China was the world's fastest growing large economy in 2013, and one of its worst performing stock markets.
While December data aren't in yet, the country's gross domestic product is believed to have expanded by 7.5 per cent last year, a rate that leaves North American and European economies in the dust. Yet the Shanghai Stock Exchange Composite Index – the nation's largest equity benchmark – fell 6.5 per cent.
The disconnect between the Chinese economy and equities is bizarre. The past decade has seen GDP almost triple (in nominal terms) while equity markets are up only 41 per cent.
Stock markets look forward, discounting future profits. It seems that investors in Chinese equities must not like what they see looming ahead.
But what exactly do investors fear? At first glance, it makes no sense that Chinese equities trade at eight times forward earnings expectations when GDP is expected to leap ahead by 7.2 per cent in 2014. The S&P 500, in contrast, trades at 17 times forward earnings when U.S. GDP is expected to grow at a measly 2.6 per cent.
To be sure, financial regulations restrict foreign ownership of Chinese stocks and this has limited market performance. But, that can't be the whole answer. China now has twice as many millionaires – 1.25 million – as France and Germany combined, according to the Hurun report on Chinese wealth accumulation. So there's no shortage of domestic funds that could drive the market higher if investors had any type of faith in the profit outlook.
Not only have China's wealthy been avoiding the country's equity market, they've been desperately trying to move their wealth entirely out of the country. Citing a study by property consultant Saville, The Atlantic's Quartz magazine reported that wealthy Chinese were the buyers for 27 per cent of London real estate sold in 2012, and the dominance of Chinese investment in British real estate actually increased during the first half of 2013.
The flood of Chinese money headed to foreign locales is in keeping with a warning last year from the International Monetary Fund, which said that further loosening of China's capital controls would risk a large and destabilizing exodus of wealth from the country.
Why would the best informed segment of China's population – the high-ranking government officials and successful businesspeople that hold the majority of the country's wealth – look to move money overseas when local economic growth is widely expected to continue at three times the rate of the United States?
I suspect the reason that China's moneyed elite isn't pouring their wealth into China's stocks is because they hear the loud ticking of the country's debt bomb.
Credit market stress was the dominant investment story in China in 2013. Because 42 per cent of the Shanghai Composite is made up of financial service firms, it was also the primary reason for the dismal performance of stocks. The end of each quarter saw sharp spikes in interbank lending and other interest rates as Chinese banks scrambled for funding.
The wobbles in the Chinese credit market reflect several worrisome factors. One is the popularity of wealth-management products – short-term notes backed by dubious underlying assets – that have grown to account for 20 per cent of all bank deposits. In addition, there is the tendency for banks to simply roll over or extend maturing loans for struggling corporations rather than list them as non-performing debt. This is obscuring the health of bank balance sheets.
The severely depressed levels of valuation among Chinese stocks imply local investors have no faith in the profit outlook for Chinese companies. Credit market volatility indicates why – and also suggests a reason why investors aren't more excited by the prospect of strong economic growth. They may fear that more credit-driven GDP growth in 2014 will just add to the problem of bad debt and unprofitable businesses.
The Shanghai Stock Exchange Composite Index is a case where equity markets are cheap for good reasons. Over the long term, it is likely that China will succeed in rebalancing its economy and return to high levels of sustainable growth. In the short term, however, Canadian investors should avoid China-related investments.