COMMENTARY
Across The Border
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Shanghai’s blue chip rally shows no signs of fading

Large companies comprising the Shanghai Stock Exchange 50 Index are likely to continue outperforming smaller companies

PUBLISHED : Tuesday, 06 June, 2017, 4:13pm
UPDATED : Tuesday, 06 June, 2017, 9:52pm

So far this year, Chinese investors have been channelling funds towards dozens of large companies with solid earnings outlooks, as a liquidity squeeze triggered by government-led financial deleveraging prompted a sell-off in more risky sectors.

While the strategy of buying into the Shanghai exchange’s top 50 blue chips has paid off handsomely, investors now face a difficult question: whether to stick with it or head for the exit?

Even though the trade is looking long in the tooth by some measures, analysts say there are some good reasons why it will continue for the medium term.

Among them, a recently imposed rule designed to restrict substantial shareholders from a rapid unwind of their holdings in listed companies may actually help extend the rally in blue chips, in spite of its intention to boost demand for equities broadly.

“Liquidity is the key,’’ said Ken Chen, a strategist at KGI Securities. “It remains unknown when the deleveraging will come to an end and the tight liquidity situation will be reversed so investors still have nowhere to put their money but the large-caps for now.’’

Funding costs have been surging in China’s financial markets, with yields on 10-year government bonds rising to an almost two-year high and inter-bank lending costs even exceeding the benchmark lending rate, as regulators increase scrutiny of wealth management products and inter-bank lending activities to reduce financial leverage.

The Shanghai Composite Index ended May with a 1.2 per cent decline. That was the third straight monthly drop for the benchmark, the longest stretch of monthly losses since the 2015 stock crash. On the plus side, the SSE 50 Index of the 50 most valuable companies on the Shanghai exchange climbed 5.6 per cent last month.

In late May, the China Securities Regulatory Commission introduced rules designed to prevent major shareholders from trimming their interest in listed companies.

For instance, under the new rules investors who acquired shares in companies ahead of an initial public offering are to sell no more than 1 per cent of their holdings on the open market every three months, while sales through block trades are not to exceed 2 per cent.

These restrictions can block insider share sales worth 1.3 trillion yuan (US$191.1 billion) for the rest of year and up to 2.5 trillion yuan in 2018, according estimates by brokerage Shenwan Hongyuan Group.

Still, analyst Gao Ting from UBS Group says the new rules won’t have a major impact of the primary trend within the market.

“The new regulations could be easily be interpreted as stabilising the market in the short term and may bring positive responses in the market,” said Gao. “However, we don’t think this is a decisive factor that could determine medium-range movements in the stock market.”

Gao recommends investors stick to consumer-related stocks, pharmaceuticals and financials, while avoiding companies whose earnings are tied to cyclical factors, citing concerns that economic growth will weaken in the future.

The pattern of buying large-caps and dumping smaller companies has been evident since the start of the year. However, it may enjoyed renewed momentum as the new rule capping stock sales by insiders is set to reduce the appeal of small-caps as “shell companies”, or buyout targets by restructurers seeking a back-door listing. Restructuring parties are likely to be deterred from such deals in the future, as the restrictions make it more difficult for them to exit the investments.

Institutional buying pushed the SSE 50 Index to its highest level last week since December 2015. Among index constituents, Ping An Insurance Group has advanced 30 per cent this year, while Industrial and Commercial Bank of China has risen 16 per cent.

The rally among Shanghai blue-chips will likely continue as earnings improve, whereas the valuations of smaller-caps will remain pressured by the ongoing financial crackdown, according to Shenwan Hongyuan.

“A simultaneous rise in risk-free interest rates and risk premiums are acting as supporting factors,’’ said Wang Sheng and Fu Jingtao, strategists at Shenwan Hongyuan. “Increased financial surveillance has also promoted value investing. These factors are still valid in the medium term.”

Meanwhile, the brokerage cited the need for caution, warning that the strategy of buying large companies has become crowded, as holdings by mutual funds rose to the highest level since 2012 in the first quarter.

The volatility index tracking Shanghai exchange’s biggest 50 companies rose to an almost five-month high on Friday, implying bigger price swings in the near future.

Trading on the broader market has been capped in a relatively narrow range since the mainland stock bubble burst in mid 2015. The Shanghai Composite has been trading in a 700-point range since then, as volatility decreases amid waning demand for equities. Turnover is now down almost 90 per cent from its former peak.

The Shanghai Composite ended 0.3 per cent higher on Tuesday at 3,102.13.

The market is not likely to break out of the pattern in the near future and investors still need to focus on earnings as the primary stock-picking strategy, said Xun Yugen, a strategist at Haitong Securities.

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