China's Getting Ready For A Long Bull Market
Summary
- Restrictions in real estate speculation will push more funds into the stock market.
- Capital market reforms show improvements in oversight, which will likely attract more investors.
- New innovations show promise in producing leading companies similar to “big tech” in the US.
- China is still a global growth engine.
China’s Shift Away from Housing
As the government restricts real estate speculation and tries to curb ever-rising property prices, the massive amount of Chinese household savings need alternatives for returns. The next move will likely be to the stock market.
In 2016, the Chinese government made its first statement on the housing market, stating that “houses are for people to live, not for speculation”. Subsequently, this started the strictest control in China, an attempt to curb the ever-rising home prices.
China’s residential property prices have been on a historic run partly due to the commercialization of land and the introduction of specialized zoning rights. The situation was further stimulated by the “4-trillion” liquidity program during the 2008 financial crisis, where most of the funds ran into buying properties instead of small and medium businesses.
The real estate industry turned out to be one of the most profitable businesses overnight. Companies in other industries tried to grab a housing project to develop residential property, sometimes at the expense of their main business. Many well-off citizens would rush to buy, while those who are average or below-average income earners would further curb consumption hoping to save enough to buy their first home. As a result, ghost towns were formed and the real economy wasn’t seeing an uptick of growth that the stimulus intended to generate. That triggered the Chinese government to step in and introduce policies to stop the buying frenzy.
At the current state, I believe the Chinese housing market has reached near-peak levels, except for a handful of China’s top-tier cities, such as Shenzhen, Shanghai, Beijing, etc. These top-tier cities have the best schools, infrastructure, and the best businesses in China, attracting talents to migrate in for better opportunities. In most of the other cities, their property prices are currently experiencing a correction as they were significantly overvalued during this period without the same prospects. Therefore, regular Chinese citizens are facing a dilemma when they are trying to find a place to invest their hard-earned savings.
On one hand, more affordable houses in non-top-tier cities have little appreciation prospects, while on the other hand, it’s almost impossible with their income levels to afford a house in one of the top cities where prices still have room to grow.
Moreover, according to a 2016 published paper, housing assets already account for over 70 percent of Chinese household wealth. It is extremely difficult to see that this number could rise any higher. With so much wealth concentrated in one asset class, the housing market has become a substantial concern for national security and economic stability. Any sharp decline in property prices in China may lead to a significant backlash from the people, undermining the legitimacy of the government. As such, China would take all measures to ensure that such an event never happens.
Yet, current high prices discourage spending. As noted previously, in China, owning property has cultural significance. Many middle-class households would work extremely hard and save substantial amounts hoping one day they could have their own home. If property prices were lower, it could unleash a significant amount of buying power. Therefore, for property prices to gradually decline, Chinese households will need to diversify their wealth away from properties.
Given the fact that the housing market is becoming increasingly difficult to invest in both from an execution standpoint and a valuation standpoint, where can the massive amount of savings go? As of April 2020, China’s total deposits are at 28.6 trillion USD, almost the size of the US and the European Union combined. Household savings rates are still hovering around high 30% according to Trading Economics.
I suspect the government already has this issue in mind with much more frequent and fundamental reforms as well as incentives to China’s stock market. If the stock market could be the next wealth-creating machine, many people may start to sell their second-property to invest, thus achieving the national goal of diversifying household wealth. This leads to my second point -- capital market reforms.
Capital Market Reforms
Reforms are improving the overall quality of the companies listed on China’s exchanges which in turn will attract more investors.
Throughout the years, China underwent some fundamental capital market reforms. There were many legacy structural issues with the Chinese market. One of the most notable was the way companies get listed or delisted in exchanges. Historically, to get on China’s main exchanges, a company must have either:
Accumulated profits of over 30 million RMB (USD 4.2M) in 3 years prior listing, or
Accumulated cash flow from operating activities over 50 million (USD 7M) in 3 years prior listing, or
Revenue over 200 million RMB (USD 28.1M) in 3 years
Such conditions make it extremely difficult for companies to get on. However, more importantly, there were no proper procedures to delist failing companies. As a result, management would work extremely hard only to get listed and once listed, they would cash out. This led to many zombie companies on the exchange only driven by headlines and speculation, brewing a strong culture of “short-termism”. Companies on the exchange could even sell their listed company shell on the exchange to another entity for them to get on as an avenue to circumvent the harsh entry requirements. Fraud is also prevalent. In short, the market is tough to get in and lacks the proper oversight and regulation after companies were listed.
In 2012, both the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE) unveiled major improvements to the delisting process. For instance, they announced that firms should be delisted if sales are less than 10 million RMB (USD 1.41M) for three years consecutively.
In 2014, the China Securities Regulatory Commission (CSRC) issued a new order to mandatory delist companies that have committed significant fraud.
In 2018, the CSRC further amended the delisting policy and procedures to fill in loopholes. The new document also stressed on strengthening oversight and delisting execution. As of December 2019, about 117 companies have been delisted as China starts to tighten oversight.
As the delisting becomes common and oversight tightens, the overall quality of the listed companies in the Chinese stock market would improve significantly, becoming more attractive to investors domestically and worldwide
Another significant event was the introduction of the Sci-Tech Innovation Board (STAR market) in June 2019 to support tech companies and foster new growth for the economy. First, the board uses a registration-based system instead of an approval-based system and significantly lowered barriers of entry. This will serve as a working example of how to gradually move China’s other boards to a registration-based system. Second, the board significantly lowered the barriers of entry to allow tech companies that have large prospects but not yet profitable to gain funds from the public. This is the second attempt China has tried to lower barriers and ease listing. The first one failed miserably but with the lessons from the first trial, I believe the STAR market will be reasonably successful. Third, the board abolished limits on daily price movements for the first 5 trading days after IPO. After that, price movements will be limited to a 20% range on either side. In China’s other markets, a stock can only move +/- 10% with the intent to protect the vast majority of retail investors. This ease in price movement restrictions would promote better market liquidity.
Currently, there are also talks about introducing “T+0” to the STAR market. Once that is implemented, it would further improve the liquidity condition in the market and gain greater traction from investors. All of these reforms suggest that Chinese leaders are beginning to put a heavier emphasis on the role of capital markets.
New Innovation posed to Ignite
China’s pace of innovation will likely lead to the creation of “FAAAM”-like stocks (Facebook, Apple, Amazon, Google, and Microsoft) in China and become the overall driver of stock market momentum
How was the US stock market able to sustain an overall uptrend since the 1980s? I strongly believe the fundamental drive was innovation. In the 80s, the US was leading in a wide range of industries, from automobiles, telecommunication, computers, etc. The boom brought prosperity to the country and propelled many companies to new highs, such as Ford, General Motors, IBM, and AT&T. Gradually, growth in the auto, chemicals softened and at the turn of the century, the internet and computer revolution took over. In the past 20 years, we have witnessed the rise of tech from a niche industry where only a few understood to be a behemoth it is today, capable of producing multiple trillion-dollar companies.
Source: Dow Jones Industrial Average from 1980 to today
In the next 20 years, artificial intelligence, robotics, blockchain, genomics, 5G and much more will be driving new growth for the global economy. If history serves as a lesson, there will be many more trillion-dollar companies that will be born out of these new technologies. With a quick assessment around the world, it wouldn't be difficult to discover that the US and China are best poised to reap the benefits of these new developments.
Historically, the East Asian giant had a questionable track record of innovation and was playing catch-up to the western world. Over the years, however, China has rapidly increased its R&D spending and is now second in the world, just behind the US. Recent events have escalated the importance of research and innovation. In terms of adoption, China shows significantly higher penetration rates than Europe and the US, most notably cashless payments.
Now with a national focus on innovation, the STAR market will serve as the home for all Chinese-based tech companies. The government is also deliberately making efforts to attract successful companies back to China as many went public in the US. For example, Alibaba is now also listed in Hong Kong. Although the US is still the best for companies to go public, with new innovations on the horizon, political tensions, and China’s pace of execution, it is hard to believe that there won’t be a handful of “FAAAM”-like companies in China.
Difficulty in Finding Returns
China is still the global growth engine and provides the world with economic stability. Investing in China may provide adequate diversification and handsome returns.
The world is growing more and more uncertain as the economic condition deteriorates. Investors are looking around the world to see where they should allocate their money. Cash is the worst kind of investment as central banks keep pumping more money into the economy to fill up liquidity gaps during this pandemic. Talks about negative rates in the US could crush returns on bonds where yields are already at historic lows. Worries about inflation are pushing gold near all-time highs. In comparison, the US stock market, despite the country being the epicenter, still looks relatively attractive with many technologies and healthcare companies that are actually benefiting from the crisis.
However, as more capital flows into these companies, they are becoming increasingly expensive. The FAAAM stocks make up 21% of the S&P 500. Amazon just recently made a new high and Apple is currently trading at a P/E ratio of 25.48, close to all-time highs. Mathematically, if the FAAAM stocks rise by 5%, for the S&P to decline by 10%, the rest of the market would need to decline by 14%. The decline could get close to 30% if we also account for healthcare stocks. This phenomenon explains mostly why there is a disconnect between the market and the underlying economy.
From a valuation standpoint, the risk to return ratio in the US stock market isn't looking very attractive. The current Shiller P/E ratio, measuring the S&P 500 is around 30.10, substantially higher than the historical average of 15, while we have record-high unemployment numbers, a pandemic, civil unrest, and an election year. If you agree that a market trajectory is based on earnings over the long run, then this market is bound to have a correction. Though the Fed is providing far more than anticipated cheap credit, it can only help with short-term liquidity, not longer-term solvency. Fundamentals are still weak and investors should be extra cautious.
Source: Shiller PE Ratio of S&P 500
On the other hand, the Shanghai stock exchange is only trading around 13.54, not far up from historic lows.
Source: Yahoo Finance
If we look at the correlation between the CSI 300, the largest 300 companies traded in the SSE/SZSE, and the S&P 500, the number historically was under 0.3 which would provide tremendous diversification benefits for any US-based portfolio. Even with the recent uptick of correlation, the value is still below 0.5.
Source: South China Morning Post
Another chart shows that SSE has low correlations among most of the market indices.
As investors around the world look for opportunities, China has several upsides besides diversification benefits. First, it has a stable political climate compared to other emerging markets. Second, China is still the global economic growth engine as more and more Chinese people reach middle-class status (Currently, its size is 400 million). Third, the regime set up in China allows the government to have much more tools if there is a slowdown, such as directing SOEs to complete projects beneficial for long-term growth but not profitable in the short-run. Fourth, if external conditions deteriorate, China, given its sheer size, could direct exporting capacities to its domestic market, which may provide protection towards the downside, compared to exporting economies in Europe.
In addition, China has made substantial moves to attract foreign capital, such as including its market in MSCI and the FTSE Russell indices, opening up Shanghai-London stock connect, and lifting restrictions for qualified foreign investors. As more international funds flow into the market, these external pressures may help raise the overall quality of the market.
A Short Note on Risk and Concerns
Though conditions look favorable, I still want to provide a more balanced view. Currently, the number of high-quality firms listed in China’s stock market is still small compared to the US. Most players are speculative and short-term investors in nature due to extremely low transaction fees and zero capital gains tax. The stock market also has a large number of retail investors, which causes large fluctuations in stock prices from headlines and irrational buying or selling. Tensions between the US and China do pose sizable risks in the foreseeable future. Finally, China's stock market is only in its infancy, with just 30 years of history. Investing in such an immature market will require extra caution.
Thanks for reading!
This article was written by
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