Market chaos: It's all Chinese to me

13 Jan 2016

By Shadforth Financial Group

The Australian market has started the first week of 2016 poorly. The Australian market has taken its lead from China as concerns of a ‘hard landing,’ China’s newly implemented stock market circuit breakers and the devaluation of the Renminbi (RMB) have sent shock waves around global equity markets.

Over the past few years, the Chinese government has tried to slowly open up the domestic or Chinese onshore market (A-shares), which is predominantly local retail investors, to offshore investors. As a result, the first half of 2015 saw a large run up in the market ahead of the Shanghai-Hong Kong Stock Connect programme, as well as monetary easing and government support for the market. Furthermore, retail investors have been utilising leverage and margin accounts to speculate on short term gains (see chart 1).

China blog 1

Source: Bloomberg

In June 2015, the Chinese government tried to slow what they saw as an overheated market by instituting restrictions on margin finance, resulting in a sharp sell-off. The Chinese government subsequently intervened in the market by utilising state owned corporations and finances to support the market. The Chinese government also introduced restrictions that prevented major shareholders from selling stocks. Consequently the end of 2015 saw the market recover slightly (see chart 2).

Chart 2: Index Performances 2013-2016

China blog 2

Source: Bloomberg, IOOF Research

The latest sell-off has once again been triggered by changes in government policy and exacerbated by the circuit breaker system implemented last year. The circuit breaker is supposed to give investors time to pause and think and avoid irrational behaviour. It seems that instead of the circuit breaker system stabilising the market, it has created further panic. The circuit breaker kicks in for 15 minutes if the market moves more than 5 per cent and if the market falls a further 2 per cent (ie -7 per cent) after this, the market remains closed for the rest of the day. This has created a downward spiral (intensified by leverage), as people fear they will not get the opportunity to exit the market or make margin calls. This circuit breaker mechanism was suspended today as it has not worked. The market was also spooked by the Chinese government reversing its earlier decision that placed restrictions on sales by major shareholders.

Chinese and global markets continue to fear the Chinese economy is headed for a ‘hard landing’ given recent data, including weak industrial production and slowing Gross Domestic Product. However, the Chinese government’s five-year plan is very clear; their intention is to move from a capital intensive manufacturing driven economy to one that is more consumer and services focused  (high value add as opposed to low value add). The Chinese government has planned for the rate of growth to gradually slow towards 5 per cent as the economy transitions.  Maintaining 7-8 per cent economic growth off a far larger economic base is near impossible and the Chinese economy should be able to sustain the lower moderate growth over the medium to longer term.

The Chinese Central Bank has also continued to allow the RMB to devalue very slowly and only insignificantly relative to the major currencies (see chart 3), yet the market has interpreted this as a sign of domestic economic weakness. We find the Chinese action hardly surprising given most major economies including the US, Europe and Japan have allowed their currencies to devalue as they utilise quantitative easing to stimulate their economies. It seems rather inappropriate for a government to stand in the face of oncoming tides without some reaction. Furthermore we do not feel that the level of the currency is a driver of economic decisions as we consider the primary objective of the Chinese government is the transition of the domestic economy and this is far less reliant on a weak RMB than an export led economy is.

Chart 3: Major Currencies vs RMB 2013-2016

China blog 3

Source: Bloomberg, IOOF Research

As China emerges into a developed nation from being a closed economy subject to government intervention and introduces developed world financial instruments, we will continue to see volatility in its stock market. This volatility tends to blur the underlying fundamentals and valuations of the underlying economy. However, the Chinese economy is the second biggest in the world and should enjoy Gross Domestic Product growth of 4-5 per cent of a much larger pie over the medium to long term.  If you would like any further information about the current situation in China, please speak with your Private Client Adviser.

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