China has long been a land of contradictions: A preoccupation with healthy habits matched only by a preoccupation with smoking. A group-first mindset that disappears — very much disappears — when seated behind the steering wheel of a car. A trusting obedience to authority coupled with a distrust of most everyone else, including authority.
Contradictions make China unique. They make it endearing. And many Chinese take pleasure in an identity that joins otherwise conflicting ideas. In the West, it is only through the lens of contradiction that any sense is made of China at all.
China’s latest contradiction is front-and-center news around the world: A stock market rally birthed amidst deteriorating economic conditions. In a year’s time, China’s stock market has doubled in the face of declining GDP growth, falling property prices, weakening exports, plunging returns on equity, and debt at 280 percent of GDP — with abundant bad loans widely believed to be masked within the system.
And now, the “rally of contradiction” is being exported to Hong Kong. Long a bastion of comparatively smoothly functioning markets, H shares have shot skyward with the ferocity of an uncaged dragon.
There’s just one problem with this story: It’s wrong.
Both markets have risen dramatically. There’s no facade there. But the idea that the Chinese and Hong Kong stock rallies are contradictory — that somehow the magical Chinese elixir can bend market physics — is simply incorrect. And until investors understand that, they don’t stand a chance of understanding how to navigate either the Chinese or the Hong Kong share market.
Economics don’t matter
Ask any intelligent person — say, a fellow HKEJ reader — what drives stock market prices over the long term, and you are likely to hear something about economic growth. It seems intuitive that a stock market be related to its country’s economy.
Unfortunately, there’s scant proof of any such relationship. Evidence shows that stock markets and economies have very little to do with each other, even over surprisingly long periods.
We looked at historical data for China, Hong Kong and 11 other stock markets. The foreign markets we included — Australia, Brazil, Canada, France, Germany, India, Japan, the United Kingdom, the United States, Singapore and South Korea — represent a smattering of West and East, of developed and developing markets, and of accelerating and slowing economies.
Economies, on average, tend to grow. Stock markets, on average, tend to rise. Neither finding should surprise investors.
The relationship between the two is another story. You don’t need an econometrics degree to see that the link between economic growth and stock market returns is dubious at best. In fact, we found that the correlation between the two was just 6.1 percent.
Do you know what else holds a 6 percent correlation with stock returns? Rainfall. Yes, one US stock market study showed that the number of centimeters of rain that happened to trickle down from the sky bore just as much relation to stock returns as the growth of the economy.
But wait — wouldn’t we expect more developed stock markets to bear a stronger relationship with their economies than less developed markets? Developing markets tend to experience more volatile economic progress and wobblier equity markets. This is a reasonable line of thought. It, too, is wrong.
None of the factors we investigated — including geography, stage of economic development and size of the economy — affects how strongly a stock market tracks its economy. There are differences, but they don’t hold up against robust investigation; the same country exhibits varying correlations depending on the time period you select.
For Hong Kong, the relationship was 1.7 percent, or roughly zero. For China, it was minus 19 percent. Assuming the future looks like the past — there’s plenty of evidence that isn’t true, either — one might expect slowing mainland growth to actually bode well for the stock market.
Explaining the Hong Kong rally
Economic growth and stock returns might be decoupled, but a slowing Chinese economy may have contributed to the stock rally in one way: alleviating uncertainty.
Markets do an awful job incorporating uncertainty into stock prices. When many good things seem possible, a company’s stock can skyrocket, even if nobody knows when the good things might materialize or how good they’ll be. Just look at the valuations of Tesla, Tencent and Amazon.com.
On the flip side, when many bad things seem possible for a company, the stock can be unduly punished. This has been the case for the Hong Kong market for some time. The possibility of slowing economic growth in China has been on the horizon for years. The uncertainty (When will the slowdown begin? How severe will it be?) is often a more powerful drag on stocks than the actual event.
Investors are beginning to be able to answer these questions. The slowing to approximately 7 percent annual growth could be a case of the devil we know outweighing the one we don’t (a certain/understandable/familiar bad thing is often preferred to an uncertain/unknown bad thing, even though both are bad), and markets are perking up with the heightening visibility.
Stock connect and cross listings
Of course, increased certainty doesn’t double a stock market. Everybody knows that the Shanghai-Hong Kong Stock Connect played a role in fueling the rally — but we believe how, exactly, is misunderstood.
The Hong Kong exchange currently lists 1,879 companies comprising nearly HK$60 trillion of market capitalization. Of those, 953 companies, or 51 percent, are cross-listed elsewhere in the world (excluding mainland China).
That seems big, but it’s even starker on a market capitalization basis: HK$56.6 trillion of the HK$60 trillion listed in Hong Kong is available on other exchanges (again excluding China).
That means, until recently, there was little reason to use the Hong Kong exchange for many foreign investors, especially considering the real or perceived risks in Hong Kong exceeding those of buying the same stock elsewhere.
The Stock Connect did two things to alter this landscape. First, it gave foreign investors an incentive to trade in Hong Kong (partly for access to A shares, and partly for a potential arbitrage opportunity). Second, it opened the H-share floodgates to mainland investors, who are much more likely to invest in companies they know on the Hong Kong exchange than in New York, Frankfurt or Sydney.
But the Stock Connect only prompted the Hong Kong rally; it didn’t carry it along. The Connect’s HK$13.1 billion daily southbound quota pales in comparison to the HK$100 billion recent average volume of the Hong Kong exchange, and especially to the HK$290 billion peak volume reached in April.
The Hong Kong market had been like dry kindling waiting for a match — a match that came through the Connect.
From a mainland perspective, it’s no surprise that Beijing manufactured the A-share rally to offset deteriorating economic news. Most governments seek to stimulate their economies during slow times, but primarily through interest rates (which Beijing cut for the third time in six months in May) or tax reductions on certain investments.
The US Federal Reserve, for example, avoids stock market interference apart from occasional broad comments.
Not so in China. Beijing was happy to nudge its citizens to invest in stocks — they opened brokerages accounts at a rate of 1 million per day — and facilitate an IPO process that fueled investor excitement with exceptionally high initial gains.
And Chinese investors, who hate to miss a rally, have learned to cooperate with Beijing’s nudges. For the past 30 years of China’s economic miracle, they’ve watched the government suggest, and the herd follow. This way of wealth creation seems as normal to them as any other.
As Beijing began to worry that its rally-creation efforts had become too successful, mainland investors noticed the arbitrage opportunity in Hong Kong shares of mainland companies available through the initially empty Stock Connect.
Unsurprisingly, mainland investors bought only mainland stocks in Hong Kong, but by April 8th, 2015, the entire 10.5 billion yuan (HK$13.1 billion) southbound quota was used up.
Go! Buy Hong Kong Stocks! (quote from the state-run China Securities Journal)
Beijing’s motives for encouraging the Hong Kong rally are both more speculative and more interesting. Obviously, diverting excitement and capital away from A shares could offload excess frenzy while still benefiting the Chinese companies whose shares trade in Hong Kong.
Goodwill between Hongkongers and Bejing — much needed considering the protests and unpopular 2017 election announcement — could be another aim, along with strengthening economic relations with the country that will presumably function as a gateway to the free-market capital that Beijing may increasingly need.
Whatever the motivation, it’s strong enough for Beijing to allow mainland mutual funds and insurance companies to invest in Hong Kong, take steps to ease the 500,000 yuan (HK$625,000) minimum brokerage account balance to participate in the Connect, to consider increasing the Connect’s quota (reportedly in discussions), and potentially open a Shenzhen Connect.
The right place for a rally
Fortunately, if there was any market that deserved a rally, it was Hong Kong’s. And even now that the Hang Seng index has surpassed 28,000, the index is still notably cheap relative to other markets and to its own history.
The most important thing about this rally isn’t the rally — it’s what the rally represents. With mainland money comes a mainland style of investing. Hongkongers will see more money, more volatility and more of a seemingly contradictory investing approach based on what worked as a command economy uncoiled from years of repression: Go with the government and the herd long enough to make a quick profit — and then sell.
The counterpoint is that fast-trading mainland investors are steadily awakening to international-level investment analysis. And Beijing, now aware of the trust that free-market scrutiny, transparency and accountability bring to markets, has become progressive enough to deliberately invite their pressure in through the Connect.
In its support of Hong Kong, Beijing is hoping for one more contradiction. It knows that trust equals value, and that China has a trust problem. The best capital and trust-building scrutiny will come from independent-minded international investors — the exact people Beijing has the least control over. They don’t respect Beijing, but they do respect the economic power of millions of Chinese investors.
Whether Beijing will continue to maintain its desired influence over mainland investors while simultaneously welcoming transparency and independent analysis — and without resorting to draconian tactics that frighten off global investors — is the key question. And it’s a question that will be answered in Hong Kong.
The article first appeared in the June issue of the Hong Kong Economic Journal Monthly.
James Early and Alex Pape, CFA, are CEO and Chief Investment Officer of Iwaitou.
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