A tale of three cities: Chinese markets cautiously optimistic, but risks lurk

Chinese and Hong Kong stocks delivered  a mixed performance in the first 10 months of 2015, a volatile year marked by the peak of a rally which hoisted equities to their highest in seven years in mid-June and a subsequent rout that erased over US$4 trillion in value from the markets on the mainland.

 The Shanghai Composite Index was down 4.57 per cent for the 10-month period from January to October, but climbed 10.8 per cent in October to post its first monthly advance since June, when the rout in equities took hold. It closed on Friday at 3,382.56.

 Shanghai’s performance was mirrored by the benchmark Hang Seng Index in Hong Kong.

 The Hang Seng is down 4.09 per cent since the start of the year, but rang up an 8.6 per cent advance in the month of October in  its first monthly advance since May. The Index finished last Friday at 22,640.04 points.

 The other major Chinese stock market in Shenzhen is in a world of its own though. The Shenzhen Composite Index settled on Friday at 2,014.86. For the month of October, it is up 17.4 per cent and has rallied 42.37 per cent since the start of 2015. Shenzhen, which is composed of small-and medium-cap stocks with a heavy technology component, has held up much better than its bigger counterpart in Shanghai.

 Recent rate cuts by Beijing and policy initiatives taken by the Communist Party plenum last week should support the market going forward.

 Those steps will “support economic growth and relieve the pressure from deteriorating fundamentals”, a report by China Merchants Securities said last week.

 “We suggest investors maintaining an offensive strategy but beware of the profit booking risk after a continuous rise,” it said.

 JP Morgan said in its Emerging Markets Equity Research report that the positive market drivers going forward for China as the last months of 2015 loom are “stabilising growth prospects; valuations [of companies that are] partly discounting fundamental weakness, and capital account liberalisation” as Beijing tries to drive the internationalisation of the yuan.

 The New York-based banking giant cautioned though that the negative drivers for Chinese markets would be “less policy flexibility, growth sectors [that are] expensive [and] excessive leverage” among Chinese corporates.

 As for Hong Kong, JP Morgan said the market in the city would benefit from “stabilising property prices [and] falling land prices” as the once sizzling property market cools off.

 It added that recovery in developed markets such as the US and Europe would boost the city’s economy along with “closer integration with the China financial system”.

 What will weigh on Hong Kong though is that it is “vulnerable to the weakness in China’s growth leading to weak GDP in Hong Kong”, said JP Morgan. The investment bank added that Hong Kong can also be hit by “credit risk from trade financing for banks” on the mainland.

 China Merchants said the risks going forward include the rising likelihood of a US interest rate increase by the Federal Reserve in December, if the easing by the European Central Bank falls below expectations and “diminishing effects from China’s pro-growth policies and other unexpected black swan events”.

 Its trading recommendations are “holding blue chips with low valuations and high betas, including China financials and infrastructure developers; overweighting laggards, mainly telecom and health care; picking beneficiaries from theme opportunities including … high-end machinery, environmental protection, renewable energy, airline and tourism”.

China’s stock market began rallying around September last year, with indices in Shanghai and Shenzhen running up strongly into early June. The Hong Kong market followed suit and tracked the rally as shares touched their highest in seven years.

But the party ended after stocks touched their highest on June 12 and began tumbling badly. After a brief respite in early August, the surprise devaluation of the yuan on August 11 triggered another wave of selling before more stimulus measures by Beijing stabilised the markets, although volatility remained uncomfortably high.