China may be down 40% but beware the value trap

The Shanghai Composite has been much harder hit than the Hong Kong-biased MSCI China benchmark with locally listed stocks bearing the brunt of investors’ increased risk aversion amid concerns about fading global growth and the potential fallout from the sovereign debt crisis.

Added to this are the multitude of worries about structural issues in corporate China and the unsustainably lop-sided nature of the domestic economy, which are combining to keep the bargain-hunters away.

‘We’re continuing to avoid playing the contrarian view on China for the time being,’ said Haig Bathgate, chief investment officer at Turcan Connell. ‘In our view, Chinese stocks were in a bubble and despite the recent sell-off this has the potential to go a lot further as the outflow from Chinese mutual funds becomes self-propagating.’

He adds that at the market’s peak there was a significant amount of share issuance, which had the effect of being dilutive. 

‘We’re not advocates of the hard landing scenario but think that investing in the Chinese domestic economy is unlikely to be rewarding any time soon – for the same reason we’re negative on most industrial commodities,’ Bathgate said.

Courtiers’ chief investment officer Gary Reynolds also has zero direct exposure, saying he is able to find significant opportunities in developed regions – the US and UK in particular – without taking the extra risks associated with markets where capital is regarded with ‘less respect’.

He says the two main problems facing the authorities remain the need to rebalance the economy and manage its faltering financial system.

He notes investment accounts for around 49% of GDP, which needs to drop near to 35% to be sustainable. But for this to happen and economic growth to continue, the slack clearly needs to be taken up elsewhere, hence the government’s drive for growth in consumption – a move unlikely to bear fruit in the short-term. ‘Private consumption is the obvious candidate as it is only around 34% of GDP at present (half of what would be “normal” in the developed world),’ Reynolds said. ‘This transition won’t be easy, even though the Communist Party has acknowledged it is necessary.’

But this strikes at the core of one of the big contradictions within Chinese policy.

‘The Chinese Communist Party uses its country’s banks as a policy tool – they take savings from China’s households and pay woefully low rates and then make the capital available to Chinese state-owned enterprises at equally ridiculously low rates,’ he says.