Chinese Economic Update – 12 May 2015

Chinese policy makers cut rates for the third time in six months, further cuts likely in the months ahead

Once again Chinese policy makers took centre stage over the weekend when they announced the third rate cut in just six months. The PBOC cited “relatively large downward pressures” facing the economy as the core reason for slashing its benchmark 1 yr deposit rate to 2.25% and the 1 yr lending rate to 5.1%.

Although Chinese central bankers have traditionally exhibited signs of reluctance when it comes to rate cuts, given what has been an almost out of control expansion in private and commercial credit during recent years, it is thought that the upward pressure exerted upon real interest rates from falling inflation has created some room for manoeuvre in this regard.


Are Chinese stocks now in bubble territory?

While we cannot be certain of what the exact impact will be on credit supply and the economy, one thing that it is possible to be relatively sure of is that with rates likely to move lower still during the months ahead, the fun run in Chinese stocks will probably continue for the time being at least.

With the Shanghai Composite Index having gained 97% from peak to trough since November 2013, some observers are now rightly concerned over whether or not we are now seeing Chinese shares moving into bubble territory.

In this regard, we note a recent report released by Schroder Asset Management (Is a bubble in Chinese stocks being inflated? – 05 May 2015) that provides a breakdown of valuations across the Chinese market.

Here, we discover that while the average price to earnings multiple for SSE Composite Index stocks is just 22 X, almost 70% of the index’s constituents are trading on multiples of more than 50 X reported EPS. Schroder cites the dilutive impact of low valuations for large cap banks as the reason that index wide averages are so low.  

However, despite what us outsiders may think, the lack of official comment or intervention from the Chinese government appears to have been interpreted by many as an implicit blessing for the market’s appreciation so far.

If this silence from the halls of government can be reliably taken as a tacit approval then there is good reason to believe that, should current market conditions not yet satisfy the majority definition of a bubble, then it is probably just a matter of time before they do.  


Our view

With corporate earnings growth in China at just 7.7% in 2014 it does not take the most imaginative of individuals to be able to envisage how investors could now be sleepwalking into portfolio positions that they may later regret.

This appears a particularly pertinent point when considering the current outlook for earnings in developed markets, where the average contraction in growth is for the most part, confined to the low single digits.

We also note that just over 70% of S&P 500 reporting companies have still surprised on the upside for Q4 &/or Q1 2015, which suggests that there may still be scope for the gap in growth between developed and emerging markets to close further over the medium term.  


A bubble in Chinese stocks could benefit both the economy as well as the Chinese government

With these factors taken into account it becomes easier to understand how some investors could probably be forgiven for thinking that the Chinese market is now one to be avoided, if it wasn’t already so to begin with.

Having said this, when looking at the current market from a pure economic perspective, there will be a number of potential benefits to both the government and to the economy if the rally is allowed to continue.

First and foremost, the wealth effect that has most likely been created as a result of the last year’s gains could fuel consumption and investment within the economy, which may ease the pace of China’s economic slowdown in the latter part of 2015.

Secondly, the appreciation in the stock market may also make it easier and more preferable for companies to raise equity finance over debt finance during the next 12-24 months.

In the event of an eventual economic collapse this may shift a larger portion of losses onto the books of equity holders as opposed bondholders, which is probably a good thing for the government given its tendency to interfere when it comes to bond defaults and the implied state guarantee that this creates.

At the very least, an increase in the number of companies opting to raise equity finance over debt finance would probably lead to a slowdown in the pace of credit expansion within the economy.

Given that the value of  private and commercial credit outstanding has quadrupled since 2008, a slowdown in this metric can only ever be a good thing for overall risk in the financial system.


The takeaway

While a bubble in Chinese stocks could ultimately benefit both the Chinese economy and the Chinese government, we cannot help but feel that the risks of investment here are still just too high.

This is not solely due to the traditional lack of transparency surrounding corporate governance but when we consider current valuations in the context of earnings growth, we are left feeling that even for the most skilful stock-pickers, the potential rewards available are probably far outweighed by the risks.

In terms of the economy and monetary policy, there remains a broad consensus that Chinese policy makers will probably be forced to cut rates once again later in the year, as inflation remains at historically low levels and growth continues to slow.

This will probably add further fuel to the fire burning beneath mainland equities although, once again, we prefer to observe price action from afar as opposed to actually getting involved in the frenzy.

SSE Composite Index / Daily Intervals



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