China s Unwinding Stock Market Bubble

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1 China s Unwinding Stock Market Bubble The Chinese equity market is experiencing significant volatility, exhibiting the classic signs of a bubble fueled by changing government regulation. Chinese authorities have implemented a series of supportive policies and globally the reaction has thus far been somewhat muted. Key Observations 1) We view risk of global contagion as relatively minimal, and remain comfortable with the health of Asia s growing middle class based on the following considerations: The Chinese stock markets are not necessarily reflective of the overall Chinese economy. Foreign investors have little exposure to Chinese equities only 1.5 percent of Chinese shares are owned by foreigners, according to Capital Economics. Chinese citizens have a relatively small exposure to their own equity market. This sentiment was well captured by an article published in the July 7 edition of The Economist which stated: The free-float value of Chinese markets the amount available for trading is just about a third of GDP, compared with more than 100% in developed economies. Less than 15% of household financial assets are invested in the stock market: which is why soaring shares did little to boost consumption and crashing prices will do little to hurt it. 2) China s A shares market is likely to face continued turbulence in the near future. According to Matthews Asia, the A shares market, which constitutes roughly 2,800 to 3,000 securities, is trading at a PE ratio of roughly 54. Meanwhile, the Hong Kong market, which is driven more by institutional and foreign investors, is trading near a PE of approximately 14. What Happened Changing government regulation led the Shanghai Composite to rise 158 percent from a May 2014 low to the June 2015 high. The primary factors contributing to the bubble were the surges in: Equity Account Openings more people opened stock accounts (see Exhibit I). Margin Trading more people bought equities on margin or with debt (see Exhibit II). Speculative Traders 68 percent of these new investors have not completed the equivalent of a high school education (see Exhibit III). Follow us on 1

2 EXHIBIT I: China New A-Share Brokerage Accounts 5 Brokerage Accounts (in Millions) A surge in new brokerage account openings Source: Bloomberg, China Securities Depository and Clearing Corporations, Glenmede EXHIBIT II: China Balance of Margin Purchases Margin Purchases (100 billion Renminbi) A surge in buying equities on margin Source: Bloomberg, JP Morgan, China Securities Finance Corporation Ltd., Glenmede Margin trading is the outstanding balance of margin purchases. Units are in 100 billion Chinese Renminbi. Follow us on 2

3 EXHIBIT III: % of Chinese Equity Account Holders with Less than a High School Education 80% 70% 60% 50% 40% 30% 20% 10% 0% 68% of new investors have less than a high school education 27% Existing Investor Households 68% New Investor Households Source: Glenmede, BloombergBrief.com, SWUFE China Household Finance Survey Response by the Chinese Government The government has implemented several supportive policies, including those listed below, compiled by research firm Cornerstone Macro: A fund worth $19.4 billion was created to buy shares in the largest companies. IPO issuance was suspended. Peoples Bank of China (PBoC) will provide liquidity to the government-backed China Securities Finance Corp. Lending and deposit rates were cut. Pension funds were approved to invest in stocks. Transaction fees were lowered. Margin ratio requirement were eased. The China Financial Futures Exchange suspended at least 19 accounts from shortselling. Additional Considerations Glenmede Monitors Chinese companies continue to suspend equity shares from trading. This could affect investors outside of the mainland equity market with exposure to Chinese equities. It is reported that investors who can t access their equity or have seen their portfolios fall may be selling other assets to raise cash. This has the potential to send ripple effects through other Chinese markets. As previously stated, foreign investors have little exposure to Chinese equity markets. Nevertheless, this could partially explain why interest rates on short dated Chinese bonds are rising. Follow us on 3

4 Glossary* A-Shares Shares in companies based in mainland China that trade on Chinese stock exchanges such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange. A- shares are generally only available for purchase by mainland citizens. A-shares are quoted in yuan, and are only available to foreign investment through a qualified program (QFII). B-Shares Most companies listed on Chinese exchanges offer two shares classes: A-shares and B-shares. B-shares are quoted in foreign currencies (such as the U.S. dollar) and are open to both domestic and foreign investment (provided that locals set up a foreign currency account), while A-shares are only quoted in Chinese renminbi. H-Shares Shares in mainland China-based companies that are listed on the Hong Kong Stock Exchange. H-shares are still regulated by Chinese law, but they are denominated in Hong Kong dollars and trade the same as other equities on the Honk Kong exchange. H- shares on the exchange are automatically included in the Hang Seng China Enterprise Index. Hang Sang Index A market capitalization-weighted index of the largest 40 companies traded on the Hong Kong Exchange. The index covers approximately 65% of the Hong Kong exchange s total market capitalization and is the most widely quoted barometer for the Hong Kong economy. Hong Kong Stock Exchange Asia's third largest stock exchange in terms of market capitalization behind the Tokyo Stock Exchange and Shanghai Stock Exchange. The H- shares on the Hong Kong Stock Exchange have an index market capitalization of the $423 billion and a volume of 3.28 trillion. Qualified Foreign Institutional Investor (QFII) A program that permits certain licensed international investors to participate in China's mainland stock exchanges, allowing foreign investors access to yuan-denominated A-shares listed on the Shanghai and Shenzhen stock exchanges. As of April, 2012, the combined quota for the Qualified Foreign Institutional Investor program was set at U.S. $80 billion. Renminbi vs Yuan Renminbi, abbreviated as RMB, is the formal term most often used by Chinese officials to refer to the currency. There is not an exact equivalent to renminbi in American English, however, an approximation might be something like legal U.S. tender. The yuan is the actual unit of currency. It s more likely to be used in everyday interactions in China. Follow us on 4

5 Shanghai Stock Exchange The largest stock exchange in mainland China. Most of the total market capitalization of the Shanghai Stock Exchange is made up of formerly state-run companies, many of which have only traded on the exchange since The Shanghai Stock Exchange has an index market capitalization of $5.49 trillion and a volume of trillion. Shenzhen Stock Exchange One of China's three stock exchanges, alongside the Shanghai Stock Exchange and Hong Kong Stock Exchange. Many of the companies within this market are subsidiaries of companies in which the Chinese government maintains controlling interest. The Shenzhen Stock Exchange has an index market capitalization of $3.83 trillion and a volume of trillion. *Terms found within this glossary are sourced from public resources, including Wikipedia and Investopedia. JASON D. PRIDE, CFA, Director of Investment Strategy Responsible for formulating investment policy and strategy Serves as a leading member of the Investment Policy Committee B.S. from Massachusetts Institute of Technology GLENMEDE CORPORATE FACTS More than $30 billion in assets under management Founded in 1956 Serves high net worth individuals, families, family offices, foundations and institutional clients Investment Strategy Notes represents a review of issues or topics of possible interest to Glenmede s clients and not as personalized investment advice. It contains Glenmede s opinions, which may change after the date of publication. Information gathered from third-party sources is assumed reliable but is not guaranteed. No outcome, including performance, is guaranteed, due to various risks and uncertainties. This document is not a recommendation of any particular investment. Actual investment decisions for clients are made on an individualized basis and may be different from what is expressed here. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss anything they see here of interest with their Glenmede representative. Follow us on 5

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