November 2018
During a year of China equity market weakness, October was the most painful month so far. Perhaps we should not have been surprised – after all, many market crashes have previously been October events.
Most of the headlines have pointed to the ongoing US-China trade tensions as the main source of market weakness. And there is no doubt this issue has had an impact. When the world’s two largest economies, which between them have contributed more than half of global growth in the last 15 years, come into conflict, then no one is likely to benefit. However, if trade is the biggest issue, then it is hard to explain the more than 20% dispersion in performance between ‘onshore’ and ‘offshore’ China equities this year. While H shares have fallen around 5% year-to-date, China A-shares are down by almost 30% in US dollar terms.
For illustrative purposes only.
Instead, our view is that there have been some idiosyncratic factors which have been particularly impacting the A share markets. These factors are related to the structure of China’s domestic equity markets which are different to offshore markets. Since the final months of 2017, government policy in China has focused on so-called ‘deleveraging’. This is in recognition that China’s economy has become too dependent on debt to support economic growth, and that this needs to be brought under control as part of a change in emphasis from ‘quantity of growth’ to ‘quality of growth’.
While few can argue about the long term merits of this policy, one significant and unintended consequence of deleveraging has been to severely limit funding for private companies. Shadow banking activities had previously provided an important source of funding for smaller private enterprises. The deleveraging policies have curtailed shadow banking activities and in doing so there has been a significant squeeze on liquidity and access to credit. In their search for alternative sources of funding, company management - who are typically controlling shareholders – have pledged large quantities of their stock as collateral against loans from brokerages. By using their stock as collateral, founders can release liquidity for personal or business purposes without losing control of their firms. As the downturn in the China A markets has deepened, there have been growing margin calls. This, in turn, has raised fears of a downward spiral in which brokerages liquidate the collateral to recoup their losses, sending prices down further and sparking more margin calls. To give some sense of scale, there are around 1000 private companies where the largest shareholder has pledged more than 50% of their stock1.
This is a large number, but it is typically a problem for the smallest companies with the greatest challenge of accessing funding. It is estimated that of the total market capitalization for the A shares, about 10 percent – or 4 trillion yuan – is pledged as collateral2. This issue does not exist in the offshore H-share market, and is a key reason in our view for the extent of the recent sell off in A-shares. Equally, we believe this is a technical issue which is in the process of being managed and provides an opportunity for fundamental investors.
1. Source: Gavekal Research, November 2018 2. CNBC, October 2018
If trade and tariffs have not been the most important reason for the market fall, then it would be no surprise if they are not the catalyst for a market recovery. It is perhaps no coincidence that the recovery in A shares in recent weeks (+10% since mid-October) has coincided with central and local policymakers instructing state-controlled funds to provide financing to private companies, as well as a number of very public policy announcements in support of the private sector in China.
This form of policy action to prevent a market decline leading to a more systemic risk is reminiscent of policy action to prevent a repeat of the stock suspensions issue in 2015. It is likely we will see regulators move to restrict share pledging in future. Besides the policy support, we are also seeing some encouraging behavior from listed companies.
China A companies are indicating, through share buyback activity, that they see value in their own shares. Year to date, more than 480 listed firms repurchased their shares, valued at nearly RMB 30 billion (USD 4.2 bn), marking a sharp increase from 2017, and reaching a record high. While the total repurchased amount is still small compared to the market free float, it helps send a positive signal to market participants.
This is for illustrative purposes only, not a recommendation or solicitation to buy or sell any particular security. Past performance is not a reliable indicator of future results.
And in addition, the market continues to benefit from inflows from global investors who continue take advantage of this market weakness. Northbound buying through the stock connect channels (i.e. foreign investors buying into China A-shares) has been on an uptrend over the past year and even picked up visibly after the market weakness in October.
Month to date net inflows hit USD 5.5bn by November 16th 2018, a significant pick up compared to the previous two months.
Source: Goldman Sachs, Allianz Global Investors as at 15 November 2018.
We are often asked about when is the right time to buy A shares. There is no simple answer to this. But what we can say is that at these levels a lot of bad news is priced into markets. Over coming years we believe many clients will significantly increase their portfolio allocations to China including A shares, to reflect the size and scale of the economy and financial markets, and therefore this may be an opportune time to start / continue this process.
10 Things you should know about China A-shares