Stock market plunge does not represent systematic risk

BY LILIAN CO

Monthly Fund Commentary
15 Jul 2015

BY LILIAN CO

China A shares tumbled in June with major indices down between 29 to 35% in one single month. MSCI China index fared better with a decline of only 7.1% as it had not run as hard as A share indices initially. The accelerated IPO approvals, further tightening of margin financing and Greece debt crisis finally took their toll on the A share market. The market correction itself was not a surprise as it was long overdue.  

It was the speed and magnitude of the decline that was a surprise. Deleveraging of margin financing in a falling market and panic selling with fear of not being able to liquidate stock holding under the down limit mechanism exacerbated the downward spiral. Large cap stocks outperformed small and mid cap stocks given much more reasonable valuation with decent fundamentals.   

Official margin lending balance was close to Rmb2.3 trillion in mid June (before the market tanked) and the level of leverage was in general less than 100%. It was the OTC margin financing deleveraging that triggered the market correction as OTC margin financing leverage was as high as 4 to 5 times. Simply put, a margin investor who loses 15-20% from investment cost will start facing margin calls. As the market started falling, it developed into a vicious cycle created by forced selling. Even the swift response from the government to cut reserve requirement ratio (RRR) and interest rate failed to stabilize the market.  Later on, the interventionist and yet clumsy measures such as allowing trading suspension, ETF buying, stock purchase by brokers and short selling ban from the government created even more panic selling as it was seen as desperate.   

In near term, market volatility may persist; however we see this as a liquidity crisis similar to what was experienced in 2013. In mid 2013, the stock market was also sold off on fear of a liquidity crunch when the interbank rate spiked up to over 10% following a sudden liquidity withdrawal from the PBOC (the central bank). The liquidity crunch was however quickly resolved soon after the central bank injected liquidity back into the system. The Investment Adviser sees the current stock market liquidity crunch a repeat of the 2013 scenario. The market should stabilize once the PBOC steps in, which it did in early July to provide unlimited credit facilities to major brokers to ease forced margin calls. Recent government subscriptions to funds run by major asset management houses should also help ease forced selling caused by redemption pressure.  

The Investment Adviser does not see the stock market plunge leading to systematic risk. Only 4.2% of the total social financing needs are raised from the equity market. In other words, bank lending is still the major funding channel for corporates. Despite the recent stock market rout, the interbank rate in China has remained at surprisingly low level. The Investment Adviser therefore does not see risk of a liquidity crunch looming in the real economy. After all, the stock market cap as a percentage of GDP in China is only around 70%. This is not particularly high compared to developed countries such as the US at close to or above 100%. Last but not least, a large part of the margin financing deleveraging has been completed.  Margin financing balances have been shrinking fast since the peak of Rmb2.3 trillion in mid June to $1.5 trillion now. This is back to March 2015 levels which was when the crazy stock market rally started. In short, margin investors with high leverage have been squeezed out and the worst part of the deleveraging should have been seen.

The Fund lost 2.7% during the month, outperforming MSCI China index by 4.4%, in June. Although the Fund had exposure to the A & B share markets totaling 23%, the focus was on large cap stocks with low valuations (in teens P/E). Given resilient share price performance, the A & B share exposure generated 1% positive return during the period. This exposure has been brought down to 14% subsequently. At the current market level, almost all the index gains of the MSCI China and CSI300 made in the second quarter (during which the most leverage was built in A share market) have been wiped out. The Investment Adviser therefore sees limited downside risk with the MSCI China trading at P/E’s of only 10 times, now looking cheap post the market plunge. Investors are likely to bargain hunting once the dust settles. Patient investors will be rewarded.

During the period under review the portfolio returned strong relative performance compared with the benchmark index. The primary driver of the alpha delivered was stock selection (+4.21%), which was notably strong in the Consumer Discretionary (+2.44%), Industrial (+1.00%) and Financial sectors (+0.88%). The only underperforming sectors from a stock selection perspective were IT and Energy, each detracted -0.47% and -0.03%, respectively. At the stock level, the top contributor was China International Travel (+0.96%) and top detractor was Li Ning Co Ltd (-0.42%).

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The views and statements contained herein are those of LBN Advisers Limited in their capacity as Investment Adviser to the Fund as of 13/07/15 and are based on internal research and modelling.