We wanted to briefly update you on recent events in China, their impact on global markets, and how we are currently exposed to that risk. As of mid June, the Shanghai Composite Index, which is comprised of both private and state owned Chinese companies, was at a lofty 5,178. It had risen well over 100% since September 2014 on renewed investor participation from retail, institutional, and government entities alike – combined with an aggressive reform program aimed at bringing international institutional investors into the marketplace. The market turned sour in June and fell over 28% to as low as 3,725 by July, falling 8.5% in a single day.
There are a number of factors which contributed to its decline. For starters, there was a huge level of speculative interest in the market with daily account openings by retail investors reaching all time highs. The Chinese market has always tended to trade off of liquidity conditions and the perception of government support. When rumors of margin calls and tighter liquidity conditions surfaced in June, the market responded as it should have following such an aggressive run up. What became clear, thereafter, was that market conditions were ripe for correction. Margin balances were overextended, and there were growing signs of a speculative bubble building with companies’ managements pledging equity shares as collateral for loans (which were naturally used to buy more shares in other companies…or their own as the case may have it).
This all led to the Chinese government, and several companies themselves, to undertake draconian measures to backstop the market. The government suspended trading in many stocks, as did companies who were facing margin calls on their shares. These types of actions can cut both ways – on the one hand you can discourage selling, or prohibit it for the time being; on the other hand, it forces investors (we use the term lightly) to liquidate other shares to meet their margin calls putting further pressure on the market. The government took additional steps and began investigating short sellers for illegal practices, which in our view is evidence of a major step backward in the liberalization of the Chinese equity markets. Then again, we were never particularly encouraged in the first place, considering that the rise in the market was largely attributable to policy conditions in the face of slowing economic growth.
Technicals in the market appear to have stabilized for the time being, although there are still intermittent bouts of volatility. We are not particularly encouraged at this point in time as our view is that it will be challenging to identify additional sources of capital to step in and push the market higher with international investors now decidedly in the wings and retail investors licking their wounds. The government will ultimately have to make some considerable effort to spur these markets higher, and the recent devaluation of the RMB would not appear to be a step in the right direction so far as international investors are concerned. Then again, it may be in the rearview mirror, but investing is a game of batted strikes.
Our direct exposure to this market is about 1.5% for the typical moderate risk portfolio. More concerning is the impact of a slowing Chinese economy on other emerging economies, particularly those commodity exporters whose currencies continue to experience pressure on lower and lower commodity prices. We see the technical backdrop as particularly weak there, especially as we face down the prospect of rising U.S. interest rates. We have written in the past about how important active management is in Emerging Markets, and this episode is further evidence of that. Nevertheless, these markets offer some of the more compelling values in the world today.