Chinese equities have continued their march upward as predicted, buoyed by positive sentiment and expectations of continued economic easing from Beijing.
The positive short-term momentum could last a bit longer. But investors with a time horizon greater than six months should be very cautious: China’s deteriorating economic realities could quickly sour their prospects.
China’s benchmark CSI 300 rose 2.2 percent on March 1, after leading index provider MSCI increased the weighting it assigned Chinese A-share stocks in its widely referenced emerging markets index. Since Jan. 1, the CSI 300 is up almost 25 percent, double the appreciation of the S&P 500 Index during the same time.
The MSCI action has been expected for months. The index provider will increase the weighting of Chinese stocks in its widely tracked emerging markets index to 3.3 percent by the end of this year from 0.7 percent today. Together with offshore Chinese stocks listed in Hong Kong, Chinese onshore and offshore shares will make up approximately 34 percent of the reference.
Investment vehicles such as exchange-traded funds that measure their performance against MSCI’s emerging markets index will need to buy the underlying stocks. It’s a mechanical exercise that will shove an estimated $80 billion to $125 billion in new inflows into the Chinese equity markets this year.
Stocks have also been boosted by U.S. President Donald Trump’s extension of a March 1 deadline to reach a new trade deal with China. Citing progress made to date, Trump has delayed the deadline for a potential in-person meeting with Chinese Communist Party leader Xi Jinping later this month.
Short-Lived Bull Market?
While the MSCI action is good news for Chinese stock market investors today, it’s also old news that has largely been priced into the market.
But peeling back the onion a bit, inflows from foreigners may not automatically equate to a bull market.
According to Bloomberg data, foreign ownership of Chinese onshore stocks currently stand at a paltry 2.2 percent of the market. Retail investors own 20 percent of stocks. The majority of shares, at almost 55 percent, are owned by insiders such as founders, existing management, and parent holding companies (read: Chinese Communist Party heavyweights).
In the three weeks leading up to Feb. 23, such insiders were net sellers of Chinese stock—to the tune of 4 billion yuan (approximately $600 million) worth of shares, according to a Bloomberg Opinion report by Shuli Ren. The selling was more concentrated in the private sector, but it shows that insiders at Chinese companies may be dumping stock when the price is elevated.
And such insiders could very well continue to cash out and sell their shares to unsuspecting foreigners lining up to buy. Why? Because the fundamentals still look bleak.
The latest Caixin/Markit Manufacturing Purchasing Managers’ Index came in at 49.9 for February, indicating that Chinese factory activity shrank for the third consecutive month. While the reading was higher than January, it showed that China’s all-important manufacturing activity is still stuck in its longest contraction since 2016.
On the trade-war front, progress has been painfully slow. Both sides have said the right things in the media to avoid spooking financial markets, but fundamental differences remain unresolved.
China’s strategy so far is to buy its way into the United States’ graces, by offering to purchase more U.S. agricultural exports. This will mitigate the trade imbalance between the nations, which is only one of Trump’s sticking points.
The two sides are still far apart on fundamental issues.
“This administration is pressing for significant structural changes … especially when it comes to issues of intellectual property rights and technology transfers,” U.S. Trade Representative Robert Lighthizer told Congress during a hearing on Feb. 27.
Issues at hand “are too serious to be resolved with promises of additional purchases,” Lighthizer added. And even if Xi acknowledges and agrees to stop technology-stealing—a big “if”—in principle, there are still major questions around enforcement and accountability.
A new uncertainty surfaced recently after the abrupt end to the Vietnam summit between Trump and North Korean leader Kim Jong Un. Some commentators in the Chinese media speculated that the risk of Trump suddenly walking away from the bargaining table is a very real threat going forward.
Barring an unexpected about-face from Beijing, there is still a lot to be agreed upon and the process could draw out longer than the headlines suggest.
Mixed Messages on Stimulus
Investors have also bid up Chinese stock prices due to aggressive efforts by Beijing to stimulate the economy and loosen monetary policy. The prevailing belief was that the People’s Bank of China (PBoC) will do its utmost to loosen bank reserve requirements and pump up debt to keep GDP growth artificially elevated, potentially reversing Beijing’s efforts since 2017 to deleverage.
But mixed messages from Beijing more recently have muddied up those expectations.
After a record credit expansion in January, following Premier Li Keqiang’s statements at the beginning of the year that Beijing will enact measures to stimulate the economy and support private enterprises, Li has apparently changed his tune.
Li issued a statement on Feb. 20 warning against “flood-like” stimulus measures. He also seemed to decry the recent expansion of short-term credit, stating that “not only does this potentially create ‘arbitrage’ and ‘empty cycling’ of funds, but it may also bring new potential risks.”
Officials at the PBoC are also downplaying the likelihood of aggressive stimulus measures. Wang Jingwu, the head of the Financial Stability Bureau at the PBoC, said Feb. 28 that monetary policy will be fine-tuned “in a measured manner and firmly avoid flooding the economy,” according to a report by Chinese business publication Caixin.
The massive credit expansion in January and the subsequent anxiety suggest that there may be increasing confusion—or disagreement—at the highest levels of the communist regime on how to mitigate increasing risks to the economy going forward.
It’s terrible optics for investors, who should no longer pencil in aggressive stimulus measures going forward.