Chinese Equity - Third Time's the Charm?
China reported a better than expected 2Q GDP growth rate last week. This makes China the first major economy to emerge from the COVID-19 disruption. GDP growth momentum will likely continue for the second half of 2020, given a risk-managed re-opening and strong export demand for electronic and medical products.
On the 2nd of July, the Shanghai composite turned bullish on the weekly chart as the index broke out from a multi-year bear market. We noticed a surge of retail investors getting into the market by investing in some equity investment funds, thereby driving the composite from 3,000 to 3,450 in a matter of five days. This makes some investors wonder if a bubble is building up and if we are getting to peak euphoria like 2007 and 2015. In fact, the previous 2007 and 2015 bull runs only lasted for 1.5 years and 7-months, respectively. The extreme short-term swing in either direction will increase the probability of large drawdowns, making the Chinese equity market less attractive to passive investors. Furthermore, the massive inflow and outflow of liquidity in a short period of time could certainly have a negative impact in the financial markets and could trigger a liquidity crunch that leads to a severe economic crisis.
There is an old saying in China called “shì bú guò sān.” It implies that something should not occur or happen three times consecutively. The Chinese government seems to be well aware of this. Since last week (10th of July), the government started to crack down on margin financing and urged retail investors to be prudent. State-owned funds also played along by trimming equity holdings, and regulators capped the size of new products for mutual funds. Policymakers also dialed back monetary easing in June as the PBoC did not cut its medium-term lending facility (MLF) rate. Additionally, the Chinese state media accelerated its anti-stock market bubble rhetoric last week. The above evidence demonstrates that Beijing clearly does not want a repeat of the ’07 and ’15 bubbles, and it is aiming for slow and steady economic growth.
Whether China can successfully maintain stable financial conditions while achieving a high single-digit GDP growth rate is still in question. Increasing geopolitical tensions as well as the potential for a larger COVID resurgence would surely bring more volatility to the market. Despite these uncertainties, China remains as one of the attractive markets in the emerging economy. Chinese PMI has registered three consecutive positive data points signaling expansionary prints. Current valuations are relatively fair-priced compared to historical EV/EBITDA multiples, with 13.2x in 2020 vs 21.6x in 2015 (A share & SHCOMP). While U.S. and China relations took a 180-degree turn in the past week, as both sides ordered reciprocal consulate shutdowns and the U.S. Secretary of State delivered a Cold War-like speech, we do not think this will have a larger impact on the respective economies. With elections coming up, the current administration’s first priority is to protect and improve the domestic job market. The U.S. economy is still in recession territory and any aggressive economic sanctions toward China could ultimately do further damage and slow down the U.S. economic recovery.
A risk-hedged, long position in Chinese equities would likely generate positive alpha in the second half of 2020.
