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China’s long-term outlook despite “A” shares correction and the main triggers

China’s long-term outlook remains compelling in spite of the recent correction in its A-shares market which fell almost 30% from its peak and triggered volatility in the Hong Kong H-shares market.

“It’s a case of the market rising too fast,” says Christine Tan, Senior Portfolio Manager with Excel Investment Counsel Inc.

The correction in the A-shares market was triggered by three main factors: (1) tight liquidity in the intra-bank market, fuelled by a rash of IPO’s which sucked money out of the market; (2) the rapid deleveraging of margin finance by brokers and other institutions following the implementation of margin restrictions by the government; and (3) the domino effect of the sell-off which spurred panic selling.

“Although we anticipate some volatility in the near-term, we believe the worst is now behind us,” says Tan.

Incidentally, the Chinese government had been concerned about the market’s run-up for some time and attempted to restrict or control margin trading. It cut interest rates this past June to improve liquidity and restricted investors owning more than 5% of a stock from selling for six months. But these measures failed to stem the market’s decline.

However, there is now a concerted effort to support the market, with different government bodies collaborating with each other to stall the market’s decline. They have implemented a series of measures and announced new polices, including: (1) providing liquidity into A-share market (2) rolling over margin financing (3) encouraging insurance companies, investment banks, and other institutional investors including the Social Security Fund to invest in the A-share market (4) increasing the Qualified Foreign Institutional Investor quota to USD $150 billion from USD $80 billion (5) preventing State Owned Enterprises from selling stocks (5) suspending IPO’s and secondary placements, and (7) encouraging management teams and controlling shareholders to hold or increase their stock positions.

Despite the near-term volatility, which will likely persist for a few months, Tan believes that “there are still a lot of quality opportunities in China.” Tan favors the shift to “newer leaders” in the “new China” and in sectors that are not capital intensive, such as technology, education, healthcare and environmental services.

In addition, there is also room for additional investment opportunities. “The market cap of China as a percentage of GDP is only 70%, compared to 100% - 150% in most developed countries,” Tan says.

From a valuation standpoint China’s A-shares are not necessarily cheap compared to its historical average, but still is relatively cheaper than US equities, providing scope for additional growth.

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