Q3 2015 Quarterly Wrap-Up: The Chinese Stock Market

The Chinese market in 2015 has been a rocky ride. As of June 12, 2015, the Shanghai Composite Index was up 60% for the year. Only two months later, on August 25, it had swung down from its high by 43%, closing down -9.5% YTD. To describe the volatility in the Chinese markets as breathtaking would be an understatement.

Why It’s Important

In one sense, the Chinese stock market is the canary in a coal mine for our planetary financial system:

If we are to evolve the relationship between the United States and China, the economies of both countries must succeed. This will require a more than delicate balance between competition and cooperation. At the heart of the matter is the question put forward by Stratfor in China’s Place in the Global Order:

“What will China’s role be in the international order five, 10 or 15 years from now? This is undoubtedly one of the defining questions in global affairs today, because whichever way we attempt an answer — whether we expect Chinese power to grow or to diminish, and how — will say a great deal about our expectations not only for China as a state and society but also for the future of international political, economic and institutional systems. A world in which Chinese power continues to expand and in which Chinese-led international institutions proliferate and take root would be very different from one in which China recedes from the geopolitical limelight or acquiesces to the norms of the existing order. For the foreseeable future, the People’s Republic, for all its constraints, will remain one of the few states credibly challenging the political, economic and military supremacy of the United States, as well as the legitimacy of the U.S. designed-and-led international order. To question China’s trajectory is therefore tantamount to asking whether and in what form the current order will persist.”

If we are going to shift out of a global financial model based on debt and towards a more balanced model using equity, we will need stronger global equity markets in both developed and emerging markets. Given its size and importance, China is going to be a part of that process. The Anglo-American alliance continues to dominate across the financial markets – in private equity, venture capital, asset management and in making primary and secondary equity markets.

Nevertheless, the financial bailouts and subsequent Treasury and central bank interventions have raised serious questions about the management and integrity of G-7 financial leadership and markets. Consequently, both West and East have reason to distrust the integrity of each other’s markets.

Success in Chinese equity markets will mean:

A more open flow of onshore and offshore equity capital
A more mature system of cross-listings of Chinese companies in offshore markets
A larger, more stable Chinese institutional and retail investor base

To date, the process of achieving these goals has been messy and organic. This is likely to continue.

For global investors, the primary question is whether the returns justify the volatility and risks in the Chinese markets. The sources of risk are numerous, ranging from cross-cultural challenges and regulatory complexity to economic warfare related to 1) the unraveling of the Bretton Woods system and 2) the emergence of a multi-polar global order.

The reason I decided to take an in-depth look at the Chinese stock market for our 3rd Quarter Wrap Up was to answer the question, “Do the Chinese equity markets present an opportunity or will geopolitical tensions consistently limit returns? Is the risk worth it?”

As an investor, what should I do?

It’s Young and It’s Big

The Chinese stock market is now the second largest stock market in the world. That means it is very big for a relatively young market. The total market capitalization of the Shanghai Exchange as of the end of September 2015 was $3.95 trillion; the Shenzhen Exchange’s capitalization was $2.65 trillion. However, the float of domestic shares available for foreign investment is smaller: approximately $2-3 trillion, which is still smaller than the Japanese stock market.

While its stock market may be relatively young, China’s culture and country is not. It is important to remember that China is 5,000 years old and that the United States is 240 years old. China’s Mandarin name – the Middle Kingdom – implies that it is the center of the world. China’s was the world’s largest economy prior to the industrialization of the West. In a sense, the mantle of “largest economy” is simply returning East.

The Chinese market is complex, with two mainland exchanges, bifurcation of shares related to eligibility of purchase and a dazzling array of cross-listing possibilities between domestic exchanges and markets in Hong Kong, Singapore, and Taiwan (as well as exchanges and over-the-counter markets in the US and Europe). Adding to the complexity, Hong Kong remains a separate market under a different regulatory structure according to the “one nation, two systems” policy.

For an overview of the Chinese markets and a more detailed description of these issues, I recommend the latest series on the Chinese markets in Morningstar Magazine.

Opening to Foreign Investment

China has taken significant steps in recent years to open domestic markets to foreign investment and to allow for a greater cross-border flow of capital. Over the last twenty years, the Chinese sent a great deal of capital abroad. Grossly oversimplified, China bought US Treasuries which financed government checks to US consumers who then went down to Wal Mart and bought Chinese goods. China was able to invest in building its production capacity partly as a result of a high domestic savings rate. But, if China is now going to build domestic consumer markets, the Chinese people will have to save less and spend more. This means more foreign capital must flow into China.

One of the biggest issues in the Chinese markets during 2015 was whether the major emerging market index funds would include China “A” Shares as access to shares improved. One of the challenges was that inclusion would result in emerging market funds with as much as 40% of their investments in China. This would result in significant non-diversified country risk unless the funds added a single country cap.

Vanguard said “yes” to inclusion. MSCI said “no, not yet.” Some of the run up in the Chinese markets this year was due to local retail speculation via margin debt. This was “front running” in anticipation of foreign funds making significant purchases if China were fully included in the emerging markets indices.

The MSCI decision paralleled the IMF’s decision to delay inclusion of the renminbi in the SDR system until September 2016. On one hand, the Western financial establishment was demanding greater maturity from the Chinese exchanges and currency managers. On the other hand, there were concerns regarding the long-term costs and consequences to the Anglo-American dominance of financial markets as China “joined the club.”

More than a few suspicious were raised when the Tianjin explosions not only rocked the port of Tianjin but Chinese markets, as well. I suspect that the subsequent reverberation which rocked US markets was an unexpected lesson to all parties that markets value competition within legal boundaries.

Transforming from an Export Economy

The greatest challenge to global stock markets is fundamental economics. Ultimately, equity markets cannot outperform the fundamental economy in which companies operate and contribute. For decades, printing money has kept bond markets afloat in complete defiance of fundamental economics. However, valuations in equity markets relate more directly to underlying economies.

This is not to say that equity economics are not deeply intertwined with government economic flows. Indeed, they are:

Government revenues flow to companies in the form of contracts and purchases
Government laws and regulations create private monopolies and markets
Governments and central banks invest in and intervene in markets

Nevertheless, a shift to equity markets and away from our over-dependence on debt raises important questions about the health of domestic and global economies. Equity markets inspire us to price out the cost of bad behavior as well as the profits and risks of disaster capitalism and war.

Challenges To China’s Economy

Developed nations enjoy per capita incomes in the range of $35,000-$67,000. China has a per capita income of less than $10,000. As technology and trade level the playing field in a global re-balancing, this leaves China with plenty of room to maintain growth rates above the other G-7 nations.

Let’s look at some of the challenges facing China’s fundamental economy:

Employment

China’s emergence on the global stage was the result of US and European outsourcing of manufacturing. As automation advances with a wide range of technologies – robotics, telecommunications, fabrication and material sciences – more manufacturing can revert to developed and local markets. To remain competitive, Chinese companies will have to automate as well. How will a country the size of China provide sufficient employment opportunities? Unemployment and inequality between the coastal cities and inland, rural areas may present formidable political challenges and risks for China’s leadership.

Aging Population

China has an aging population which does not depend on a governmental social safety net. One of the challenges to building consumer markets is that the Chinese have a high saving rate to provide for their old age. Alternatively, building a social safety net is an expensive proposition.

Environmental Pollution

By outsourcing low-cost manufacturing to China over the last twenty years, the United States and Europe have succeeded in outsourcing a significant amount of environmental pollution to China. Now China has a serious problem which may have devastating consequences for the health of the Chinese people unless it is successfully addressed.

Infrastructure

China has created significant engineering and construction expertise in the process of developing its domestic infrastructure. Its recent proposal to finance and build infrastructure throughout Asia and the emerging markets is a logical step to continued economic growth. However, as events in 2015 made clear, the effort to build up other BRICS economies can ruffle more than a few political feathers. The US response to China’s proposed Asian Infrastructure Investment Bank was quite negative and resulted in 1) redoubled efforts to push through the TransPacific Partnership and 2) a phased withdrawal of forces from the Middle East as the US military pivots to Asia.

Military & Space

Whether building out its satellite infrastructure, launching its first aircraft carrier or announcing an expedition to the dark side of the moon, China has clearly indicated that it is prepared to expand its projection of force to protect its financial interests. This will include evolving its currency into a globally competitive option for both trade and asset management. While investments in military and space can create significant domestic economic activity and employment, they run the risk of increasing geopolitical tensions with the G-7 and with China’s neighbors. This raises an important question: with production capacity breaking free on planet earth, is it possible to have a politically and economically productive space race?

State Owned Enterprises

One of the frequently mentioned problems with Chinese equity markets is the prevalence of state owned enterprises (SOEs). In my opinion, this is a comparison with the G-7 markets which has not been thoroughly analyzed or understood as yet.

When the profits of a US company depend on government contracts and/or purchases, we refer to such a company as being privately owned and operated. However, this is not really the case. Often times, government (or a shadow government) considers the company to be a “proprietary” and expects it to function on behalf of long-term strategic interests…as opposed to optimizing profits.

Indeed, as we have seen in the case of the banks, when these companies encounter financial trouble affecting national interests, they are bailed out. The US oil industry has managed oil prices very much in accordance with long-term national strategic interests, versus in a manner which would optimizes profits (read or listen to our interviews with Jim Norman on The Oil Card). Numerous industries such as mortgage credit and financing are highly “socialized” via federal credit in both the banking and mortgage systems.

The collusion of US legal, regulatory and tax policy with corporate interests is as significant as it is in China. However, it is much more subtle and invisible.

If anything, the danger in China is that political interests will have the upper hand. The danger in the United States is that the economy will be destroyed in the interest of consolidating cash flows into corporate monopolies created via massive political contributions. The reality is that both markets – China and America – are struggling with “intimacy” between centralized government and large corporations which, in turn, breeds corruption and detracts from healthy long-term performance.

In part, the real question for investors is how do we stay away from centralized powers and continue to build financial wealth?

There is a need for a serious analysis and comparison of the real relationships between corporations and the state in China, the United States and the G-7 nations. We must examine what this will imply for best practices in these countries as it relates to the interests of corporate governance, shareholders and taxpayers.

The presence of significant dependencies of large corporations on government financial, legal and regulatory largesse throughout the global economy needs to be taken into account when underwriting companies and comparing price-to-earnings ratios. Currently, this is no easy task – particularly given the size of the hidden system of finance and the black budget in the United States. Increased investment in space by both the G-7 and BRICS nations will only exacerbate this situation.

This area calls out for serious academic inquiry – the kind a joint British-Chinese effort might be inspired to undertake.

Investor Base

One of the reasons why the Chinese stock market is so volatile is that it is dependent on a relatively small base of retail investors. The majority of Chinese people are not stock market investors. Chinese personal savings continue to be channeled to property, gold and bank deposits. If the Chinese stock market is to succeed, it must develop a broader base of retail and institutional investors.

This brings us back to a point we made in this year’s Annual Wrap Up: Planet Equity (and in a number of Equity Overviews): will the emerging middle class in the G-20 nations become equity market investors or will the growth of these markets continue to depend on the purchases of government institutions and central banks? Whether or not global retail participation emerges will have important consequences for the direction of the global economy and political order.

This means that it is in our interest that the Chinese people broaden their interest and ownership of global equities.

So…What is an Investor to Do?

After much research and soul searching, this is where I stand on the Chinese stock market:

The Chinese people, their economy and stock market are too important to ignore or to avoid. I am in investor.
I anticipate significant volatility in China’s markets for some time to come. Consequently, I am planning to cap my portfolio participation at a percentage which is no greater than China’s relative contribution to global GNP. I am interested in investing in stocks or funds which I am prepared to hold through significant downturns. Among other things, this means that the quality of governance is essential and that dividends matter.
For a portion of my “China” investment, I prefer to invest in derivative investments: high-quality companies in more mature markets related to China such as Singapore, Hong Kong and Australia, or in G-7 companies which have a significant brand presence in China.
The potential impact of overweighting the Chinese market in emerging market ETFs or index funds is a concern, particularly as China continues to grow. I am reminded of the importance of tracking the terms of inclusion or exclusion of China in any Asian or emerging market basket.
Economic warfare and geopolitical tensions between China, some of its neighbors and the US are likely to lower investment returns and to increase volatility for the foreseeable future. Unfortunately, this means that the ideal time to buy will be when “blood is in the water.”
Given the size, complexity and politics of this market, I will continue to look for active fund managers who specialize and who have historically outperformed the broad index funds.
I will continue to track the emergence of a global middle class and its meaning to the markets.

This process of re-balancing the global economy means that you and I live in unique and interesting times. As always, I wish you good luck and good hunting!

Resources:

The Shanghai Stock Exchange

The Shenzhen Stock Exchange

The Hong Kong Stock Exchange

China also maintains a special exchange for State Owned Enterprise:

Wikipedia: China Beijing Equity Exchange

Chinese Stock Market Regulators

Global Stock Exchange Statistics

Major Chinese Stock Market Corrections

Important Terminology

Chinese Credit Rating Agencies

Other

References

The Chinese Stock Market: Volume I: A Retrospect and Analysis from 2002, edited by Siwei Cheng and Ziran Li, Palgrave Macmillan, 2014
The Chinese Stock Market: Volume II: Evaluation and Prospects, edited by Siwei Cheng and Ziran Li, Palgrave Macmillan, 2014
China’s Stockmarket: A Guide to its Progress, Players and Prospects (The Economist Series), Stephen Green, 2003
Chinese Companies and the Hong Kong Stock Market (Rutledge Growth and Economic Development Series), Flora Xiao Huang and Horace Young, 2014