Stock Markets and the Economic Disconnect: China Edition

Stock markets according to popular wisdom serves as an indicator of economic growth conditions.

This Bloomberg article shows why popular wisdom has been wrong when applied to China: (bold mine)

China’s 20-year economic boom has boosted the wealth of its 1.3 billion citizens at the fastest pace worldwide and spawned some of the biggest companies in history. Foreigners earned less than 1 percent a year investing in Chinese stocks, a sixth of what they would have made owning U.S. Treasury bills.

The MSCI China Index (M8CN) has gained about 14 percent, including dividends, since Tsingtao Brewery Co. (168) became the first mainland company to sell H shares to international investors in Hong Kong in July 1993. That compares with a 452 percent return in the Standard & Poor’s 500 Index (SPXT), 322 percent in the MSCI Emerging Markets Index and 86 percent from Treasuries. Only the MSCI Japan Index had a weaker performance among the 10 largest markets, losing about 1 percent.

While China’s shift toward a market economy has lifted per-capita incomes by 1,074 percent and helped its companies raise at least $195 billion through stock sales in Hong Kong, investors with $695 billion say that corporate governance concerns, competition and state intervention have eroded returns for minority shareholders. Now, as China allows unprecedented access to its local capital markets amid the weakest projected gross domestic product growth since 1990, Aberdeen Asset Management Plc says valuations must fall further before it buys.

China’s bear market means cheap valuation getting cheaper…

The gauge of companies from Industrial & Commercial Bank of China Ltd., the world’s second-largest lender by market value, to PetroChina Co. (857), the third-biggest energy producer, entered a bear market last month after falling as much as 22 percent from this year’s high in January.

The Hang Seng China Enterprises Index (HSCEI), a gauge of 40 H shares, has declined 18 percent this year. It’s up 138 percent, excluding dividends, since Tsingtao Brewery began trading on July 15, 1993. The Shanghai Composite Index (SHCOMP) of mainland-listed companies has dropped 10 percent this year and is up 143 percent during the past two decades…

China will increase a program for foreign funds to invest in its local financial markets to $150 billion from a previous limit of $80 billion, according to a statement posted on the China Securities Regulatory Commission’s website on July 12. The government restricts access to mainland markets through its Qualified Foreign Institutional Investor program, which has granted firms a combined quota of $43.5 billion as of June 26. That compares with the $3 trillion market value of locally-listed companies.

MSCI’s China measure trades for 9.3 times reported earnings, versus 16 times for the S&P 500index, the biggest discount since September 2003, weekly data compiled by Bloomberg show. The MSCI Emerging Markets index has a multiple of 11.

How state directed credit hurt the stock markets…

Under former President Hu Jintao, banks were directed to lend to local governments during the global financial crisis to boost growth, while artificially low fuel prices have hurt refiners such as PetroChina. ICBC, the Beijing-based lender, traded at a record low 4.9 times earnings last month, while PetroChina (857) fell on June 25 to its lowest valuation since 2011.

More than 25 percent of China’s state-owned enterprises are unprofitable and their productivity growth has trailed that of private firms the past three decades, the World Bank said in February 2012.

And how state interventions affects corporate governance…

China was ranked ninth out of 11 Asian countries for corporate governance as of September 2012 and had the biggest deterioration in the region since 2010, according to a survey by CLSA Asia Pacific Markets and the Asian Corporate Governance Association…

SOEs “primarily serve the interests of the government, frequently making decisions with little regard for return on investment,” Hsu said in an e-mailed interview on July 11. Hsu said he invests in Chinese companies run by entrepreneurs with large ownership stakes, while he’s selling short shares of state-owned companies.

The following charts from tradingeconomics.com demonstrates the relationship between China’s stock market and economic growth.

One of the major reason why China’s stock market has languished has been due to the boom-bust cycle.

Stock investors participants not only made miniscule returns over 2 decades, but lost money in terms of real or inflation adjusted returns.

China’s previous stock market boom has coincided with a surge in both domestic credit as % to the economy (middle) and the domestic credit provided by the banking sector as % to the economy (bottom). 

The implication is that a credit boom functioned as the backbone for the stock market boom. Unfortunately the unsustainable boom was not to last.

However, when China’s stock market bubble imploded along with 2008 global crisis, what spared the Chinese economy from going into a recession had been the huge RMB¥ 4 trillion (US$ 586 billion) stimulus whose unintended effects are presently being felt.

Thus the side effects of 2008 stimulus are being revealed in “cheap” valuations which seem as getting even much more “cheaper”.

A potential financial crisis as indicated by the recent cash squeeze, purportedly to weed out shadow banks will only aggravate such dynamics.

You see the problem with relying on financial metrics? They are based on historical ex post events. 

If China’s economy has been materially slowing despite the recently announced marginally changed statistical growth data of 7.5% in the 2nd quarter from a government who hides, deletes and censors economic data, then an environment where a pullback of economic growth will also extrapolate to the slackening of sales, which should be reflected on cash flows, curtailment of investment expansions and eventually reflect on earnings. A crisis, which will be marked by massive liquidations, will exacerbate such conditions.

This means that today’s "cheap" valuations may become "pricey".

And another thing, given the non-resolution of the imbalances in China’s economy, the recent spike of credit or loans growth has only been redirected or rechanneled, instead of the stock markets, to the monumental and destabilizing debt fueled rampant speculations in the property sector, partly financed by shadow banking system, which China’s government has been attempting to regulate.

The disconnect or the apparent "parallel universe" between China’s stock market and the economy reveals of the huge effects of inflationism and interventionism in the economy.

As the Austrian economist Fritz Machlup wrote

A continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply

China’s boom bust cycle should be a noteworthy example.