Is a major correction coming in the China market?

Schroders became the second firm in a week to warn on China’s overheating market after BlackRock said it would be selective and continuously flexible in terms of sector picking and choosing between A-and H-share stocks.

Emerging-market assets could be impacted when the US Federal Reserve hikes interest rates, according to a recent research note from Schroders.

The rate hike could trigger a reversal in carry trades, where investors borrow in a country with low interest rates to fund purchases of higher-yielding assets elsewhere. The unwinding of positions in the carry trade could then impact investor risk appetite.

“Emerging markets, which includes China, is still perceived as a risky asset class,” the firm said.

In the near-term, the most likely trigger for a correction would be any announcements by the regulator to tighten leveraged trading, Schroders said.

“We have seen corrections already when the regulators have hinted at stricter controls, only for markets to rally again as these have not been enforced. The more markets run, and the more leverage is used, obviously the greater the chances of such a policy change occurring.”

Another factor driving the market is speculation on further policy easing measures such as a cut in domestic interest rates and the reserve requirement ratio for banks, the issuance of bonds and possibly some form of quantitative easing.

“However, if this does not come through as expected, maybe because Beijing authorities are more optimistic about the prospects for growth  in the second half, then this could also undermine one of the pillars of the market,” Schroders said.

If policy measures fail to boost the economy, the outlook for companies earnings and valuations are likely to come under greater scrutiny.

Investor concerns are likely to then resurface due to structural factors such as rising corporate and local government indebtedness, overcapacity in many industries, weak margins and profitability, poor cash flows and risks to banks’ balance sheets.

Another significant change would be a shift in the loose monetary policy to neutral or even a tighter-bias, in response to stronger economic data or higher consumer inflation.

A-shares vulnerable

A-shares, which have been rallying since last year, are vulnerable to correction, the fund house said.

Frothy valuations, an increase in initial public offerings, deteriorating corporate earnings and capital outflows are the reasons. 

“Therefore, we would not be chasing A-shares.

“Valuations in many sectors of the A-share market are already stretched, and hence there is little justification to buy H-shares indiscriminately simply because they are at a discount.”

A-shares received a boost after the launch of the Shanghai-Hong Kong Stock Connect in November and monetary easing measures by the government.

The bullish sentiment and onshore liquidity then started to spill over into the Hong Kong market from early April after China allowed domestic mutual funds to access the Stock Connect and investors started noticing the discount of H-shares versus A-shares. 

“As for H-shares and the broader Hong Kong market, it is less clear, although valuations are currently at a more reasonable level.”

Portfolio positioning

The fund house is cautious on banks as it sees their margins coming under pressure.

“Although there are hopes that current policy easing will reduce the tail risk of a major credit shock to the system, and justify a re-rating of the sector, we expect to see a continued, steady deterioration in operating metrics and ROEs [return on equities] for the sector in coming months and years.”

The firm prefers to hold secular growth businesses, which are less reliant on market liquidity for a re-rating.

Sectors such as healthcare, e-commerce, insurance and renewable energy that have performed well in recent years should continue to benefit from structural shifts in the economy over the longer term, the firm said. 

The fund house has increased exposure to the telecommunication sector this year on expectations of growing data consumption and 4G subscriptions and an improvement in free cash flows as capital expenditure peaks.

However, profits have been booked in real estate, railway and nuclear energy-related companies.

“We have also trimmed our real estate stocks as their NAV discount has been significantly narrowed on the back of recent government policy easing.

“In the long term, we are still cautious on the structural issue of the [real estate] sector given the oversupply situation in the lower-tiered cities.”

Meanwhile, the firm said it will revisit select NASDAQ-listed Chinese companies as these have lagged in the current rally and their valuations are becoming attractive.