later, grew up at a time of unprecedented stability and relative prosperity, so they have the confidence and money to spend on their own wellbeing, personal fulfillment and entertainment. They are starkly unlike their forebears who were frugal, often through necessity.
As a vibrant emerging economy, China is undoubtedly a challenging market to explore. Investing in China not only requires research capabilities and experience, but also a nimble mind on policy movements. It also necessitates a thorough understanding of the true nature of China’s investors. According to a report from China Securities and Deposit Clearing (CSDC), more than 95% of investors are individuals. The profile of individual investors in China is often correlated with a greater sensitivity to information and less tolerance of volatility. Any piece of news, confirmed or unconfirmed, can cause a sharp and significant impact on market participants’ behaviour. What happened in 2015 and 2016 was a typical example of the speed at which Chinese markets can move.
2015 will remain unforgettable for most investors. The Chinese stock market experienced two steep moves – one breathtaking bull run followed by a dramatic free fall in June. For the record, from July 2014 to June 2015, the Shanghai Composite Index increased by more than 130%, a trend that had been long-awaited by market participants. In the early days, people thought it was simply too good to be true. However, once the momentum was confirmed in early 2015, the enthusiasm became quite unstoppable. No wonder investors were so thrilled after a five-year bear market. But from a macroeconomic point of view, there was no significant improvement in the underlying fundamentals. CPI was only around 1.5%, causing deflation concerns, and PPI had been negative since March 2012. Supply-side reform continued to add extra pressure on industrial and material sectors. The PMI hovered around 50, which was not yet a confirmation signal for any sort of recovery.
The situation prevailing in 2015 was negative for fundamental long-term investors and hurt investors’ confidence.
So, what was the driver? It is clear that excessive liquidity has always provided the "speculative fuel". Starting in late 2014, margin financing – using borrowed money to trade shares, was liberalised enabling traders to place even greater sums on the equity market. Increasing leverage soon became the main support for the market uptrend. The number of market participants also increased tremendously. According to the annual reports from the CSDC, the ratio of active trading accounts to total accounts was only 36.6% in 2013 and 42% in 2014. In 2015, the ratio quickly increased to 60% with the majority of these being individual investors.
However, fairy tales don’t last forever. The overheating trading behaviour and apparent denial of risk finally attracted the authorities’ attention and concern. A sudden tightening on margin financing was quickly announced in June, which instantly halted the craziness and resulted in a huge market sell-off. The Shanghai Composite Index lost 50% in just the next three months. But where there is a will to speculate, there is often a way. The more the markets plummeted, the hungrier investors became. In China, shorting equities is not yet permitted so index futures turned out to be the next best alternative. Alpha strategies (such as CTA) were the new target for profits. That again forced the authorities to take action by limiting daily allowable future orders from 100 to only 10. This eventually prompted markets to cool down while investors began to look for new opportunities.
Performance table – MSCI China A since 2001
What has changed in 2016
People often and rightly believe that investing in the stock market requires considerable professional knowledge and experience. Those who want to be long-term winners in China also need local knowledge and experience. The Chinese market is indeed volatile and full of uncertainty but never short of investment opportunities. Even though macroeconomic conditions are weaker than in the past, a hard landing is unlikely. After all, the current situation is a result of a raft of economic reforms, and it should not be interpreted as a fundamental slowdown in activity. In the past, secondary industries, especially the real estate sector, were the drivers of domestic growth. Now the ongoing reform is meant to enhance the contribution from the tertiary industry. According to the statement accompanying the 13th five-year plan, China aims to double its 2010 GDP and per capita income of both urban and rural residents by 2020. As a result, it could ensure a more balanced, inclusive and sustainable development.
Within those reforms, the “new economy” investment cases are emerging as key investment targets for long-term investors. Among others, compelling investment ideas are emerging from national defence, aerospace, the new-energy motor sector, medical services, information, intelligence concepts, and technology, media and telecom (TMT). Basically, those are the sectors highlighted in the 12th and 13th five-year plans. Even though some of these concepts are already quite mature in Western countries, this is not yet the case in China.
Chinese equity markets are likely to be volatile in the short run but should gradually resume a normal trend thanks to the winners in the new economy. The lack of confidence amongst market participants on state-owned sectors makes the overall investment sentiment much more short-term. Thematic and consumption-led investment cases are expected to dominate positive market movements. As for liquidity, with the mission to complete supply side reform in the near future, the Chinese government is unlikely to release a series of monetary or fiscal stimulus polices, but rather to maintain a moderate level with open-market operations. In the long term, while real estate prices are meant to remain high and bond yields to decrease, there is a compelling argument that equities, especially the undervalued ones in the fast-growing sectors, will continue to offer greater asset allocation advantages than other assets. “New stories” emerging from a growing consumption-led economy will remain the alpha drivers in the markets.
The situation prevailing in 2015 was negative for fundamental long-term investors and hurt investors’ confidence. Artificially created excess liquidity and government intervention had a real negative impact on the trust most investors had in the market. This was the case both locally and internationally. This situation has brought the market towards an important drift between favored strategic sectors and privately-owned businesses. There are signs that this important sector shift is more than a little overdone with perhaps too much support provided to those slowing or no growth sectors like some of the low quality Banks and Steel producers. A period of "irrational exuberance" can often represent the best entry point for contrarian and/or long term investors with an active approach in what remains a fertile field for the informed stock picker.
Fund Manager - Asian Equities