In just a few months, the Asian powerhouse has transformed from a major threat to world economic stability to its saving grace. The proactive stance is paying off, which bodes well for Chinese assets, as well as emerging markets more broadly.
That’s the world that Patrick Zweifel, chief economist with Pictet Asset Management, lives in.
Meanwhile, back here where the rest of us reside, there are pressing concerns about whether the absurd rally in Mainland shares means gravity is about to reassert itself, leading to a nauseating nosedive.
I’m just kidding – I mean, I’m not actually kidding, but that latter bit is hyperbolic.
Between the apparent inflection in Chinese PMIs, myriad stimulus measures (something “new” on the fiscal and/or monetary front is announced seemingly every day and while Beijing has been keen to insist that China won’t “flood” the market with stimulus, the slow trickle of targeted measures is adding up), positive news on the trade discussions, the MSCI decision (here) and the addition of government and policy bank bonds to the Bloomberg Barclays Global Agg, there’s a veritable laundry list of catalysts for Chinese assets. And what’s good for China is good for EM more generally. So ol’ Patrick’s got a point.
But, anecdotally, this looks precarious:
There’s nothing at all nuanced or otherwise special about that chart. It just is what it is – Mainland shares are up some 35% so far this year and when it comes to manic rallies that tend to run out ahead of anything that even approximates a fundamental rationale, nobody does it quite like China’s retail investor base.
Goldman has written a series of China “FOMO” pieces of late, some of which we’ve documented in these pages over the course of the 2019 A-share surge. In the latest edition of that series, the bank reminds you that “there have been 9 bear markets (defined as >20% correction) since 2002 when CSI300 index was launched, with an average duration of around 11 months [and] if we classify the remaining periods as ‘bull’ markets, there were 10 of them in the past 17 years, also with an average time span of 11 months.” So, Mainland China has careened between bull and bear markets every year, which to Goldman “suggests the latest bull run starting from early January could extend.”
(Goldman)
The bank breaks this down further, noting that A shares have rallied 20% or more without a 10% correction 15 times in the past 17 years, and during those 15 periods, Goldman observes “a 76% and 59% ex-post probability that the rally could extend over a 1m and 3m period, possibly reflecting the general ‘momentum’ nature/bias of Mainland retail investors, who represented 82% of market daily turnover in 2017.” You’ve got to love the lengths the bank goes to in the course of employing euphemistic language to described irrational behavior on the part of Chinese retail investors.
(Goldman)
From there, Goldman attempts to model the probability of the CSI 300 being in a “risk-on” state versus a “risk-off” mode. We won’t bore you with the specifics of that model, but suffice to say the bank assigns a 70% chance to the market being “already in or morphing into a ‘risk-on’ scenario” which would then suggest upside to their 12.5X multiple target.
Goldman reiterates that domestic equity mutual funds and international investors are underexposed to A-shares, but that’s not really the most important factor when it comes to igniting the kindling, as it were. The most important factor is, again, retail investors.
“Retail investors, who will likely be the primary driving force in a valuation overshoot scenario, are holding close to Rmb80tn of cash (1.7x of free-float market cap) and are allocating only 8% of their total assets in equities, suggesting ample capital deployment potential from retail investors into A shares should risk appetite further improve there”, Goldman goes on to say, before suggesting that in addition to progress on the trade front, a variety of potential catalysts could stoke retail animal spirits further, including the above-mentioned MSCI inclusion and the inaugural IPO listings on the Sci-Tech Innovation Board later this quarter.
This is where it gets funny. Goldman next moves to quantify potential “risk-on upside” using three “techniques”, the first of which involves assuming multiples expand either to their 2015 peaks or to an average of 2015 and 2018 levels. The former case implies ~50% upside, the latter ~30%.
Second, Goldman imagines a scenario where a variety of factors the bank monitors for assessing risk appetite in Mainland shares revisit either their 2015 peaks or an average of 2015/2018 highs. The former case implies some 80% worth of upside, the latter a “mere” 70%.
Third, the bank notes that in “previous ‘risk-on’ episodes, realized valuations could overshoot ‘fair’ P/E by as much as 80% to 90% (in late 2007 and mid 2015).” Extrapolating from that using their estimated 12-month forward multiples, Goldman says A-shares could see 70% and 25% upside depending on the reference period (i.e., 2007, 2009, 2015).
Ok, so for the “risk-on” case, Goldman takes, quote, “the lowest of the above-three-suggested returns assuming the market to trade at comparable valuation and sentiment levels largely akin to the average peaks of 2015 and 2018.” In that scenario, the CSI 300 could rise to roughly 5,000, or 25% upside.
Now, here’s the punchline (from the note):
“Euphoric” case: We simply assume the market will trade at peak multiples and magnitude of over-valuation comparable to the 2015 episode in this scenario. However, we believe the likelihood for a repeat of 2015 should be significantly lower than the “risk-on”case given the authorities are arguably proactive (and early) to fend off speculative activity, and the former can also be seen as a close-to 3 sigma event statistically (i.e. <1% probability) if we benchmark the over-valuation (82% above fair value) in 2015 vs. its historical distribution since 2007.
There you go, folks. If you’re looking to rationalize your 6,000 CSI 300 target (or, more generally, a bullish take on A-shares), there’s a coherent, well-researched justification for a “euphoric” melt-up.
Of course “coherent” and “well-researched” doesn’t equate to well-grounded, and in fact, Goldman goes out of their way to emphasize that the euphoric case is unlikely. For the bank, China A is now fairly valued, which accounts for Goldman’s “modest” 4,300 12-month target.
But, I suppose the overarching point is that when you’re talking about China A, you don’t want to write off or otherwise underestimate the power of the uneducated Chinese retail investor.
Unfortunately, the same dynamic also works in reverse, which means that when things get going in the wrong direction, the only way to convince the crazed masses on the Mainland not to sell is to use a collection of state-backed vehicles to onboard 5.5% of the market’s free float, halt the market or, when all else fails, start arresting people.
