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China averts short circuit, markets relieved

China averts short circuit, markets relieved

08-01-2016 | Insight

On January 7, the A-share market fell sharply after the opening bell. This triggered the new circuit breaker mechanism which had been implemented on the first trading day of 2016, freezing trading on the stock markets for the second time this year. Meanwhile, the Chinese authorities have already decided to suspend this new rule.

  • Jaap  van der Hart
    Jaap
    van der Hart
    Equity Fund Manager
  • Victoria  Mio
    Victoria
    Mio
    CIO China, co-Head Asia Pacific Equities, Fund Manager Robeco Chinese Equities

Speed read

  • Newly installed trading freeze rule suspended to reduce volatility
  • Short term: weakness likely to continue in A and H shares
  • Medium term: plenty of attractive investment

Multiple factors are causing the current poor sentiment on China’s markets. An important one is China’s weak economic growth, with increasing pressure from employment and bank bad debt. This is aggravated by increased overseas market volatility. Chinese domestic investors also have concerns about near-term liquidity conditions caused by the implementation of a registration-based IPO system and the launch of a strategic emerging industries board. In addition, the prohibition for large shareholders to sell holdings was to expire on January 8, 2016. Also, the market has rebounded significantly since September 2015, leading to some profit-taking pressure.

Market pessimism has been exacerbated by the renminbi’s depreciation in both onshore and offshore markets in recent days.

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The circuit breaker had an adverse effect

To give investors some time to cool off, the Chinese authorities recently introduced a circuit breaker mechanism in the domestic Chinese stock exchanges. This is a set of measures to avert panic in markets and is applied in various markets, including the US. China recently also introduced one: if the benchmark CSI 300 Index moved up or down by 5% from the previous close this triggered a 15-minute trade suspension. A 7% rise or fall prompted a trading halt for the rest of the day.

Rather than mitigating market correction pressure, this immature circuit breaker mechanism appeared to add to it. With A-shares already subject to 10% daily upper and lower limits, the necessity of introducing a circuit breaker mechanism was not strong anyway. The sharp market volatility in the second and third quarters of last year was mainly caused by the immature margin trading & short selling system.

In the two trading days when the circuit breaker was triggered, once the first threshold (-5%) was reached, the second threshold (-7%) was reached quickly following resumption of trading. This is mainly caused by the fact that retail investors account for the majority of the A-share market and many are short-term, sometimes speculative, investors.  The circuit breaker had the effect of narrowing the exit in a small and crowded room where every person rushes to get out.

The circuit breaker mechanism needs to be adjusted

Based on Chinese trading statistics, the CSI 300 index moved up or down by more than 5% in almost one of every 25 trading days before China launched the circuit breaker mechanism. This is more frequent than other markets that have adopted such a system. In addition, the small gap between the first and second thresholds (only 2 percentage points) cannot significantly stabilize the A-share market dominated by investors with a short-term horizon.

‘Circuit breaker mechanism suspended but financial reforms will continue’

A possible solution could therefore be to significantly raise the first threshold and widen the gap between the first and second thresholds. In other equity markets without daily upper or lower limits to individual stocks, the first threshold tends to be set at 7% or even higher and the second and third ones at 13~15% and 20% respectively.

The duration of the trading suspension may also need to be adjusted. Trading suspension for the remainder of the day after the second threshold has been triggered tends to squeeze liquidity and cause panic. The trading suspension after hitting the first threshold should therefore be extended.

If the circuit breaker mechanism were to be re-introduced, the rule of daily lower and upper limits (10%) for each stock also needs to be abandoned or revised, and the T+1 trading rule may also need to be adjusted, as it is detrimental to market liquidity.

Lower return expectations

Investors are likely to take a prudent stance at the beginning of 2016 as the renminbi is still under pressure, economic growth remains anemic and most of the A-share stocks have expensive valuations. Although the broader market’s decline amid poor sentiment may also present opportunities, investors should expect lower returns in 2016 than in the past two years.

The sell-off in A shares has also increased selling pressure on H shares. The ongoing depreciation of the renminbi and the 11-year low in oil price have further raised investors’ fears. As the stock prices of Hong Kong-listed Chinese companies are in Hong Kong dollars, and the earnings of these companies are in renminbi, the depreciation of the renminbi has caused investors to mark down earnings and downgrade their outlook based on lower growth assumptions and potential FX losses. The weak sentiment feeds into the belief that it is now easier to make money by shorting rather than buying the market.

In the short term, more weakness is likely in both the A and H share markets, unless favorable government policies are announced to stabilize sentiment. Investors are viewing the depreciation in the renminbi as a sign that China’s economy is getting worse. However, we believe the currency reflects a mix of complex factors relating to the rate hike expectation and appreciation of the US dollar, the global risk-off sentiment, the capital outflows from emerging markets, the appreciation of the renminbi against a basket of trade-weighted currencies, the opening of the Chinese capital account and the liberalization of interest rates.

Opportunities

For the first half of 2016, we are cautious but not particularly bearish. In the economic review politburo meeting chaired by President Xi, the Chinese leaders indicated that they would pursue an expansionary fiscal policy. Moreover, it normally takes six to twelve months for monetary policies to show their effect on the real economy. We therefore expect the further RRR cuts to bring about positive improvements in the macro-economy in 2016. In the second half of 2016, H shares are more likely to perform given their already very low valuations, global investors’ light positioning in MSCI China and the more bearish views that have been priced in.

Although growth is slowing down, it is still relatively high. Of course there is a debt problem, but the authorities still have the means to solve this internally. It is often local governments that have incurred debts. If these debts are no longer tenable there are a few possibilities. The bank takes the loss, the debt is assumed by a central government or the central bank tries to reduce the debt through inflation by printing money.

As the Chinese stock market is very diverse, it is certainly possible to find companies with attractive earnings growth, or stable earnings and a low valuation. The consumer sector and the services sector are particularly attractive. Robeco Emerging Stars Equities, for example, invests in, among other companies, car insurers, telecom and electrical utilities.

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