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News - July 8th, 2015

The China Story #1

by Infocus

The China Story

Recent falls in the China stock market – usually represented by the Shanghai Composite Index – have alarmed some people. It has fallen by about ???28% in a few weeks as can be noted from Chart 1. But it can also be seen from that chart within our financial year 2014/15, there had been a rise of about 150% to the June 2015 peak. So the market is still up over 80% since June 30th, 2014 after the correction/bear market!

Chart 1: Shanghai Composite Index

Chart 1: Shanghai Composite Index

Source: Thomson Reuters Datastream

But to put the problem in perspective, I have taken a longer historical series – from back to the start of 1991 when the data first became available – and I have used a so-called ‘log scale’ so that past booms and busts are not overshadowed by later compounding returns. This is standard practice with long, high trending data series as a log scale makes increases on the vertical axis effectively measurements in percentage change terms rather than changes in the number of ‘points’ on the index. A 100 point decrease on an index that stands at 2,000 is much more violent than a 100 point decrease on a market that stands at 5,000.

I also changed the Chart to the more standard landscape mode. Yes, you’ve guessed it.  I am trying to show you how some of the media unknowingly (or could it be knowingly?) trick some investors into unreasonable fear. Just compare a ‘proper’ presentation in Chart 2 against the tricks embedded in Chart 1!

Chart 2: Shanghai Composite Index on a log scale

Chart 2: Shanghai Composite Index on a log scale

Source: Thomson Reuters Datastream

If you’ve ever seen those wall charts some financial planners display in their offices for the All Ordinaries going back to 1900 or before – this is how they do it or you wouldn’t even be able to see where the Great Depression or the 1987 crash occurred!

By what might seem like magic, the recent ???28% or so correction now seems to have vanished! What this Chart 2 really shows is that the Shanghai Composite has always been very volatile when compared to major indexes such as the ASX 200 or S&P 500. The China market is not yet sophisticated.

Although I choose not to follow so-called “technical analysis” of stock market data, I cannot ignore that the recent high in Chart 2 was getting close to the pre-GFC high and that may have made some investors nervous – and ,hence, a sell-off.

So is China concerned about its stock markets and what, if anything, is it doing? Importantly, should the China market worry us?

Margin lending, that amplifies both gains and losses in a market, is very present in the China stock market. When a market falls, some investors might get close to a margin call and sell stocks if they don’t have the cash to comply with an actual or near margin call. This behaviour accelerates and amplifies the price fall. China is actually supplying more funds to increase margin lending! But that does not stop prudent margin call management.

About one quarter of listed companies requested a trading halt to prevent further falls until order is restored.

So part of the China market fall is possibly profit taking and part is probably managing LVRs (Loan to Value Ratios).

It is also clear from Chart 2 that the market at the start of 2014 was almost down to where it was at the worst point in the GFC! Perhaps the index needed a run to play catch up? It has only grown at about 12.5% pa since the late 2008 low. That’s modest growth for a country with economic growth that has seen some double digit growth during the period and 7% now. Of course economic growth is measured after taking inflation out but that is not the case with stock market indexes.

But the China government is hard at work managing the whole economy. The PBOC (People’s Bank of China) has made four 0.25% interest rate cuts since November 2014 to encourage economic growth. It also again reduced the RRR (Reserve Ratio Requirement) which allows the banks to lend more to investors. This ratio is a bit like managing the capital requirements our banks need to hold by regulation. APRA is talking about lifting our requirements soon. The PBOC is arguably only acting like the RBA, the Bank of England or the US Federal Reserve would in the same situation.

So what about commodities? Port Hedland just shipped a record amount of iron ore in June – up 14% on the previous June. The iron ore price has fallen a lot since its peak but more because of an increase in supply rather than a reduction in demand. It does mean small players with higher costs of production (like Atlas Iron) will be hurt much more than the big players like BHP and RIO at home and Vale in Brazil.

A similar fall has recently happened with oil prices. OPEC seems to be trying to put US shale oil producers out of business. Oil prices are also being affected by the Iran negotiations. Iran wants to be a player in the nuclear space. John Kerry, the US Secretary of State, and others are reportedly making progress in talks. But oil supplies from Iran critically depend upon the outcome as sanctions will be lifted. An agreement might be reached this week.

Iran has an estimated 40 million barrels of oil stored and ready to be delivered. With world demand at about 1.5 to 2 million barrels a day, Iran’s supply is putting downward pressure on oil prices. It might take a year for normal production of 200,000 barrels a day to be restored. So that explains the additional recent price volatility.

China’s GDP growth seems to be on track at around 7%, but trade figures have been a bit volatile. The PMI (Purchasing Managers Index) for manufacturing has been steady above the key level of 50 and is much higher for the services sector. Even India is coming into focus with growth now outstripping that in China! India might soon become the next big thing. I recall five years or so ago we were all talking about India taking over from China as a home for our exports at some near point in the not-to-distant future.

And finally – what does it all mean for us? There is very little international investment in the China stock markets and even less in China property. So if there was some new event that caused a major fall in the China market it shouldn’t flow on to us. No GFC is in store. But there might then be a temporary slump in resources demand from China – but that is certainly not our base-case scenario.

So all in all, I find the China story totally over-sold in the media – just like Greece was and is. But, as always, we can and should have empathy with any inhabitants of those countries that are adversely affected.

I am not a rampant optimist that sees no problems ahead. I spent part of yesterday with a friend who is an adviser for a global wealth manager to discuss down-side risk. We seemed to readily agree that the big problems in our world relates to how Australia deals with its aging population and the costs of keeping it healthy. How will the US ever repay its debts? It owes $4.5 trillion just from Quantitative Easing. If the Fed raises rates, that would make it even harder for the US to get its balance sheet in place.

These major problems need to be solved, but there is no massive rush. Just acknowledging the extent of these long-term problems by all sides of politics would be a great start. Then we can roll up our sleeves and act.

I am not even slightly worried by recent events in Greece and China. I am almost fully invested in equities (including the US) and I have no plan (yet) to migrate to cash. But, if the investment situation changes, I am prepared to either borrow more to invest or sell down to cash. I would be pleased to have the opportunity to communicate with you again if my stance changes.

Yours faithfully,

Ron Bewley PhD,FASSA
Director
Woodhall Investment Research

Important information

This information is general information only. You should consider the appropriateness of this information with regards to your objectives, financial situation and needs. Infocus Securities Australia Pty Ltd ABN 47 097 797 049 AFSL and Australian Credit Licence No. 236523 trading as Infocus Wealth Management.

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