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China: Mind your Ps and Qs (and As and Hs)

The gloom-mongers have been quick to assert that the People’s Bank of China’s (PBoC) decision to cut its one-year benchmark lending rate by 25 basis points was 'insufficient'.

Old Mutual Global InvestorsThe gloom-mongers have been quick to assert that the People’s Bank of China’s (PBoC) decision on Saturday 27 June to cut its one-year benchmark lending rate by 25 basis points and to ease reserve requirements for commercial banks was “insufficient” to prevent Chinese equities from entering a bear market, following their stellar performance over the first half of 2015. While there is no denying that Chinese equities have given back some of their earlier gains, we beg, politely, to differ with some of those commentators taking a negative view on the outlook for Chinese stocks.

Our main contention is that the China “bears” are presenting an over-simplified case that fails to address the real situation of a large proportion of Asian equity investors, because it ignores the important differences between the Chinese mainland “A” share market, and the “H” shares of companies incorporated in mainland China, but traded on the Hong Kong Stock Exchange.

We have believed for some time that Chinese real interest rates were too high, and that policymakers’ true desire was to ease monetary policy with a view to stimulating the real economy. The difficulty rate-setters were facing, however, was the seemingly unstoppable rise of the “A” share market, which greatly weakened the case for monetary easing.

The unfolding crisis in Greece – and an almost-universal acknowledgement that the global economy is once again in uncharted territory – has led to increased volatility in virtually all financial markets, including in both the China “A” and “H” share markets. Perhaps perversely, it is this very volatility that has enabled the Chinese authorities to engage in their latest round of monetary easing.

Despite jitters in some quarters, we think it is probably fair to say that most of the risks associated with the various potential outcomes of the Greek crisis have been largely priced into markets. The facts would seem to support this thesis. If contagion risk to other peripheral European markets (and beyond) was the primary concern of some investors, then the reaction of markets to the imposition of capital controls and the increased likelihood of a Greek sovereign default – so far, at least – has been relatively muted: the yield on 10-year Portuguese government bonds for example rose in trading on Monday 29th June (after a torrid weekend of failed negotiations between Athens and its creditors), but nevertheless spent much of the day below 3.0%.

In short, this is hardly the level at which you would expect to see the yields on government bonds issued by a country on the brink of default. A further sell-off from these levels is of course a possibility amid any more generalised flight to safety by investors, but given how much of the “worst possible” news was already being discounted by the market, our belief is that it would require further destructive revelations to cause such a flight.

This is not to understate the risks of a “Grexit” scenario; Germany, for example, holds some US$80billion dollars of Greek bonds. Clearly, the stresses in Greece are deeply unappetising, but in the overall context of the global economy, the potential for contagion needs to be seen in relative terms; Greece’s GDP at US$241 billion is a little over half the size of that of, say, the State of Massachusetts at US$460 billion in 2014.

If global markets have indeed taken the Greece-related risks in their stride – as discussed above, our current instinct is to say that they have – where does this leave the reasonableness of valuations of China “A” and “H” shares, and what are the implications for Asian equity investors with exposure to China?

In our view, there is cause for further optimism, especially when we consider that international mutual funds – including both the Old Mutual Asian Equity and Old Mutual Pacific Equity Funds – gain their China exposure through the “H” share market. While the “A” and “H” share markets are of course correlated to a degree, our belief is that if the “A” share market can stabilise on the back of the recent easing measures, then the prospects for the “H” market should be relatively rosy.

Once again, the facts speak to a large degree for themselves: as at 29th June, the 12-month forward price/earnings ratio for the Shanghai Composite Index (one of the main “A” share indices) was 16.4x, whereas the Hang Seng China Enterprises Index (the primary “H” share index) was trading on a 12-month forward price/earnings ratio of just 9x. These could scarcely be described as expensive valuations, not least in the context of a global equity market in which US stocks (as measured by the S&P 500 index) are trading with a 12-month forward price/earnings multiple of 17.6x. 

Put another way, the volatility in global markets that has been caused primarily by concerns about a potential “Grexit” has enabled the Chinese authorities to ease monetary policy without the fear that doing so will cause the “A” share market to rally even further. Indeed, the latest policy announcements should allow the “H” share market to continue to benefit from monetary stimulus and the long-term structural reforms China has been undergoing. These are supportive trends, underpinning a strong case for maintaining a meaningful exposure to the China “H” share market.

All data source: Bloomberg June 2015

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The views expressed by external contributors are not necessarily those of Old Mutual Wealth or Old Mutual International.

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