Bubbleeeeeeer?

There have been concerns of an impending correction in the Chinese equity
market and potential contagion effect on the rest of Asia. Here are our comments
to address these issues and to clear up some misperceptions:
Some investors have voiced concerns over the booming China stock market and
are worried that this “bubble” is on the road to an impending correction, not unlike
a repeat of what we saw at the end of February this year. Warnings from
respected commentators, ranging from former US Federal Reserve chairman
Alan Greenspan to various Chinese government officials to Hong Kong
businessmen such as Cheung Kong chairman Li Ka-shing, have also magnified
these concerns.
Indeed, the China domestic Shanghai and Shenzhen composite indices,
comprising ‘A’ shares, are up 56% and 124% respectively year-to-date. On the
other hand, the Hang Seng China Enterprise index, comprising Hong Kong ‘H’
shares is up just 3% year-to-date. A clear distinction between these two
categories of shares needs to be made for a better understanding of the current
issues surrounding the China market. China ‘A’ shares are restricted largely to
domestic investors (with a total limit of only US$10bn amount currently available
for investment by selected Qualified Foreign Institutional Investors), while the ‘H’
shares are Chinese companies listed on the Hong Kong stock exchange and
available to international investors. China ‘A’ shares now trade at over 30x one
year forward PER while, ‘H’ shares are still trading at more reasonable valuations
of about 16x one year forward PER.
The much-touted “bubble” of the China stock market in our view, refers only to
the domestic ‘A’ share market, which has recently run up much faster than other
regional markets, and other China stocks listed overseas. This recent sharp
divergence between these ‘A’ shares and overseas listed China stocks is due to
unique local liquidity conditions in China and the closed nature of the ‘A’ share
market . Most of the estimated US$4 trillion plus savings is trapped in China and
they have been ploughed into the ‘A’ share market, driving up their valuations, as
the Chinese endeavour to earn higher returns than their low deposit rate.
Moreover, as foreigners have limited access to China ‘A’ shares, they are not
fungible with similar stocks listed in HK. Hence, this valuation premium has
persisted.
Fears of a correction should in fact be focused mainly on the ‘A’ share market,
not on China shares listed elsewhere. In terms of valuations, China stocks listed
on the Hong Kong ‘H’ share market are trading at a substantial discount (50+%)
to the ‘A’ shares. In addition, with the Chinese authorities’ policy to allow more
investments by Chinese banks and insurers overseas (QDII), H shares and
China stocks listed in other overseas markets will be the immediate beneficiaries
of the liquidity coming out of China. Nonetheless, we recognize that there may be
some contagion effect on the overseas-listed Chinese stocks on near-term
dampening in sentiments. But we view that any such correction will be short-term,
contained and should present a buying opportunity at the right market level.
We maintain our view that we will continue to see strong performance of the
China stocks this year. This is underpinned by strong economic growth, upward
revisions to earnings and strong liquidity. In addition, past studies have shown
that stock markets in the host country of the Olympics have done well in the one
year run-up to the Games. China has been enjoying more than 10% economic
growth in recent quarters. We believe at least high single-digit growth (close to
9%) is sustainable as it is coming from a low base. Per capita incomes in China
are rising rapidly, driven by urbanization. The continued strong trade surpluses
contributing to strong GDP growth are a reflection of the comparative advantage
that China has in manufacturing and the opening up of its economy. We view the
Chinese authorities’ moves to cool down the economy as positive as it is aimed
at preventing an over-heating of the economy and at maintaining sustainable
strong growth. This is important to create more jobs and maintain social stability
with rapid urbanization. They also want growth to proceed in an efficient manner,
being conscious of the impact on the environment.