Chinese equities could have done without the spillover from last week’s meltdown on Wall Street.
Mainland shares have been mired in a bear market for quite a while thanks in no small part to the psychological overhang from the trade war with the Trump administration.
China’s economy was already decelerating and the trade frictions have the potential to turn the glide path into the dreaded “hard landing” that China doomsayers have been predicting for what seems like a decade.
Initially, Chinese officials seemed more concerned about shielding the economy from the effects of the tariffs than they were about protecting the stock market and so, the yuan was allowed depreciate and equities were left to fend largely for themselves. Even as the losses mounted for A-shares, there wasn’t the same sense of panic as that which prevailed during the 2015 crash. Given that, it’s possible (indeed, it’s likely) that Beijing wanted to save the National Team’s dry powder for when it was really needed.
Starting in August, it became apparent that China is intently focused on protecting the 2016 lows on the SHCOMP. On Thursday, following the rout on Wall Street, the index sliced through those lows amid the worst session for mainland shares in more than 31 months.
On the week, the SHCOMP fell nearly 8%, the worst weekly loss since February.
Given all of this, you might be wondering whether it’s time to buy the dip in Chinese equities and Goldman is out with a new piece weighing in on the issue.
The bank begins by putting the current rout in historical context, noting that over the past quarter century, there have been 17 periods during which the Chinese market has corrected more than 10%.
“In this sample universe, the average magnitude of the drawdowns is 31%, with an average duration of 168 (calendar) days”, Goldman writes, before classifying those 17 episodes into 3 categories: “Minor (<20%), Major (>20% but <40%), and Systemic (>40%).”
Based on those classifications, the current selloff is approaching “systemic” in line with the AFC, the TMT bubble and 2008, and is now tracking along the path of the 2015 meltdown.
Given that the latest leg lower comes courtesy of spillover from an S&P drawdown, Goldman takes a look at what’s happened in the past when U.S. stocks correct. “In the 18 episodes over the past 21 years where SPX was down more than 10% (average -19%), MXCN on average corrected 22% during the same periods, implying a ‘correction beta’ of 1.2 (1.5 on median) for China vis-a-vis the US”, the bank writes.
Obviously, this time will probably be different given how far Chinese shares have already fallen and also considering how far the de-rating has run in China versus the U.S.
So what’s priced in and how bad could it conceivably get?
Well, on the former point, Goldman says Chinese stocks have priced in “either 0.5pp decline in GDP growth, 5% RMB depreciation, or over 140bps increase in US 10Y bond yield”.
On the latter point (i.e., “How bad could it get?”), the answer is apparently “Pretty damn bad”, although Goldman is careful to note that “by no means do these estimates represent our fundamental expectations for macro and equity conditions.”
By “these estimates”, they mean the following three scenarios that take account of potential macro developments and fundamental factors (this is truncated, and includes excerpts from three separate models):
If we arbitrarily assume that macro growth (on a GDP-equivalent basis) slows to 6%/5%, USDCNY depreciates 5%/10% from 6.92 currently, and US 10Y bond yields rise 50bps/100bps by 2019 in our “Bear” and “Crisis” case respectively, and on these premises, our top-down macro model would give 8% and 38% downside from the current index levels. If 2019E consensus EPS growth for MSCI China and forward PE were to revert to levels largely consistent with past-10Y historical “Major” (“Bear”) and “Systemic” (“Crisis”) correction lows, the implied market downside would be 10% and 34% respectively. On a simple premise that risk-free rate is the only variable driving equity valuations (i.e. ERP to remain constant), we estimate that a 50bp/100bp rise in US 10Y bond yields (from 3.15% now) would translate into around 13% and 21% valuation compression in our “Bear” and “Crisis” scenario.
If you roll all of that up, you end up with “average” (i.e., across methodologies) further downside of 10% in the “Bear” case and 30% in the “Crisis” case.
Again, the assumptions used in Goldman’s three-pronged approach to deriving those estimates do not reflect the bank’s base case for macro conditions or fundamentals in Chinese equities.
Rather, this exercise is simply meant to provide what the bank calls “some sensible range as to how equity prices may react when fundamental conditions change and/or risk appetite further deteriorates.”
But don’t worry, because as Donald Trump told 60 Minutes, he’s not planning on trying to drive China into a “depression” (although he does seem at least a little bit impressed with himself when it comes to the 30% drop in Chinese stocks)…