21 October 2016
China needs to restore investor confidence after its recent equity market rout, which has spilled over to other bourses in the world. Photo: HKEJ
China needs to restore investor confidence after its recent equity market rout, which has spilled over to other bourses in the world. Photo: HKEJ

Why the market correction may play out some more

The Hang Seng Index has tested the 2014 March-low, and the benchmark should now find some technical support at the 20,800 level.

Both Hong Kong and mainland markets have sharply swung to bear market territory after strong rallies earlier. 

Chinese companies currently account for a bigger share of the Hang Seng Index, making the Hong Kong market more volatile. The local market is easily affected by a sell-off on the mainland.

The bursting of the A-share bubble has come amid a combination of factors, including deleveraging, slow economic growth and yuan devaluation.

China has come to a tipping point of deeper market reforms or sticking with the planned economy. This has, not surprisingly, brought about various uncertainties.

Market participants have failed to get enough clues from policymakers and gradually lost confidence. This has led to the current market meltdown.

Beijing has ample room to stabilize growth as expected by the market. However, it has repeatedly made mistakes in intervening, such as ordering the “national team” to help arrest the market slide.

The Chinese government now faces a harsh dilemma, with some foreign investors wondering if we are going to see a repeat of the 1997 Asian financial storm.

I expect the mainland and Hong Kong markets to continue their correction in the current quarter, which could set the stage for a new round of market rally.

As for Wall Street, it doesn’t make too much sense to attribute the sharp correction there in the past few days to slower China growth.

China’s economic slowdown has been well expected, and it could affect earnings of companies like Apple who rely heavily on the China market.

Meanwhile, US market valuations had already reached a high level, and a correction is quite natural. 

Hong Kong and mainland markets have both long been driven by sentiment. The Hong Kong market posted a whopping gain back in March and April, while it suffered heavily from a sell-off two months after the Hang Seng Index peaked on June 8.

The shift in market sentiment is not in line with any deterioration in fundamentals.

Over the last 40 years, the Hang Seng Index has retreated many times from peak levels due to excessive valuations, such as 63 times PE in 1972, 26 times in 1997 and 24 times in 2007.

But now the market valuation has dropped to around 9 times earnings, from 13 to 14 times at the middle of this year.

There is limited downside from the support level of eight times P/E. However, the global market turmoil could easily ripple into the local market, causing further damage. The Hang Seng Index may find a bottom in the current quarter, and investors should patiently wait for the market downturn to wind up.

The Shanghai market has failed to stabilize despite market rescue efforts.

In the latest support measure, the national pension fund has been allowed to invest up to 30 percent of its net assets in the stock market, potentially leading to the injection of over 1 trillion yuan into domestically-listed shares over the medium and long term.

However, the move offers very limited help for the market in the near term. In the meantime, expectations are already factored in for rate cut and reserve requirement ratio reductions, or even some tax cuts, to restore market confidence.

The yuan devaluation has triggered a currency war and worsened capital outflow. Foreign investors have been short-selling A-shares in a bid to cash in on the downturn in the market.

Among other factors, fresh tensions in the Korean peninsula could increase market volatility in the region.

Investors are also worried about a domino effect of potential debt defaults in emerging markets, prompting them to dump some assets and move into cash to cope with the uncertainty.

Beijing has hoped to stimulate domestic consumption in a bid to offset the impact of weaker exports and foreign demand.

However, as people have suffered losses on investments in precious metals and equities, and the housing market is also plagued by some ills, there are doubts on how much consumers will step up.

China has tried to maintain 7 percent GDP growth to keep employment rate at a healthy level. Slower growth could spark fears of rising jobless rate and waning consumption demand. It remains to be seen how Beijing will navigate the various problems.

This article appeared in the Hong Kong Economic Journal on Aug. 25.

Translation by Julie Zhu

[Chinese version中文版]

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columnist at the Hong Kong Economic Journal

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