Share prices had risen strongly but steadily in the nine months to March before rallying between April and June, fuelled by an explosion in investment lending to retail investors. By mid-June the Shanghai market had risen by around 150% from June 2014 levels. By June 2015 valuations were looking extremely stretched in a number of sectors in the context of underlying earnings prospects.
The average market Price to Earnings (PE) ratio (a common measure of share market valuations) of around 30 times (the long term average for American shares by comparison is 16 times) somewhat masked the speculative valuations in ‘new economy’ sectors, including IT, Healthcare and Media where PEs averaged closer to 60 times. Smaller companies were trading at more than 100 times future earnings.
Given the desire of central Chinese authorities to stimulate the economy, in new more market driven ways, they have encouraged share ownership. This has included offering participation in under-priced initial public offerings (IPOs) which has had the unfortunate effect of pulling money out of the secondary market and making it vulnerable to a sharp decline. Measures including China’s state-owned banks lending $209bn and the suspension of trading in more than 1,400 companies have been actioned showing that the authorities were prepared to do whatever it takes to manipulate share prices higher. Some of the measures introduced are in contradiction to the Chinese government’s intention to allow the economy to become more market driven.
On the other hand, real GDP growth in China continues to move towards lower levels, with policymakers setting a lower 7% target for this year, after missing the 7.5% target for 2014.
China has been dealing with slowing GDP growth for some time, and it can be misleading to form equity return expectations based on prospects for economic growth. Unexpected economic news can certainly move markets sharply on a daily basis. However, a subdued growth expectation for China may be already priced into the markets, so that equity investors who buy into a stream of slower-growing earnings at the right price may still earn normal returns.
When investing in emerging markets in general, and China in particular, the focus should be on diversification. Investing in emerging markets and in China is about gaining exposure to a growing share of world GDP. By growing at 7% or even at 6% per year, China's share of world GDP continues to expand. It's the share of world GDP, not the GDP growth rate, that long-term investors should take into account.
Moreover, China continues its market-oriented reforms. Policymakers in China are gradually opening the economy to the flow of international capital. This is great news for global investors.
Gaining access to the A-shares market in China (until recently open only to mainland investors) means having more exposure to a much larger pool of Chinese companies; including smaller companies and certain market sectors that tend to be under-represented in the H-shares (Hong Kong) market. Investors will be able to capture the associated diversification benefits in their portfolios.
The volatility in China certainly affects global share indices. China (mainland companies listed mainly in Hong Kong, Singapore, London and New York) accounts for 24.8% of the MSCI Emerging Markets Index and 2.6% of the MSCI All Countries World Index as at 30 June 2015.
Exposure via emerging markets where the China related losses have been felt, is small for most Australian investors in well diversified portfolios. For Australia it’s the broader Chinese economy that counts most. Australia is not only vulnerable to a slowing Chinese economy, but moving from investment intensive growth to consumption impacts demand for Australian resources. That has the potential to lead to a weak economic outlook for Australia, including a fall in income and significant negative risks for the Australian dollar.
When it comes to long-term global equity portfolios, investors should pay more attention to China's progress in terms of financial liberalisation than to its transition towards lower growth rates.