Crisis of confidence hits Chinese equity markets

The Chinese equity market has taken another tumble overnight, falling 8.46% to 3200pts. The market is down 36.6% from its recent high of 5050pts reached in May 2015. This is in fact the 2nd bubble achieved in the Chinese equity markets, since the market rallied to 6000pts in late 2008. What are we to make of the current fall?

It is apparent from the chart below that the market is destined to follow a similar trajectory. My expectation is that the Shanghai Composite Index is destined to fall to 2500pts, and that it will find support at that level before rallying once more. China is of course the ‘wild West’. We have to expect such volatility in the market.

I am expecting the Shanghai Composite Index to find temporary support between 3200-3400pts, however it can be expected to fall back to 2500pts before we can expect a ‘big bounce’. That bounce could be expected to take the market up to 3400pts in the long term, as long as ‘cost-of-living’ inflation remains low globally. There is good reason for this to be the case for another decade. It is fair to say that the Chinese market, having consolidated, has upside again to 4,000-6,000pts. I believe, based on fundamentals, that the Shanghai index is destined to ‘break out’ for inflationary reasons in years to come. That’s as long as 15 years away. For this reason, we should see the current sell-off as an opportunity. That (purple) ‘base line’ is a solid support, and a good level for buying Chinese equities.

Shanghai Composite Index
Shanghai Composite Index

Source: Sheldon analysis of 4-Traders.com

The reason to expect the market to recover is:

  1. The sustainability of low interest rates – There is no prospect of inflation in the medium term
  2. The appeal of China as a place to invest – There are a lot of positives for China still even as labour costs creep up
  3. The appeal of Chinese workforce. Yes, you can find cheaper labour costs outside of China, but you will struggle to find a more disciplined work culture. That’s not to say it doesn’t exist in certain individuals, and certain countries like Vietnam, but China is a ‘large strategic market’ and its akin to America’s industrialisation in the 18-19th Century.

Now, the cause of the crisis of confidence in 2008 was the sub-prime crisis in the USA. In this case, the collapse really resulted from the ‘threat of rising interest rates’ and simply the belief that the markets were over-bought and could not justify their yields. Moreover, the specific production/export statistics from China were conspicuously bad. On my Sheldonthinks page, I identified the cause of the weakness in the US market, and its fair to say that both markets are strongly linked, given that China greatly depends on its import penetration into the US, and the state of the US market generally. Given the Trump is the leading Republican candidate, and his talk of tough trade negotiations, its possible that Chinese investors are seeing a prospect of changing trade relationships with the USA. We have seen talk of ‘currency wars’, but really that is a ‘relativist’ argument compared to the prospects of a ‘trade war’.

China is in a transition stage. Notwithstanding the strategic importance of China, there are other markets, like India, Vietnam and Indonesia, that are going to make as much sense as export centres. The Philippines has in recent times become a centre of investment (at China’s expense). This is not simply related to China’s activities in the Spratly Islands, and the military takeover in Thailand. There is a simple fact that ‘cost wise’ and ‘strategic commercial diversfication’ was going to make other Asian markets more appealing, and for China to focus more on domestic development.

A great many people are concerned that China’s debt levels are too low. Such thinking tends to ignore several factors:

  1. The corresponding asset base of China – these debts are being spent on infrastructure and property development
  2. The sustainability of its fundamentals – China remains competitive and strategic
  3. The high savings rate in China – The implication being that Chinese indebted state enterprises can sell down assets; in fact the constituents struggling to find a channel for their cash would like nothing more. The debt of the state sector is dwarfed by the assets and savings of the private sector. Selling off state assets will make a big difference; as will rising taxation and the efficacy of tax collection.
  4. China has pent-up internal demand or ‘opportunity’. Chinese people are apprehensive about their future. In order to get conservative Chinese people spending, there is good reason to expect the government to offer a state pension system, welfare and other ‘protections’. There is already public education, however we might well expect further developments with insurance, with the intent being to give Chinese people more confidence to bring spending forward.
  5. China’s various markets can be expected to undergo considerable reform over the next 10 years, and that can be expected to see a slowing of Chinese based production and investment, and a corresponding growth in consumption. It will still be ‘solid’ and substantive in absolute terms, but we can expect more Chinese investment abroad.

For the simple reason that global market fundamentals are strong, and there is no problem of ‘cost-of-living’ inflation, there is no reason for this rosy outlook not to persist for the next 10-15 years. There might well be another bubble ahead, however that will be a problem of ‘asset inflation’ rather than an indelible absence of fundamentals.

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