Leverage overhang leaves mainland China stocks exposed to fresh falls
The mainland’s US$3.9 trillion stock market unwind could be barely halfway through, with a key price-to-earnings ratio still running at roughly twice the level analysts say is fair value and some US$600 billion worth of margin debt and collateral pledges left to clear.
Opaque off-balance-sheet lending has left money managers and financial analysts groping for reliable figures on which to base estimates of further downside risk, even as mainland stock markets enter a second week of relative calm after their biggest battering in at least seven years.
“The question is what do you do now?” Francis Cheung, head of China-Hong Kong strategy at broker CLSA, told the South China Morning Post. “The market is not cheap and the problem is that as the margin finance gets cleaned out, you’re taking out a lot of things that support the market at current levels.”
Leverage is still high, and further deleveraging, which is necessary, will create selling pressure
Cheung calculates that mainland shares are trading at a price-to-earnings ratio of 33 times when banks are excluded.
Beijing ordered state-backed lenders to help fund a clean-up of the financial mess left by a three-week rout that started in mid-June. Stripping out that policy support mechanism, and its implicit drag on overall earnings for constituents of the Shanghai Composite Index, leaves the market trading at roughly twice the fair value level that strategists at firms such as AXA Investment Managers believe is viable.
“Leverage is still high, and further deleveraging, which is necessary, will create selling pressure,” AXA analysts Aidan Yao and Franz Wenzel wrote in a recent note to clients. “Valuations, outside the large blue chips, are still expensive, resulting in a natural tendency for correction. We see a further 10 per cent to 20 per cent market decline from here, with a [maximum] peak-to-trough correction of 40 per cent.”
The policy dilemma for Beijing is that having ordered a clean-up of the market to deliver a slow, sustainable bull run that fosters long-term stability in the financial system, more downside risk is likely to be stacking up in the short term.
Official margin finance – the money borrowed to buy stocks which has been largely blamed for the market turmoil – has fallen by around 40 per cent from its June 18 peak of some 2.3 trillion yuan, though that still leaves it running at around 8 per cent of stock market capitalisation.
