The Short- and Long-Term Impact of China - 3Q15

The price of Chinese-listed 'A' shares on the Shanghai Composite Index since 2010 to the middle of 2014 remained largely unchanged as market participants were concerned about the Chinese economy's declining growth rate and elevated debt levels. Either a result of domestic stock value seekers or the Chinese government initiating their agenda, the price of 'A' share stock climbed dramatically by 150 percent since June 2014. Similarly, the ChinaNext index (consisting of startup companies in China) rallied 225 percent in one year, bringing the price-earnings ratio of its constituents to 128.

As shown in the Correction in Chinese Stock Markets chart below, the abruptness of the rally that seemed to lack justification retraced quickly, similar to the spike that occurred earlier in the year. There are usually two reasons for such a sharp turn in prices: the use of borrowing and frothy expectations. When momentum investing is prominent, it is usually accompanied by leverage to derive a larger return when cash is not available. In China, the level of debt used in market trading is historically high. In June, the balance of margin financing outstanding was 2.2 trillion yuan or 12 percent of the free-float market cap of marginable stock and 3.5 percent of gross domestic product (see China Margin Trading chart below).

Correction in Chinese Stock Markets

Source: Bloomberg

China Margin Trading

Source: Bloomberg

Also adding to the frothiness was the type of investor likely involved in the rally. The number of A-share trading accounts spiked significantly during the duration of the rally, as shown in the New A-Share Trading Accounts chart below. These two factors drove speculation in pushing trading higher and exacerbated the downturn when investors received margin calls.

New A-Share Trading Accounts

Source: Bloomberg

One can argue that valuations are perhaps extreme and do not justify the current price, but the long-term prospects remain intact. The long-term equity market prospects of China are compelling when we analyze countries that have previously made the step from one with developing characteristics to one with developed characteristics:

Effect of Urbanization

Source: Bloomberg

For example, the United States saw significant appreciation in its stock market once the urbanization rate hit a level of 70 percent and gross domestic product per capita went parabolic:

GDP per Capita and Equity Market Returns: U.S.

Source: Bloomberg

The same could be said about South Korea when it had substantial growth in GDP per capita, its stock market trended in tandem:

GDP per Capita and Equity Market Returns: Korea

Source: Bloomberg

Though this is a while away for China, the reason to be invested in those countries is clear, but the catalyst for short-term performance does remain elusive.

For more information, please contact your Fifth Third Bank Client Consultant.

Fifth Third Bancorp provides access to investments and investment services through various subsidiaries. Investments and Investment Services are not FDIC insured, offer no guarantee, may lose value, are not insured by any federal government agency, and are not a deposit. © 2015 Fifth Third Bank

View Institutional Trends Archive >