The spectacular A-share rally which has made mainland equities the best performing major global market over the past year and YTD derives not only from historically low starting valuations (the rationale for our overweight stance a year ago and since), but also diverted real estate flows. The ongoing anti-corruption campaign and sustained overbuilding have depressed long booming housing prices (down 5.5% y/y in February, with sales down almost 18%). Most analysis on China focuses erroneously on GDP and earnings momentum as the equity market driver as it would be in a normal economy, when within China’s hybrid structure the allocation of household capital flows is far more important. Indeed, the inverse correlation between Chinese equities and the housing market has long been evident, given the absence of liquid alternative investment opportunities for wealthy Chinese households (the wealthiest 1% of households own at least 30% of all residential property, while there are about 2.5m USD millionaire households in China).
Easing monetary policy, looming SOE reform, the perception that the 1trn RMB debt swap between local government and Beijing is a form of de facto QE and the further deterioration of the housing market in Q1 have all helped drive the CSI 300 above 4,000. The rally has until recently had official media sanction, as it helped offset the tightening of financial conditions via the RMB’s rapid real appreciation (and a trading band widening remains likely this year) and still rising real borrowing costs as producer price deflation intensifies, against the backdrop of vast excess capacity in fixed investment related sectors.
There are now clear signs of speculative froth as reflected in margin debt surging by over 1.5% of GDP since late summer (and margin trading comprises about 20% of daily volumes regularly exceeding 1trn RMB), record first week rallies for recent IPOs and A-share trading account openings total a remarkable 2.8m for the past couple of weeks – overall valuations have reached about 18x forward earnings for the large cap CSI 300, on a par with the S&P 500 but small cap valuations are have soared to 60-70x.
From a 10% discount last summer, A-shares are now on a near record 35% premium versus HK listed H-shares. Back in December, I suggested another 15-20% rally was feasible in mainland shares this year; H-shares on 8x 2016 consensus EPS and 25% average discounts to dual listed mainland peers are now the preferred China exposure, and the difference between this episode and 2007 is the rise of aggressive domestic hedge funds to both exploit and eventually counter the retail mob. They have already generated volatility in global commodity markets like copper and can now short the A-share market via futures and via the HK connect scheme take advantage of the huge ‘free lunch’ cross border arbitrage opportunity which was clear in the opposite direction last summer. As well as H-shares, the broader MSCI China looks set to play catch up with the huge move in mainland equities, even as the latter enter a more volatile period in Q2…