Should we worry about China?

Investors struggle with bubbles. Sure, we know they eventually burst, but lessons are quickly forgotten. Now China is a puzzle: it might look like a bubble, but what to do? Uncontrolled Yen devaluation could break China’s Renminbi peg and trigger more global deflation. But, timing and is hard to assess. Analysts and the press pay little attention to such an apparently remote problem, and investors do not seem concerned about the possibility of a crash in China. Indeed, with memories of the financial crisis receding, risk appetite is growing. But, data from China should worry investors in all markets.

If investors are to learn from experience, what does the 2007 credit bubble tell us? Certainly, in retrospect, the graphs of money growth, credit and house prices globally looked scary. But, as weeks pass and stock-markets do not fall apart, concern eases. It is the slow but steady growth of bubbles that deceives; too often the danger becomes a threat everyone can live with. There seems no immediate consequence, and even potential for missing out on the later stages of the boom. Bubbles are derived from failings in social behaviour as much as individual psychology.

Now, China’s stock-market looks as frothy as Western markets did in 2000 and 2007, or Japan in 1989. A rampant re-rating since last October has seen the MSCI China Index gain over 30%, and the average prospective price earnings ratio for China A shares has almost doubled. Companies on the Shanghai Composite Index now trade at a median 62 times reported earnings. And, unlike markets that have printed money and delivered a devalued stock-market boom, China’s currency is pegged and has not collapsed.

The stronger China’s stock-market, the more it sucks-in less sophisticated investors. The number of new share accounts in China has soared. Now, worryingly, the shadow banking wealth funds which China has already tried to defuse, are reported to be offering returns of 9% to investors to compete with shares. Margin leverage has driven the boom, and total margin is estimated to be at its highest ever level versus the free float of China shares. The stock-market looks frothy, drawing in savers with unrealistic expectations. Recently, solar business Hanergy, on a multiple of 65, took just 24 minutes to halve. Its market capitalisation was 7 times bigger than that of the biggest US solar company.

Yet, much of China’s economy is slowing. Recent data has shown many economic indicators falling even faster than consensus estimates; fixed asset investment, industrial production, retail sales, cement production and broad money supply growth. Whilst official figures suggest a soft landing onto a lower, but still impressive growth rate, many question the official figures. Electricity consumption, historically a better indicator of industrial output, points to a sharp slowdown.

To counter the economic slowdown, the PBOC has become more accommodative, trying to keep lending rates low. Indeed, seven-day repo rates are now at the lowest level for years. Worryingly, however, policy changes are increasingly announced on Fridays or the weekend – a pattern Western central banks tried in 2007/8 in an attempt to increase impact. Every stimulation and reform is seized on by optimists who trust the Chinese government to fix everything. But, reforms in China appear mainly designed to centralise party control in Beijing, and increase China’s geopolitical muscle.

China’s economic importance might be evidenced by the fact that its banks now occupy the top four slots in Forbes’ list of the world’s most powerful companies. Or, maybe not. History points to similar surprising patterns in Japan before its collapse, and more recently the brief pre-eminence of dotcom companies. But, rankings like this are enough for China bulls who believe that through the stock-market they are buying the world’s future. This bias is representativeness: believing that a growing economy equates to good equity prospects.

Many behavioural biases are at play in bubbles and the subsequent crashes. It may even be that China defuses slowly, as Japan has. But, on the way, it could trigger competitive devaluation, disrupting other asset classes. Correlations between asset classes globally are growing. Whatever happens is likely to be deflationary – in the short term, at least. Investors can build some resilience into portfolios, and should remember the optionality of cash.

A version of this article was published as in the Behavioural Finance Series in Citywire on May 29 2015.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable; however, I make no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

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