• Wealth Management

A Method to China’s Stock Market Madness?

Is the run-up in Chinese stocks sustainable, or just another chapter in speculative excess with a predictably sad ending?

Despite a burst real-estate bubble and overall economic slowdown, China’s equity market has been on a tear. As of mid-May, the benchmark Shanghai Stock Exchange A-shares Index was up 35% in the year to date and double its level of 12 months earlier.

What’s going on in China that has local investors so excited? Is it sustainable, or just another chapter in speculative excess with a predictably sad ending?

Morgan Stanley’s Global Investment Committee (GIC), a group of seasoned investment professionals with whom I meet regularly to review the economic and political environment and asset allocation models for Wealth Management clients, has been positive on Chinese equities since March 2014. Although China’s equity market performance has surprised us this year to the upside, we believe a number of factors in play could justify the lofty climb.

Strong Policy Response

The biggest surprise so far is Beijing’s muscular response. China’s central bank has been more aggressive than expected in cutting interest rates and lowering margin requirements for the banks. These moves should release incremental capital into an economy that is growing its money supply too slowly to support the government’s 7% growth rate target.

The negative interpretation of these actions is that things have become so bad, the government is pulling out all the stops. While it’s true that the Chinese economy has probably decelerated more than expected over the past year, it remains far from recession, and should benefit from the acceleration in both Europe and Japan, not to mention India and other countries in Southeast Asia. Secondarily, lower oil prices since last year are a huge boon to China, which imports virtually all of its consumption.

Second, the government announced a “New Silk Road” project last year to connect China to the Middle East and Europe via rail and a new “Maritime Silk Road” that will build and connect ports all the way to Africa.

Global Standing

Third, China has championed the Asia Infrastructure Investment Bank as a means to help finance projects in regions that need access to capital. China will also help fund it with some of its $4 trillion in foreign exchange reserves. So far, more than 50 countries have agreed to join the proposed bank.

Fourth, China is opening up its local stock market to foreigners and making it easier to execute cross-border transactions. In time, this will eliminate the need for special classes of stocks and lead to more free-flowing capital. This should help close the widening discount between local “A shares” and the “H shares” carved out for foreign investors.

Finally, China has applied with the International Monetary Fund for special drawing rights, with a good chance of getting them later this year. This would add the yuan to the other four component currencies—the dollar, euro, yen and sterling—of the IMF’s supplementary international reserves, representing a big step for China toward gaining developed-market status, perhaps the most important change for equity market money flows and prices.

Keep in mind that Chinese stocks had gone nowhere for six years before they began their run last fall. No doubt it will be volatile, but we are sticking with our positive view with an emphasis on Chinese H shares, which should benefit from the current discount of more than 20% to locally owned A shares.

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