China’s Deflating Housing Market Inflating Mainland Stocks…

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…

Chinese Housing Market Risks Subsiding…

Whenever I walk around a Chinese city, I’m struck by how poor the finish can be on ‘luxury lifestyle’ new developments of bare shell flats which rarely match up to the billboard images of foreign sophistication. A key issue is that with no national building code, the quality of construction is generally very poor and sometimes downright dangerous compared to HK or Singapore (thin floor plates with exposed rebar, disconnected sprinkler systems etc.) and the depreciation rate will be far more rapid. There have been numerous cases of new towers subsiding into the ground soon after construction, and the same is now happening to prices in several markets. Average new home prices in China’s 70 major cities rose 7.7% y/y in March, slowing from 8.7% in February but activity and prices are slumping in some second and third tier regional cities.

For instance, although national home sales declined 7.7% in Q1, in the weaker provincial markets they collapsed e.g. -38% in Hangzhou, -25% in Wuxi, reflected in developers slashing prices to sustain cash flows, a trend I highlighted in a note last month. Indeed local media have reported that the cities of Changsha, Hangzhou and Ningbo have been openly discouraging property developers from cutting prices further. The coastal city of Wenzhou, which saw an SME liquidity crisis, and Ordos in Inner Mongolia where coal mining profits spawned a well-publicised boom of empty towers have seen their property markets hardest hit by the shift in sentiment. In Hangzhou (home city of Alibaba), the average selling price for residential units in the downtown area is down by over 11% y/y while as of March, 76,004 residential housing units were available for sale, an annual increase of 36%.
<New property construction starts fell 25.2% y/y to 291m square meters (the lowest quarterly amount of new floor space started since Q1 2009).

Urban real estate investment accounts for more than 10% of GDP, so ongoing weakness in the property sector would be a drag on H2 GDP growth. Some degree of policy loosening has already begun, with a few of the worst hit cities discussing removing curbs on property purchases but the key remains to boost supply of low-income rental housing (with a 7m unit public housing target this year, and 4.8m completions – the latter is actually over 600,000 fewer than last year) and accelerate the property introduction (being piloted in Shanghai and Chongqing) to curb speculative hoarding and expand the local tax base. Low income housing only accounted for 13% of total real estate investment last year (or 2% of GDP), so it can’t offset weaker trends in the wider market – the focus in any case seems to be on renovating existing 1950s/60s shantytown flats rather than Greenfield new build.

Beijing and other Tier 1 cities remain resilient although momentum is slowing; developers remain aggressive buyers with the total value of YTD land sales in Beijing reaching 102bn RMB as of last week, a level not seen until late September last year and even allowing for a moderation, the total is likely to exceed 200bn RMB this year for the first time. Meantime, commercial property investment also seems to be stalling after a huge rise in values (e.g. prime office space up 65% in Shanghai in the past 4 years, with gross yields sub 6% and flat to falling). I think indoor shopping malls (of which the country has 2,500 and still rising) remain the most egregious example of real estate over-investment and looming write-offs now that the online share of retail sales has reached 10%. At the moment the risks of a property crash look more regional than systemic, but contagion risks to Tier 1 cities bear close watching in coming months. In the meantime, with China’s total foreign debt at only about 9% of GDP and export demand still sluggish, the RMB will continue to take the growth strain.