Abstract: The recent surge in China's stock market has captured attention worldwide, with many discussions centering on the drivers behind the rally and whether the market has entered bullish territory. In a recent interview, Zhong Wei shared his assessment of the recent market rise and drivers of a future uptrend including the role of monetary policies.
I. The recent market surge is due to adjustments to stock valuations, and China's stock market will grow mildly until 2021.
Q: What is your take on China's recent stock market rally?
Zhong: Firstly, from a historical perspective, the recent rise of the A-share stocks is adjustment to market valuation.
From the second half of 2015 to the first quarter of 2016, China's A-share market experienced drastic swings, and in the following three or four years, the Shanghai Stock Exchange Composite Index (SSE Index) lingered in a bear market despite some fluctuations. On March 23, 2020, the SSE Index closed at 2660.17, hitting the lowest point so far this year. Recently, the stock market has seen a gradual rise, with the SSE 50 Index breaking 3,100 points and the ChiNext Index reaching 2462.56 points on July 3, which were roughly the levels at the end of 2015 and the beginning of 2016. From a long-term perspective, the overall rise of the stock market is not that big. By contrast, China's GDP grew from 68.9 trillion yuan to nearly 100 trillion yuan during 2015 and 2019.
From an international perspective, since the beginning of 2011, the US stock market has experienced the longest bull market in history, with all three major stock indexes rising significantly. Even after the outbreak of the COVID-19 this year, regardless of the huge fluctuations, the NASDAQ still set a new high, closing at 10,207.63 on July 2, while the Dow Jones Industrial Average Index closed at 25,827.36, up nearly 1.5 times from the beginning of 2011.
In fact, the A-share market has not outperformed that much over the past decade when compared with European, the US and Japanese stock markets, when measured by the stock market capitalization-to-GDP ratio. For instance, Japan's Nikkei 225 index, which bottomed at about 15,265 in 1995, has now risen remarkably to around 22,306, but in contrast Japan's GDP has barely grown in the past 25 years. Since 2011, the US GDP has risen from about $14.7 trillion to a little over $20 trillion, while the rise of the US stock market has been much more than that of GDP.
These facts show that in the past five to ten years, while the ratios of stock market to GDP in major western countries have all increased significantly, that in China remains relatively low.
Therefore, both the historical and international perspectives suggest that the recent A-share market surge is due to adjustments to stock valuations following a long cycle in the past four years. Patient investors will find that modest growth will be the main feature of China's stock market for the rest of this year and next year.
Q: What are the major characteristics of the recent stock market surge in China?
Zhong: The recent adjustments of market valuation have been accompanied by several new characteristics.
Firstly, market fever has not been as high as it was in 2012-2015, leverage has not been high either, and investor sentiment in the A-share market has been relatively stable. Investor preferences this time are still skewed toward growth tech stocks, and consumer goods and import substitutes which drive domestic demand, which is reasonable. At present, the foundation of the A-share market has significantly improved thanks to favorable factors like the establishment of the Science and Technology Innovation Board (STIB) and improvement of institutions and rules in the stock market.
Secondly, compared with 2015 and 2016, foreign investment institutions have become increasingly important in China's financial market. China's real economy faces pressures of decoupling from the US. However, China's financial system has become increasingly integrated with the international financial system with its continued efforts to pursue high-level and high-quality opening up.
This is reflected in the fact that the value of foreign capital in China's bond market has reached 2.6 trillion yuan as of June 2020, holding about 2.4% of the total volume of China’s bonds and 9% of China's government bonds.
Meanwhile, the value of foreign investments in A-share market has also surpassed 2 trillion yuan, which, therefore, makes foreign investors as a whole the second largest institutional investor in both the A-share and the bond markets in China. Foreign investors are betting on China's bond and equity markets which are providing attractive returns for investors with large fund base at a time when major central banks around the world continue to increase money supply and cut interest rates.
Overall, I think what is happening in China's A-share market is still an adjustment of market valuation from a relatively long-term perspective of four to five years. Whether compared historically or internationally, in the process of opening up, China's capital market is growing steadily, driven by investments in tech growth stocks and stocks on domestic demand-oriented consumer goods and import substitutes. Despite potential structural bubbles, the A-share market is healthy overall, even though it has reached the high-level of 3,100 points.
II. The belief that 3000 points is the starting line for a bull market is groundless, which, nevertheless, does not weaken the judgment that the A-share market will continue to attract domestic and foreign investors
Q: Is "3000 points" the starting point for a bull market?
Zhong: The claim that "3000 points" is the starting line of a bull market has no basis. On June 19, the Shanghai Stock Exchange and China Securities Index Corporation announced that the compilation method of the SSE Index will be revised on July 22. Right now the market is waiting for the revamp, but even after the new compilation scheme is adopted, it's still hard to say whether "3000 points" will become a benchmark for a bull market. From the angle of mean reversion in the long term, it might be acceptable to take "3000 points" as a starting line for a bull market. However, whatever the understanding is does not weaken domestic and foreign investors' interest in China's A-share market.
Besides, the main driver of the recent market rally has been the startup board since the beginning of the year, followed by the SME (small- and medium-sized enterprises) board, the SZSE Component Index, the SSE Index, and the FTSE China A50 Index. This does not support the belief that reaching 3000 points signals the beginning of a bull run, either. Compared with the "3000 points", the performance of SME and startup boards are more important to the overall performance of the stock market. Therefore, more attention should be paid to the growth potential of SME and startup shares, and whether their valuations are reasonable.
Of course, the "3000 points" threshold is not completely meaningless. When there is a structural bubble in the valuation when, for example, startup and SME boards rise drastically, the market will adjust some of the deviations, which may lift the SSE Index and FTSE China A50 Index temporarily. But after the adjustments, the startup and SME boards may still be the focus in the capital market. So, it is difficult to determine for now whether the current market preference for startup and SME boards will shift. At present, the market has yet to reach a consensus about whether investment appetites will shift from growth stocks to blue chips. Personally, I think that without substantial changes to the state-owned economy through mixed ownership reform and the adoption of employee stock ownership plans, the shift of investment preferences in the market, if any, will hardly sustain, though there will be adjustments in investment styles periodically. In addition, attention should also be paid to the Hong Kong stock market which has been adjusting for a while. There are many similarities among the listed stocks in H- and A-shares markets, and as the situation in Hong Kong stabilizes, the growth opportunities for H-shares should be evident.
Q: What are the potential drivers of an uptrend in the stock market in the future?
Zhong: In general, two factors will contribute to the steady rise of the A-share market until 2021—economic growth in medium term and the development of COVID-19 vaccine in short term.
Firstly, China's economic growth will continuously climb for the rest of this year and next year. Chinas economy will pick up slowly in the remaining quarters of this year. While it’s possible for China's economic growth to reach 1.5%-2% in 2020, economic performance will likely be much better next year, with a potential growth rate exceeding 7% if the situation continues to improve. Therefore, in the seven quarters following the peak of the COVID-19 outbreak, China's economic growth will steadily increase, which will help the investors to adjust their mentality and risk appetite in the A-share market.
Another potential factor contributing to a market rally is the successful development of a COVID-19 vaccine. But even without a vaccine, the process of economic reopening will not be stopped because there is no so-called tradeoff between "economy first" and "life first". Epidemic prevention and control must be normalized, and no matter with or without a vaccine, the economy must be reopened, though the pace of reopening may differ. Of course, recovery will be faster with a vaccine. A resurgence of the virus will have negative, but not significant, impact on the overall recovery.
The economic impact of COVID-19 will be asymmetric in the future for China and the rest of the world, that is, the disease will continue to have negative impact, but not as dramatic as it did in the first three to four months this year. Because the virus has become known to people, the success in vaccine development in the future will bring huge positive impact on the economy.
Therefore, with a continuously climbing Chinese economy and the potential success in vaccine development, investor sentiment can further stabilize, and the steady recovery of the Chinese and global markets can also sustain.
III. Liquidity supply in the market has passed peak, but monetary policy will remain highly flexible
Q: Some of the recent monetary policy moves seem to suggest that China is planning to exist the uniquely loose monetary policies launched earlier this year. How would the liquidity condition in the market look like next?
Zhong: It is likely that liquidity supply in the market has passed peak in 2020.
Firstly, the liquidity easing measures introduced by China's central bank earlier were temporary policies, mainly aimed at offsetting the impact of the pandemic. Liquidity condition will not be loose permanently. For now, monetary policy has shown signs of tightening in a marginal sense, which has led to the rapid rise of short-end interest rates in the money market.
Secondly, it is necessary to study the expectations on future economic growth and inflation. Judging from the official data, China's economic growth is likely to return to positive territory in the second quarter and will remain relatively stable in the second half of this year. China's economy is expected to achieve a moderate growth of 1.5%-2% for the whole year.
In terms of inflationary expectation, CPI (Consumer Price Index) dropped significantly in May and June, back to a level between 2%-3%. In the second half of this year, the year-on-year CPI growth is expected to stabilize at around 2.2% or 2.3%, while PPI (Producer Price Index) may continue to pick up. So the expectation on inflation is roughly consistent with the expectation on economic growth.
At present, both China's 10-year bond yield of 2.9% and inflation rate are slightly higher than those in most western countries. As China's economic growth slows and inflation declines, mid- and long-term interest rates also tend to decline. It is highly likely that the 10-year bond yield will gradually fall to a level slightly above 2.5%. However, there is little sign showing that medium - and long-end interest rates will fall significantly this year.
Looking at China's monetary policies so far this year, I think interest rates have already seen turning points since late May, and liquidity supply is also approaching a turning point.
Q: To what extent will monetary policy affect the A-share market?
Zhong: The impact of monetary policy on A shares is not that big. Both the deposits of corporate sector and the financial assets of the household sector grew rapidly in the first half of this year. For example, the financial assets of China's household sector were about 180 trillion yuan to 200 trillion yuan, among which 50%-60% belong to a small number of high-net-worth individuals. The scale of these assets relative to the market value of outstanding shares in China's A-share market indicates that liquidity is sufficient at present. To put it another way, when the market outperforms, the money of residents and enterprises will eventually flow into the stock market, but when the market underperforms, the support of liquidity to the market will be limited.
In general, market performance at present is determined by the adjustments of valuation and investors' risk appetite, and as investor sentiment becomes optimistic, valuations have adjusted to quite a high level. The tightening of monetary policy in a marginal sense may bring some psychological effects and cool the stock market to some extent, but the actual impact will not be that much. Liquidity at present is reasonably ample.
Although the impact of monetary policy on the stock market may not be particularly large, that on the bond market could be very heavy. The main reason is that bonds issuance will face significant pressure in the second half of this year, no matter local government bonds or special purpose anti-epidemic bonds. In fact, the current relatively low bid-to-cover ratios of these bonds suggest some tightening of liquidity in the bond market. The bond market will be affected by monetary policy significantly more than the stock market in the second half of the year.
IV. Where does the 1.5 trillion-yuan interest concessions come from?
There is still room for further cut of the RRR and interest rate.
Q: Chinese government has urged financial institutions to make interest concessions as appropriate to businesses and expedite fee cuts, which are expected to bring benefits worth as high as 1.5 trillion yuan. What are the sources of the 1.5 trillion-yuan interest concessions? What is the direction of monetary policy for the second half of this year? Are further rate cuts possible?
Zhong: There has been great controversy over the 1.5 trillion-yuan interest concessions, as it is quite difficult to realize. Basically, the cost of capital for the real economy is determined by four major factors:
One, the borrower's credit quality and repayment capability, which are reflected in the risk premium; second, the cost of capital for financial institutions, which is mainly the cost on financial institutions' liabilities and closely related to risk-free rates, such as the 10-year bond yield; third, the efficiency of financial institutions, also known as operating cost; fourth, compliance costs faced by financial institutions as a result of abiding by financial regulations imposed by the central bank, the Banking and Insurance Regulatory Commission (BIRC), and the China Securities Regulatory Commission (CSRC). Therefore, risk premium, risk-free rate, operating cost as well as compliance cost determine the cost of capital in the real economy.
At present, despite the central bank's efforts to lower the risk premium, it is still difficult for enterprises to make profits in 2020 amid an economic downturn. For instance, in the first half of this year, the growth of SOE (state-owned enterprises) profits was about -50%, which shows that it is difficult to reduce risk premium under downward pressure.
In terms of the risk-free rate represented by the 10-year government bond yield, there is still room for it to fall in medium- and long-term, which, though, seems to be stable at present. The operating cost of financial institutions is already very low, while the compliance cost is relatively high.
Therefore, among the above four kinds of costs, the one which still has room to fall is the risk-free rate. For instance, the 10-year bond yield could be further lowered by 20-30 basis points to around 2.5%-2.6%. Besides, compliance cost can also be lowered. As compliance cost also increases the overall cost of capital of financial institutions, it might be necessary to reduce this cost in the future.
In addition, on June 30, the People's Bank of China lowered the rediscount and reloan rates, which I think are aimed to support agriculture and small- and micro-sized enterprises, and hence will have little impact on the A-share market.
At present, the market is expecting continuous and steady rate cuts from the central bank. In terms of the reserve requirement, China's foreign exchange reserves have long passed and fallen significantly from the peak. A significant recovery of China's foreign exchange reserves seems unlikely in the foreseeable future. So I think China still has room for a RRR cut.
In the meantime, the decision of cutting interest rates also depends on inflation and government bonds spread between China and western economies. Now it seems there is still room for China to lower medium- and long-end interest rates.
Wha's more, we also need to guard against the tendency to allocate funds by executive orders, and to better balance between executive orders and market disciplines. The role of market in resource allocation should be given more play in steering the direction of fund flow. After all, commercial financial institutions are different from policy-based financial institutions, and monetary policy is not almighty. Proactive fiscal policy should be bold and effectively implemented.
If funds failed to reach the real economy precisely, we should not blindly blame financial institutions or the monetary policy transmission mechanism, instead, we should see the difficult efforts financial institutions have to make to balance between complying with policy requirement and market pressure, between social responsibility and their own interests.
