November 2015

The Big Sell Off

CVF News

The Big Sell Off

Gary Hui

The S&P/ASX200 index returned -8.0% in 3Q 2015; with the Energy and Materials sectors being the biggest losers, posting -25.9% and -12.8% falls respectively. Only the Utilities and Industrials sectors managed to post positive returns, up +1.3% and +2.4% respectively.

China was both the cause of the sell off and the epicentre of its impact, with the Shanghai Composite Index posting -28.6% in the quarter.

Prior to the calamities of 3Q 2015, China’s Shanghai Composite Index had appreciated for five consecutive quarters, posting a cumulative gain of 110.4% from March 2014 to June 2015; tidy returns by any measure.

So what drove the big run up in China’s stock market? It wasn’t earnings; in fact both trailing and forecast earnings per share for that market have been falling since 4Q 2014.

Our perspective is China’s great bull market was spurred on by a heady cocktail of state sanctioned margin lending1, expectations of A-share inclusion in the MSCI Indices2 (to which many of the largest equity managers benchmark) and positive expectations of increased market liberalisation (equity and currency). Many investors bought in, reasoning that a strong equity market would lead to secondary equity issuance and the potential for a “beautiful deleveraging” of China’s chronically indebted corporate sector.

As a measure of the frenzied zeal with which local investors embraced this bull market, in May 2015 fourteen million new China A-share brokerage accounts were opened by the nascent investing public; 13x the number opened just three months prior and 44x the number opened in May 2014.

China Stock Market – New “A” Share Accounts

The Shanghai Composite index peaked a few days after MSCI deferred A-share inclusion in their indices on 9th June 2015, and then the sell off began at pace. From 12 June to 8 July, the market fell 32.1% in 17 trading days (8 July was the day over 500 A-share listed companies announced trading suspensions, bringing the total suspended companies to over 40% of listed companies). And then it was over, or so it seemed.

On 11 August the PBOC devalued the RMB by 1.9% which caught the market unawares and triggered a fresh bout of frenzied selling. The messaging of this small devaluation by the PBOC was poor; investors were clearly spooked with huge portfolio outflows the result which in turn saw official foreign exchange reserves decline by US$94bn in August, the largest outflow on record. On 24 August 2015 the Dow Jones Index had its largest ever intraday fall, opening over 1,000 points lower before closing down 3.6%.

The official Chinese response to all of this was telling. Draconian measures ensued; like the petulant child playing backyard cricket who storms off the pitch when they don’t like the score, many State Owned Enterprises simply suspended trading in their shares. Government owned companies were banned from selling shares, market participants were threatened (including one brokerage in Singapore which received a demand for the identities of anyone short selling China A50 index futures), some journalists were jailed and government agencies began buying the market to support it (thereby undoing any hope of deleveraging).

Reflecting on these events, the official response to the market sell off parallels the official stance on the economy; denial. Official GDP chugs along at ~7%, but increasingly the evidence mounts that this is fantasy. The Chinese equity market has, apart from a few small pockets of structural gain (internet, health) exceptionally weak revenue and earnings growth; this seems to us more reflective of underlying reality. Markets are discounting mechanisms, so we remain alive to the possibility of reform and rebalancing given Australia’s economic leverage to China, but for now these are concepts, there is no broad based positive earnings story here.

Shanghai Composite Index vs China Margin Loan Balances

From these events we take away a few perspectives:

  1. Increasingly, the Chinese Communist Party’s control is over economic statistics rather than economic outcomes
  2. The expectations gap between reality and official growth is real yet somewhat unknown. We wonder how it closes
  3. What happens in China matters more than ever before. On 24 August, Chinese markets inflicted the largest single intraday correction in the Dow Jones Index’s history
  4. Thus we consider China to be the single most important external factor to consider in our portfolio construction

We remain deeply circumspect with regards to any China linked investment thematic and frankly its often hard to escape either the primary or derivative linkages when considering many Australian and New Zealand equities.

1 State owned media encouraged citizens to invest in the market.  China Securities Finance Corp was the government institution providing margin lending services to qualified brokerages.
2 MSCI consultation on the China A-Share Index Inclusion Roadmap began in March 2014.