In November, China’s Communist Party released a comprehensive reform plan, addressing social, financial, economic, environmental and security issues. Immediately following the release, market participants cheered and the H-share-dominated MSCI China Index rose by over 4% in a single day on November 18. But what are the long-term implications? Should we expect reforms that alter China’s profitable growth model to be positive for equity returns? In the long run, stability in China’s economic growth, improvement in demographics and market-oriented economics should be positive factors. However, 2014 might be another tough year for Chinese equities.
The importance of banks to broad China benchmarks reveals the negative impact that unintended consequences of market-oriented policies might have for China investors in the short run. At 39%, financials have the largest weighting in the MSCI China Index. But more than that, the recovery following the global recession of 2008 has been led by profitable state-owned Chinese banks and a soaring real estate sector. A downtrend in the Chinese banking sector has tended to prove disastrous for the broad MSCI China Index. Similarly, our analysis suggests that, as the real estate sector goes, so goes China’s equity market.
|A maturing population and Chinese stock prices|
Annual data, end-1994 to end-2050 (log scale)
|Source: Haver Analytics|
Downtrends in bank and real estate stocks could materialize, given the potential impact of reforms such as the liberalization of the banking sector, reining in of social lending (commonly referred to as shadow banking), and freeing of interest rates. Each might negatively affect the profitability of Chinese banks or threaten to derail the real estate sector. And further efforts to cool real estate speculation are among our chief concerns for 2014. Rising interest rates and greater down-payment requirements on second mortgages have already created a headwind for real estate stocks. However, real estate prices continue to ascend rapidly. Cooling efforts might need to be ramped up even further.
Also, much less discussed but widely expected, is a further loosening of the renminbi’s peg to the US dollar. To the extent that the renminbi would then continue its rise against other global currencies, the move might create another headwind for Chinese stocks, especially exporters. A strong renminbi has been a negative factor for Chinese stocks since 2011. Although China recognizes a need to shift away from an export-driven economy, the transition will likely take years. A strengthening renminbi would continue to put pressure on Chinese equities.
Another concern for China’s stock market in 2014 is an ageing population. Demographics remain abysmal for China. Although China plans to loosen its one-child policy, the stock market impact will likely not be felt for some time. Our work on demography stresses a strong correlation between the middle-age to youth (MY) ratio and inflation-adjusted stock market returns. The MY ratio is a concept popularized by Stifel Nicolaus. Simply explained, the youth population generally has a lower income and is starting families. It is traditionally not putting money into risk assets such as stocks. The 35-49 demographic, however, is typically in its peak earning years and retirement savings are much more on the front burner. A falling MY ratio, therefore, has tended to be synonymous with a weakening stock market, as the prime investment demographic is shrinking in comparison to those just beginning their careers. China’s MY ratio will remain a concern until at least 2020.
China is clearly in need of a comprehensive reform package, given exploding debt levels, rampant real estate speculation, an ageing population and low levels of consumption as a percentage of GDP. And although initial market reaction was quite positive, these reforms might drag down stock returns throughout 2014. We would recommend watching trends in interest rates, the renminbi, and banking and real estate stocks when making an assessment of Chinese equities, recognizing that a demographic headwind exists until at least 2020.
Tony Welch is emerging market analyst at Ned Davis Research.