Seeing the ‘A bubble’ in context

While there has been plenty of investor consternation around recent events in China, Maple Brown Abbott’s Geoff Bazzan writes that the “A” share bubble need not burst the Asian equity opportunity.

The excessive volatility observed in the Chinese mainland (A-share) equity market has wrought plenty of hand-wringing from investors caught long, matched with equal amounts of joy from those invested elsewhere.

Although our portfolios were shielded from the precipitous falls observed in the A-share market, many clients posed the eminently sensible question of what the market rout means for Chinese securities listed in HK (‘H-shares') and the broader market generally.

We do not believe the abrupt share market falls and subsequent loss of capital in China to date poses a systematic risk for capital markets in China, or elsewhere in the region, for two reasons. Firstly, though the recent falls have been abrupt with the Shanghai exchange falling 23 per cent from its June peak, the market is still up significantly over the preceding year (90 per cent at the time of writing).

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Secondly, whilst the level of margin debt used to propel the market in its recent vertical trajectory is massive and unsustainable in absolute terms at around RMB2.4 trillion (at its peak), it is probably manageable in the context of an aggregate economy of RMB63 trillion and gross household savings of RMB53 trillion respectively.

We have been underweight China for some time, primarily due to concerns that a weakening earnings outlook meant cheap trading multiples were not as attractive as they appeared on a medium term basis.

Indeed, our own recent research visits to China have only served to further reinforce impressions that although the market is highly influenced by central policy initiatives, economic activity and corporate profitability is slowing quickly and caution is warranted.

Whilst economic growth should not be viewed as a prerequisite condition for strong equity market performance, deteriorating earnings momentum during a period of rampant stock price appreciation had stretched valuations. In that context, the recent declines in the A-share market are not surprising and were well overdue.

Unlike most other equity markets, China's mainland stock market remains reliant on retail investor participation (estimated at between 80 per cent—90 per cent), a cohort known for their notoriously short-term, and momentum based behaviour.

This might explain the surprisingly aggressive and haphazard manner in which policy-makers and regulators have responded. Most notably, the voluntary suspension of more than half of all listed mainland companies, directed stock purchases from state instrumentalities, selling restrictions imposed on large shareholders and the suspension of all pending Initial Public Offerings (IPOs).

Financial history is littered with unintended consequences arising from such indelicate measures of market stabilisation; the potential for this to occur in China is high. At a minimum, one likely consequence of such interference should be greater scrutiny imposed by global benchmark providers such as MSCI when considering the eventual inclusion of mainland traded securities in regional and global benchmarks.

To that end, the level of speculative fervour in the A-share market, coupled with its relative rigidity in terms of access and regulation, leaves us content to pursue China exposure via Hong Kong and US listed companies for the time being.

Further justification is evidenced in the respective trading patterns of Chinese companies dual listed in both Shanghai and Hong Kong. It is perplexing to note that post the commencement of the much heralded Shanghai-Hong Kong Stock Connect programme designed to further facilitate the opening of China's financial system, price discrepancies between those companies dual listed have in fact increased.

The distortionary impact of Stock Connect can be demonstrated through one of our portfolio holdings, Guangzhou Automobile Group (GAG), one of two licensed manufacturers of Toyota and Honda cars in China.

Since the commencement of trading in Stock Connect in November last year, the premium between what investors in the A-share market versus what those in HK are willing to pay for the very same company has more than doubled to 70 per cent as at the end of the quarter.

Therefore, shares in the exact same economic entity, in this case GAG, are valued in Shanghai at almost twice the level prevailing in the more liquid HK line, despite investors in both markets now being able to buy or sell shares on either exchange (subject to some restrictions).

This example is by no means unique; with the average premium of A versus H-shares moving from a position of parity at the commencement of Stock Connect to a 33 per cent premium as at the end of June.

Although shares in neither GAG nor any other dual listed company within Stock Connect are fungible with each other (precluding the opportunity for an arbitrage between HK and Shanghai), rational investment logic would suggest such inconsistencies are not sustainable on a long-term basis.

Despite this bout of heightened volatility, China's ongoing internationalisation is set to remain an irreversible trend, the implications of which will be transformational for both regional and global benchmarks over many years to come.

That the world's largest economy (as measured by purchasing power) is accounted for in the global benchmark of world equity markets at just 2.4 per cent (All Country MSCI World Index) versus the US at 51.9 per cent is demonstrably unsustainable.

However, the pace of inclusion is likely to be gradual, and as is universally almost always the case, the success or otherwise of mainland China investments (A-shares) will ultimately be a function of the price paid and not the hype it attracts.

Geoff Bazzan is Head of Asia Pacific equities at Maple-Brown Abbott.