Both China’s nominal GDP and corporate earnings saw double-digit year-on-year growth in the first half of the year. China’s equity market, supported by these strong fundamentals, performed handsomely – MSCI China Index grew 33 percent in the first seven months while CSI 300 index grew by 12 percent.
However, the rate of economic growth in the second half is expected to decelerate following the implementation of tightening measures such as deleveraging in the financial and corporate sectors as well as curbing of property bubble.
Under this circumstances, how much longer can this bull cycle sustain, and is policy tightening going to derail China’s bull market?
In the past 15 years, we have gone through five cycles of macro policy tightening in China, with three of them derailing the bull market (in 2007, 2011 and 2015) and the other two (in 2004 and 2013) experiencing temporary setbacks before the market returned to its upward trajectory.
Historically, we’ve seen three scenarios under which the bull market would remain in good shape despite policy tightening.
The first is when growth drivers in the real economy stayed largely independent from the macro controls. For example, in 2004, when the government attempted to curb overheating in the industrial and property sectors and tightened land and credit supply, foreign trade was then undergoing a golden era with export recording close to 40 percent growth.
Similarly, in the second quarter of 2013, in the face of liquidity tightening and stringent measures curbing shadow banking, local governments issued massive amounts of debts to ramp up infrastructure investment.
The second scenario is that no distinct asset bubble existed ahead of policy tightening. This was particularly evident in mid-2013 when turnover in both China and Hong Kong’s equity markets was dismal and valuations were distressed.
Thirdly, policy tightening is driven by proactive risk management rather than passive response to economic imbalances such as inflation and investment overheating.
Two commonalities emerged in the three instances when policy tightening did derail the bull market: clear signs of a capital market bubble in 2007 and 2015, and a sharp hike of funding cost which wreaked havoc on real economy (market rates surged by 160, 100 and 130 basis points in six months’ time in 2007, 2011 and 2015 respectively).
Currently, we hold the view that this cycle of policy tightening is not going to pose a major threat to the equity market. The 13.5x trailing P/E ratios of MSCI China and CSI 300 indices are broadly reasonable. And under the backdrop of global economic recovery and China’s inflation being under control, companies are able to absorb part of the financing costs induced by policy tightening.
More importantly, valuation of the equity market does not only rely on the prospects of economic growth and profitability of listed companies, but also on the sustainability of growth and economic structures.
Policy makers leveraged the economic rebound to proactively reduce dependence on debts and the property sector to drive economic growth. This would help improve investors’ confidence in the growth’s sustainability in the medium to long run, paving the way for equity valuations to move higher.
Growing the economy and rebalancing economic structures are two policy objectives that must co-exist in harmony. Stock market may react very negatively if either of the policy targets is missed by a large margin.
In the coming quarters, we are aware of the risk of a possible market pullback, given the uncertainty looming over external demand and domestic property market. But at this stage, growth drivers such as exports and private investments can help sustain corporate earnings growth, while policy tightening mitigates systemic risks.
A combination of strong fundamentals and structural reforms will most likely extend the bull market run until next year and beyond.
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