The Move. The PBoC has recently cut the Required Reserve Ratio (RRR) to 18.5%. The RRR represents the portion of cash that banks must deposit with the central bank. The size of the cut has been 100 basis point, double the expected 0.50%. A cut of the RRR represents a conventional monetary policy tool, through which the PBoC stimulates the economy. This move is in line with the monetary easing program that Chinese monetary authorities have been undertaking since the end of 2014 when PBoC cut the benchmark interest rate.
The Real Side. The move comes only a few days after bad economic data about China: GDP expanded at a modest annualized rate of 7% during Q1 2015, the slowest pace in 6 years. Chinese inflation rate was well below PBoC target of 3%, being stationary in March at 1.4%. The trade balance, too, dramatically worsened in March. Exports decreased 15% year on year and imports fell by 12.3% in the period.
This reduction in overall trade is a symptom of China further entering the “new normal” stage, after years of aggressive growth rates. If we analyze the overall effect of changes in exports and imports, we are faced with a well-below-expectations current account surplus of only $3.1bn, compared to the previous $60.6bn for January and February. Both weaker demand and low commodity prices (especially oil) contributed to the stagnant trade figures. Therefore, we see the PBoC move directed to address the lower GDP growth rate and rising disinflationary pressure.
Moreover, Chinese debt-fuelled construction sector has started cooling off after years of overheated growth. This has left many buildings unsold and has caused problems for state-owned developers which have been heavily supported by huge injections of debt. Thus, the PBoC move to lower the nominal level of interest rates can also be explained as a measure to bring relief to these highly indebted companies. In fact, by decreasing the nominal interest rate and pushing for higher inflation, the PBoC could achieve a reduction in the real interest rate and so in the debt burden borne by debt-fuelled corporations. This would help the construction industry, which retains a dominant position in the Chinese economy, contributing to around 1/6 of the overall economic activity. As a further proof of the negative trend in the property market, the prices of newly built houses have been falling rapidly in the past 6 months. In an attempt to stop this trend, state authorities implemented both a reduction in the minimum down payments required to buy second houses and decreased the period required to benefit from a property tax deduction.
If we look at the broader spectrum of EM economies, the IMF warning about a lower-than-potential growth for developing economies in the period 2015-2020 perfectly fits our analysis of the Chinese “new normal”. In fact, the IMF predicts that potential annual average growth rates in the period will deteriorate to 5.2% from the 6.5% figure characterizing the previous five-year period. This would further hamper real economy growth perspectives in China. This environment is also the inevitable result of a transition from the export- and investment-led growth model implemented in the previous years to a more sustainable domestic- and consumption-led model. This transition has benefitted from the increasing Chinese middle-class and from more and more liberalization in the product markets. Therefore, we see this as an adjustment stage in the growth history of the world most-populated country.
Given this macroeconomic situation, the PBoC is trying to reinvigorate growth by incentivizing banks to lend more and by convincing companies to invest at lower interest rates. However, the real economy is still not benefitting from this move since final demand remains low and corporate balance sheets are debt-heavy, especially among the previously mentioned state-owned construction companies. In fact, factory output stayed at a record low of just 5.6% in March and, as a further signal of distress of the real economy, retail sales and fixed-asset investments all decreased quite sharply in the same period.
The Financial Side. On the financial side of the economy, we instead find an opposite situation. The Shanghai Composite (SHCOMP) has recently reached a peak of more than 4500. In order to find a similar height we need to look back to March 2008! The index is up more than 30% since the beginning of 2015 and 120% over the past year. Chinese shares have been the best performers during 2015 so far in the entire world.
This has also spilled over to Hong Kong Hang Seng (HSI), which reached the highest since 2007. This financial contagion was certainly helped by the implementation of the Shanghai-Hong Kong Stock Connect in November 2014, which allows cross-trades between the two markets (as a reference please see our previous article https://bsic.it/hong-kong-shanghai-connect-bridge-nowhere/). However, the Shanghai Composite is trading at a quite significant premium of around 25-30% over the Hang Seng.
Taking into consideration the situation of the real economy, we expect further stimulus by Chinese authorities. This would inflate even more the valuation of Chinese equities. In fact, the lower interest rates and the decrease of profitable investment opportunities in the real economy and, particularly, in the oversupplied housing market, would direct many more funds into the equity market. On the forex market, we expect to see depreciation of the Renmimbi in case of further stimulus measures. This would certainly help Chinese exporters, which constitute an important fraction of Chinese listed corporations.
Regulatory measures and new financial products are playing a role in this stock market frenzy. Two new equity index futures were recently launched on the China Financial Futures Exchange. Moreover, Chinese authorities increased the number of shares available for short selling to 1100, up from the previous 900. On the regulatory side, the Chinese Securities Regulatory Commission has recently reported that foreign investors would be allowed to buy majority shares in Chinese mutual funds. The date of the move is still not clear but it would be a great reform. In fact, this would allow huge capital inflows into Chinese funds, thus increasing their ability to invest in the Chinese stock market and possibly further increasing investments in Chinese equities. Furthermore, Chinese authorities seem to be organizing an enlargement of the Stock Connect to other Asian countries such as Taiwan. We believe that this would determine higher demand for Chinese equities, thus driving up their prices. The new possibilities available to Chinese retail investors have boosted the growth of trading accounts opening. Daily volumes have dramatically increased and there are signs that valuations are getting farther and farther away from their fundamentals.
We think that this divergence between real-economy fundamentals and market valuations has already led to the development of a stock market bubble. Around 30% of Shanghai stocks are trading at forward P/E ratios of above 50. Furthermore, if we look at the difference between the actual P/E ratio and the one estimated by Bloomberg for SHCOMP, we spot an increasing positive divergence, especially in the last 6 months. On the other hand, we see an increasing negative divergence for the HSI, with the actual P/E ratio being increasingly lower than the estimate (discontinuities in the graph are the result of seasonal readjustment of the estimate).
As far as the SHCOMP is concerned, we bet on short-term worse-than-expected real-economy data putting pressure on Chinese authorities to furtherly ease monetary conditions and on increasing inflows into Chinese equity market. In fact, we believe that the PBoC will cut again both the RRR and the benchmark interest rate in the two coming quarters. Evidence on this is also given by slower monetary base growth, which would require lower RRR in order to keep the money multiplier constant.
Given the afore-mentioned scenario, a long-term broad investment in Chinese stocks is very risky and unlikely to outperform. However, as long as foreign money keeps on entering and retail investors flock together, SHCOMP can rally further. If we look at 2008 peak, SHCOMP reached more than 6000, while now being at around 4500. Therefore, we would suggest to open an options-based bull spread strategy: this is achieved by buying a call option with a lower strike price (slightly in the money or at the money) and selling another call option with a higher strike price (out of the money) with the same maturity. This strategy better reflects our view because we believe that the upside potential, while still being there, is by now quite limited to no more than 10%. On the other hand, since the stock market bubble is mainly driven by retail investors, we also need to be cautions and limit our potential downside exposure. To sum up, long call strike 4400 and short call strike 4840 with maturity 5-6 months. Our breakeven would be given by the lower strike plus the net premium paid.
As far as the Hang Seng is concerned, we bet on a realignment of the value of the index with both the current estimates and the performance of its neighbor of Shanghai. It will offer us the opportunity to long cheaply and benefit from the spillover effect from SHCOMP through the Stock Connect. Evidence is given by increasing inflows from Shanghai through the cross-border link. Hence, we opt for a simple long futures on the Hang Seng index.
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Carmine De Chiara · 3 May 2015 at 13:03
Given the scenario of possible future monetary easing but, at the same time, an on-going bubble for the SHCOMP, I would like to ask two questions (assuming your investment horizon of 5-6 months):
1) What are the main drivers of the “bubble”? The monetary policy? The flows in the index? Both? It seems strange to me make the bubble depend on an easing that is non that massive compared to the Japan, US and ECB experience. I agree on the weaker fundamentals and on the foreseeable future actions by PBoC, but in a zero yield developed world, do you think 5% of growth is low?
2) If you really believe monetary easing will increase and will keeping sustaining the value of the index, what is the reason to enter in a costly bull-spread rather than go long futures or even better a tracking ETF? I got your willingness to protect from the possible burst, but do you believe this is probable in the next 5-6 Months?
Thanks a lot!
Davide Brugola · 7 May 2015 at 10:04
Dear Carmine, thanks for the good questions! I will try to answer as accurately as possible:
1) As far as the main drivers of the bubble are concerned, there is a mix of:
– Flows into the index, especially by retail investors;
– Monetary easing by the PBoC, in the form of RRR cuts and benchmark interest rate cuts;
– In a minor way, increasing openness of the Chinese equity market to foreign investors.
Actually the main drivers are the first two. For what concerns the flows into the index, they have dramatically surged, with millions of trading accounts opened by retail investors and with ample use of margin trading. For what concerns monetary policy, you are perfectly right in saying that a 5% growth in a zero yield world is not low. However, we believe that the main aim of the PBoC is creating wealth in the equity market in order to counterbalance the problems in the real economy, particularly in the construction industry, which has a pivotal role in the Chinese economy and has historically attracted many investments. Therefore, during this phase of transition from export/investment-led to domestic/consumption-led development model, the Chinese authorities may want to ease monetary policy to achieve both a more gradual shift and to boost equities.
2) Great question! We decided for a bull call spread because we are worried about retail investors, and not about the PBoC furtherly easing monetary policy. In fact, as previously highlighted, there has been a boom in retail trading, involving a lot of on-margin transactions. Therefore, while on the one hand we are quite confident in further easing by the PBoC (for the reasons explained above), on the other hand we would like to hedge against sudden shifts in retail investors’ mood and on the way Chinese authorities face this. Furthermore, you can find evidence of Chinese authorities’ sudden policy changes regarding trading in this recent FT article http://www.ft.com/fastft/318131.