China's Shanghai Composite has been on an absolute tear over the past 6 months, with the index rallying around 50%.
While the Shanghai composite has rallied, the economic news out of China has been increasingly bearish. November manufacturing PMI was 50.3, barely above the breakeven 50 level. Similarly, China's housing bubble is beginning to regress. In November, the price of newly built houses decreased 3.7% year over year, marking the third straight month of declining home values. Given that housing is the largest sector in the Chinese economy, as housing slows, China's economy slows.
One reason for the market/economy divergence is that the index is not necessarily dependent on economic news. The Shanghai Composite has been basically being flat since 2001 even though the Chinese economy has averaged 8% growth every year. If the market can be bad while the economy grows, then it stands to reason that the market can be good while the economy slows.
While I postulated that the principle reason for the market/economy divergence was that foreign investors and speculators were buying China for the first time, one commenter wrote that the Shanghai index was rallying because the market was anticipating additional easing in addition to the Chinese government wanting the equity market to play a larger role in the allocation of capital.
I have to agree with that commenter. Given the precipitous fall in crude prices and China's continued housing price decline, China is more and more in danger of deflation than ever before. To prevent deflation, China's central bank will likely continue to lower interest rates from the present 5.6%. Given that loose monetary policy/QE has ignited massive stock market gains in both the S&P 500 and the Nikkei, loose monetary policy could do the same for the Shanghai composite as well.
In a way, a rising Shanghai index is part of the Chinese government's market oriented reforms. Having a growing equity market is good for China because equity markets are more efficient at allocating capital than banks, as the market is less susceptible to political influences. The equity market is less eager to assign low cost capital to inefficient SOE's, for example. If the equity market becomes larger, it will allocate more capital, making China's economy healthier.
The Chinese don't have many options in terms of realizing a decent return on their wealth. CD's pay very little and housing prices are declining. The stock market is one of the few places to earn a decent return (albeit possibly a temporary one). Because the Chinese don't have many other options, the Shanghai Composite could continue rising in the face of the bad economic news. A rising stock market can sustain itself for a long time through the wealth effect, relative valuation, recency bias, and additional margin for bulls.
Even though China's current economic data does not justify the Shanghai Composite's rise, the index's rise is justified if the Chinese economy does well in the long term. If President Xi Jinping's reforms succeed, the Chinese economy will be more dynamic and profits will rise.
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