Wednesday, June 24th, 2015

China Will Shake the World

The bull market in China A shares rolls on, but many international investors are not sure whether a crash there would matter. They point to the restrictions on direct ownership which prevent most international investors from having more than a token exposure. They can also cite the low correlation with the rest of global equities, and restrictions on the capital account and currency trading which would limit contagion in an economic sense. We have reservations about all of these arguments, but that is not really the point. Even if China doesn’t matter today, one day it will. The gross market capitalisation (before free float adjustments) of the A&B share markets is now equivalent to $10 trillion, excluding H shares quoted in Hong Kong. This makes mainland China the second largest equity market in the world behind the US, so we need to know if our tools work, before we are forced to rely on them. It is time we treated China in the same way as all other major equity markets, even if the available data set is short by international standards.

Against this background we have taken the decision to beef up our coverage of China. This week we launch a model which looks at China from the perspective of a local institution, comparing the total return on equities with the total return on local-currency bonds issued by the Bank of China. Our chosen equity index is the CSI300, which combines the leading A shares from the Shanghai and Shenzhen stock exchanges. These represent the most liquid shares in China, which only Chinese residents and certain approved foreigners can buy. (Over the summer we intend develop a sector-based equity model and maybe one which captures the unique influence of margin trading by the Chinese retail investor.)

In principle this is exactly the same process we use to compare the US equity market with Treasuries or Japan with JGBs. We will have to see how the signals develop, but in terms of performance the omens are good. Over the last two years this model has produced an estimated annual return of 34.5% compared with 20.2% for a constant 50/50 equity/bond model. The volatility and the drawdown are also higher, but the return per unit of risk is still better at 1.47 vs 1.28. The current recommended equity weighting is 100%, and it has been at the level since December 2014, which suggests that local investors are unlikely to be deterred by last week’s sell-off. However international investors may not be quite so sanguine. We have another model which compares the combined A&B shares market in US dollars with the global equity index ex US. According to this model the recommended overweight has fallen from a maximum 100% in early May to 70% now. This is still very positive, but not as positive as it was a few weeks ago.

There is always a difference between international and domestic views, especially if the benchmarks are different, and investors have to ask themselves which model is likely to have the greater predictive power. For most emerging equity markets we would suggest that it was the international model, but China is different. Domestic investors still account for the lion’s share of share ownership and turnover, and their risk appetite remains undimmed by last week’s sell-off, as our new model shows. It’s not that they don’t matter to us; at the moment our opinion doesn’t matter to them.

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