● A-shares, trading at 39x P/E, look stretched in valuation. But Chinese money has limited access to investment opportunities abroad and faces negative real interest rates at home. Productivity gains through structural changes are large, and earnings momentum is robust. We do not foresee an end to the bull market yet, given the excess liquidity and productivity gains.
● But Beijing is likely to take action to cool down the market soon, causing a short-term, possibly volatile, correction. Bank deposits are exiting for the stock market at unprecedented pace . most new investors have zero experience in equity investment. We expect more aggressive rate hikes, the introduction of tax measures, a sell-off of state shares, and tough comments from senior officials in the coming weeks.
● We argue that any sizeable market movements in China would have global implications. International investors may not lose money from the A-shares, but worries of weakened Chinese demand for commodities and machineries would likely surface. Statistics show a much stronger correlation between A-shares and global equity markets this year.
Valuation is stretched, but . . .
We agree that valuations of the A-shares are stretched, but refrain from calling it a bubble at this stage.
We argue that the Chinese stock market is in the process of monetizing China.s huge economic success and productivity gains over the past two and a half decades. The lack of RMB exchange rate movement has caused real exchange rate appreciation, including asset inflation. Further, huge structural changes have taken place in recent years, including WTO entry, banking system reform, capital market reform, and a corporate tax cut. Each of them represents a major productivity gain to the economy. Last but not least, listed companies are reporting unprecedented strong earnings, which grew 130% year on year in Q1 2007. On a full-year basis, 2006 net profits have increased 44% YoY from the prior year, an acceleration from the 27% YoY growth in 2005.
Why a correction soon?
However, we still see a major correction in the near future. We sense that Beijing has become increasingly nervous about the increased level of speculation in the capital markets. Beijing so far has been taking a more tolerant stance toward the surging stock market, perhaps for the reasons we stated in the prior section. In addition, it needs to raise capital through the domestic equity market for banking system reform and establishing a pension system. However, the rapid exit of bank deposits for the stock market seems to make the leadership worried. China opened up its banking sector to foreign competition beginning last December. A strong deposit base is viewed as the biggest asset of the local banks against foreign banks, but outstanding residents deposits declined by RMB167.4 bn in April from the prior month.most likely this money entered the sizzling stock market. An even bigger worry is that the general public is jumping in without thinking much about the downside risk. In the case of a severe correction, this could lead to social instability. That, in our view, provides enough incentive for the leadership in Beijing to act quickly.
Central scenario
Our central case scenario is that the government will launch a coordinated campaign to curb stock market speculation. That possibly includes larger-than-expected interest rate hikes, probing misuse of bank loans for stock speculation, raising stamp duty on equity transactions, and other tax measures, and harsh comments from the official media and senior government officials. There is a strong likelihood that the government will release more state-controlled stakes in listed companies.
We expect to see an approximate 30% correction of share prices, with perhaps a temporary reversal of capital flows out of the stock market. We set out a relatively moderate and short-lived correction as our central case scenario because excess liquidity and negative real interest rates still persist in China, giving a fundamental reason for deposits to be shifted out into other higher-yielding assets. Also, we think the government would soon send out positive messages to prevent the correction from being overdone.
A global event now
To mainstream global investors, China is no longer an exotic emerging market, in our view. When China announced its robust Q107 GDP and CPI inflation results on April 19, the global markets moved in fear of economic overheating and a re-launch of austerity measures. We believe any significant correction in the Chinese stock market would prompt newsflow about a triggering effect on domestic demand, which in turn could cause slower import demand in commodities and machineries.
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