The China Bubble That Wasn’t

Kenneth Rapoza Contributor | Forbes | Original Source

The world wanted China to go capitalist, did it not? Well, welcome to capitalism, people.  When a country as powerful and as large as China is allowing for its investor class to ship money out of country, and is allowing foreigners to ship money into its stock market for the first time ever, this is what is going to happen. Asset prices are going to go crazy for a little while.

A handful of companies have taken a hit recently, becoming unwilling examples of the China Bubble — as if China is the only country to ever have a bubble. Better yet, in the West, the narrative is that China is just not allowed to have a bubble. It can open its market, but asset prices can never inflate.

I’m going to go out on a limb here: China knows what it is doing. It might take a few years to see this, but they do.

Three things are happening to Chinese equity markets that are worth putting into perspective. One, the market is opening up to the rest of the world. Foreign investors can now buy Chinese A-shares for the first time. It’s currently on a quota system so as not to overburden the markets.  There will be no opening of the flood gates.  Instead, it will be more of a constant chisel chipping away at the dam until the water flows through naturally.

picSee this lady here? She and her friends in Shanghai are driving up the value of Hong Kong stocks.  Oddly, Westerners always wanted China to break down its walls and open its market. When it does, it gets blamed for creating a bubble as if it is the only economy ever to have such a thing. (Photo by JOHANNES EISELE/AFP/Getty Images)

This year’s creation of the Shanghai-Hong Kong Stock Connect allowed foreign firms with Hong Kong broker/dealers to tap into the mainland A-shares market for the first time. It had some issues at first that needed to be worked out, such as settlement dates. And for the most part, global fund managers at places like State Street Bank, HSBC, Guinness Atkinson and Ashmore Group, to name a few, all told FORBES that they were cautiously optimistic about the so-called thru-train. They all said this would inevitably drive demand into mainland Chinese equities by American and European institutional investors.

The China-haters, which are in no short supply, all called the thru-train a failure within its first month of operation.

Although the Deutsche X-Trackers CSI China A-Shares (ASHR) exchange traded fund doesn’t measure the precise northbound flow into mainland Chinese equities via the thru-train, here is how the ETF has done this year as a result of this new and growing market.

ASHR3The majority in the financial media are focused on Hong Kong’s recent equity boom as if it is an example of the China Bubble expanding south of the border. The bigger story has been the A-shares, helped along by the People’s Bank of China’s mini-QE.

Just as Hong Kong brokers can now bring Americans and other foreign investors into mainland China via Shanghai, so can Chinese investors now invest in Hong Kong instead of Shanghai or a condo in a ghost city in Nanjing.

This is what happens when a million Chinese, who have been getting richer over the last 20 years, are finally given an option to invest outside of the mainland.

ASHR3The iShares MSCI Hong Kong ETF is up over 19% year to date. Other QE induced equity markets have done better at the outset of central bank asset buying. China also has another caveat: its mainland investor class, mostly all short term casino gambling equity players, now have access to Hong Kong listed shares for the first time.

Lastly, and just as important, there is this little institution in Beijing called the People’s Bank of China. It has about $4 trillion in cash, and a lot of room to move when it comes to stimulating the economy. China GDP is slowing as Beijing moves tortoise-like from its export-driven model to a more entrepreneurial economy focused on local consumers.

Unfortunately, the local consumer has failed to pick up the slack in export manufacturing and big banks are not lending like they used to. So the PBoC is providing the economy with some monetary stimulus. Some of that money will inevitably flow into equities.

“China is becoming one of those central bank markets — wherever there is an active central bank, you buy,” says Krishna Memani, CIO of OppenheimerFunds in New York. “All indicators are that the PBoC may get even more active.”

If Memani is right, we all know where the market is heading.

This is what happened to the S&P 500 after it bottomed in early March 2009 and the Fed was three months into its first round of quantitative easing.

ASHR3Using the same five month time line as EWH and ASHR, State Street’s SPDR S&P 500 ETF was more jacked up on QE and investor appetite than anything we are currently seeing in China. If there is a bubble in China, then there is a bubble in SPY and in the iShares MSCI Europe (VGK).

The general talking heads on CBNC celebrated the S&P’s meteoric Fed-induced high. But on China, the recent gains are somehow a complete mystery; a dark cloud waiting to rain on grandma’s 401k parade.

There are roughly 4,000 companies listed on the Hong Kong Stock Exchange. But instead, the panic of late — reported on by Bloomberg — is around just three extremely rich firms who have lost over a third of their market cap in a single trading session. One is Hanergy Film, a solar panel equipment maker whose stock soared in April, then declined one day in May. Rumor has it that this was an insider pump and dump.

Year to date, Hanergy is still up over 40%, which means its market cap is still higher now than it was last year.

Moreover, anyone who has every followed Hanergy price movements knows this volatility is not new. On Oct. 2, the stock was worth $4.40 (Hong Kong dollars) per share only to fall to $0.96 four weeks later.

Goldfin Financial fell off a cliff on May 21. It has been flat-lined since. Still, that stock is up 117.4% so far this year. Yes, it lost market cap, as the alarm-ringing headlines showed. But the company’s market cap doubled this year already.

Then there’s Goldfin’s housing developer, Goldfin Properties, run by billionaire Pan Sutong. It also fell on May 21. Sutong told Bloomberg that he didn’t know what was behind the demand for his company’s stock of late.

“I don’t know why, I didn’t buy any,” 52-year-old Pan told Bloomberg on May 12. “I know the market is buying, but I don’t know who specifically.”

If he doesn’t know he, he is either not telling the truth, or the flow is from a few thousand Chinese short-termers who buy stocks like they play Sic Bo at the Sands in Macau.

That particular stock is up 217.9% year-to-date. Their one day loss, looked at over a longer term, is minuscule compared to how much their equity values have ballooned in 2015.

The thru-train is getting a new route: Shenzhen will join later this year.

In July, the MSCI index will likely include the A-Shares in its MSCI Emerging Markets Index, meaning any fund investing in that index, such as the massive iShares MSCI Emerging Markets (EEM) and Vanguard Emerging Markets (VWO) ETFs, will have to rebalance to reflect the change. That will mean more money coming into China A-shares. The market will only allow so much in at first, but it’s a big market and it will gradually get bigger as Beijing slowly expands its quota. For now, the trickle is significant. Everyone knows where this is heading.

“We haven’t been big players in the A-shares yet,” says Memani. “If we see an opportunity to use that channel we have everything set up to use it. When that process started, the expectation was that a large number of foreign investors would buy A shares. Instead, the movement we are seeing most is mainlanders buying H-shares,” he says of the Hong Kong listed equities.

Trillions of dollars have poured into the mainland over the years looking for much higher returns than they were getting in Hong Kong. Now that the return on investment is slowing, especially on the export-focused firms, individual businessmen from China and Hong Kong want to get their money out of the mainland. It is not easy to get money out of China through official channels. The thru-train is the easiest way.

There is a case to be made that Chinese are diversifying away from their home market and Hong Kong is one way out. But that is only part of the truth.

On the investor side of the equation, it is clear that Chinese locals are going ga-ga for the Hang Seng. It’s up 19.2% this year. Some dare call it a bubble. It’s probably not. These upticks are temporary.

“The investment channels in China are very limited,” says Grant Engelbart, a fund manager for CLS Investments in Omaha. The firm manages $6.5 billion in private accounts.

“If you’re Chinese and don’t want to buy real estate, and are already invested in Shanghai and Shenzhen, Hong Kong just makes simple sense. Of course there are a lot of new accounts opening, a lot of margin buying and that is worrisome because it drives up demand. But if Chinese investors are purchasing their own markets..is that so bad?” he asks, quickly coming back with the answer during a phone interview last week.

“No, it’s not so bad. And it’s not worrying to me. The quick and abrupt movement in price needs to settle down a little bit and will. The government isn’t too happy about retailers buying on margin, but I think the market doesn’t always remember that Beijing can control their economy and its citizens. The U.S. stock market is more institutional than China’s. Once institutional investors take more control of the volume, China’s equity market will become more stable,” he says.

This is still many years away yet. China’s gradual opening of its securities markets is in its early innings.

Retail investor dominate the A-shares and are now piling into the H-shares. Some companies took a hit, but most are not as dramatic.  The $9 billion Tsingtao Brewery is down 4.5% year-to-date.  The $3 billion developer SOHO China Ltd is up just 2.2%. The Hang Seng’s overall 19% rise is not indicative of a bubble, even if everyone in New York is busy looking for one.

In early May, the narrative was that the 5% sell-off in the Shanghai Composite meant the bubble was popping.   You could almost read “toldya so” written between the lines of most articles and commentary in Bloomberg and CNBC.

Waiting for a bubble to pop in China is like waiting for the Second Coming of Christ. It might be worth it when it happens and you’re first on the scene. But if it doesn’t show up for another 20 or 100 years, you’ll probably be dead by then anyway.