Chinese Gyrations have little to do with Fundamentals

The big story in the world’s financial markets over the last six months or so has been the fall of the Chinese stock market. The Dow Jones Shanghai Index (INDEXDJX:DJSH) hit a high of 713 on 12 June last year but fell to 452 by 08 July. Thereafter, it gyrated inelegantly throughout the autumn. But in the course of January 2016 the bears stampeded. It started the month at 484 but finished at 368. This inauspicious start to the year seems to have spooked all the major stock markets of the developed world and many pundits are mired in gloom.

Has something fundamental happened to depress the outlook for the world’s second largest economy? Or are we seeing some kind of stock market adjustment, further to which normal service will be resumed? As we know, China’s growth rate has slowed from around eight percent per annum to around six, but, as such it is still dynamic. Only India has a higher growth rate amongst the big countries. Surely no one imagined that China’s eight percent growth rate could be sustained forever.

Professor Farok J Contractor of Rutgers Business School (New Jersey, USA) thinks that the sell-off in the Chinese market can be attributed to investor behaviour in what is still an immature stock market[i]. It is nothing to do with the fundamentals of the Chinese economic miracle.

In China, affluence for the overwhelming majority is a recent blessing which has not erased traditionally frugal habits. Contemporary Chinese are avid savers just as their rurally based parents stored rice or dried meat in case of hard times. American households save less than 4% of their disposable income (it’s even lower in the UK). Chinese households have a savings ratio of nearly 30%. The government is trying to stimulate consumption, but engrained habits are hard to change.

In the past, provident Chinese have favoured gold. Only the Indians prize the yellow metal more. But the canny Chinese know that gold has not been an efficacious investment of late. Bank deposits yield negative real returns, given an inflation rate of around six percent. Real estate prices have quadrupled over the last decade, but many fear that prices may have peaked. Foreign investment is not an option for most ordinary Chinese citizens because of capital controls.

In this environment many ordinary Chinese punters turned to the stock market for the first time around the beginning of 2015. It seems that huge numbers of novice investors piled into the market over a relatively short period of time. Novice investors, as we know, do not have a sophisticated grasp of the risk-reward continuum, and tend to have unrealistic expectations. It is paradoxical, but well understood, that people who are frugal savers become risk-takers when they speculate. Add to this a long-standing tradition in some parts of the community – particularly young men – of gambling, and you have a recipe for a bubble.

Chinese brokers allow investors to buy shares on margin with borrowed money. Notoriously, margin calls exacerbate volatility.

A survey commissioned by State Street found that over 80% of Chinese retail investors trade more than once per month – a much higher level of trading than in most developed countries. About ten percent of Chinese households had equity investments in early 2015. The suspicion is that these minnows, leveraged up with margin debt, may have precipitated the stampede.

This is not to say that we should be blasé about China’s economic prospects. On 01 February it was revealed that the Purchasing Managers’ Index (PMI) contracted at its fastest pace in almost three-and-a-half years in January[ii]. At 49.4 it suggests that most managers anticipate a slowdown. Electricity consumption and output is broadly stable but Chinese manufacturing output is now falling.

The Chinese model of economic growth was based on the primacy of manufacturing. It will not be possible to transition to a service-oriented economy without some dislocation. On the other hand, the growth of China’s service sector will open huge potential opportunities for domestic and foreign investors alike. Mature economies are skewed towards services. China is becoming more like us.

We should probably take the bursting of the Chinese bubble in our stride. Would I invest in China right now? I must confess that I do not like markets where foreign investors are restricted to less favoured share classes. The idea that round-eyed westerners exploited China in the bad old days runs deep, and it’s not likely to change in the foreseeable future, hence the unfairness. But the ADRs of certain Chinese stocks like Baidu (NASDAQ:BIDU) – about which I have written elsewhere – and Alibaba (NYSE:BABA) are still probably must-have holdings in a large, diversified portfolio.

[i] Writing in The Times of India, 23 January 2016.

[ii] See for example: http://www.theguardian.com/business/2016/feb/01/china-manufacturing-sector-shrinks-for-sixth-straight-month-january-figures-show