Too Early To Bottom-Fish For China’s A-Shares (NYSEARCA:ASHR)

Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (NYSEARCA:ASHR) tracks the performance of the CSI 300 Index, which is a free-float weighted index that consists of 300 A-share stocks listed on the Shanghai or Shenzhen Stock Exchanges.

The index has corrected by approximately 20% year-to-date. We believe the decline was mainly due to rising uncertainties over economic growth in China.

Why do we think it is too early to buy China A-shares?

Covid-19 lockdowns in key cities will hold back the economy in the months ahead

While most countries are re-opening their economies following the Omicron coronavirus variant, China has continued to struggle to defeat the outbreak with its zero-COVID playbook.

Shanghai, the largest city in China and the world, has been under a tight lockdown since late March. Over the weekend, Shanghai authorities even sealed off entrances of public blocks and closed off entire streets with two-meter-tall green wire mesh fences. This gives us an impression that the lockdown in Shanghai is unlikely to end soon.

In Beijing, COVID-19 testing for all residents of its biggest district Chaoyang was launched on Monday after dozens of cases were reported. This sparked panic buying in Beijing’s supermarkets amid fears of a hard Covid lockdown.

The lockdowns and travel restrictions have taken a heavy toll on businesses and the economy as a whole. For example, China’s vehicle sales shrank 10.5% last month, and it is reported that electric vehicle manufacturing in Shanghai may halt completely in May due to shortage in parts and workers.

The economy is weakening, but policy support is insufficient

In early 2022, the Chinese government set a GDP target of around 5.5%. Such a target is lower than that of the previous year, but an above-5% growth rate is still a good target for most investors. However, the GDP growth in the first quarter was only 4.8%. Retail sales also contracted by 3.5% in March, suggesting a weakening trend on a sequential basis.

Last week, UBS economists cut their China gross domestic product growth forecast to 4.2% from 5% “in light of the intensified downward pressure on the economy,” while Barclays economists trimmed their assessment by 20 basis points to 4.3% “in expectation that Covid disruptions will be prolonged.” In an extreme case where a national lockdown is imposed, Goldman Sachs estimated China’s economic growth could drop to 1.5%, the lowest in more than four decades.

As the economy slowed, investors generally had high hopes that the policymakers would announce a new round of stimulus to underpin economic growth and boost the equity market. Note that, China’s A-share market is sensitive to policy. Historically, strong policy supports, such as a reserve requirement ratio (RRR) cut, interest rate cuts, and huge infrastructure projects have helped the CSI 300 index to rebound.

China’s central bank, The People’s Bank of China (PBOC), has announced both rate cut and RRR cut in the past few months: 1) On January 17, PBOC announced it would reduce the rate of its one-year medium-term lending facility by 10 bps in the first rate cut since April 2020, releasing 700 billion yuan ($110.3 billion) of liquidity into the interbank system. 2) On April 15, PBOC said it would cut the RRR for all banks for the first time this year by 25 basis points (bps), releasing about 530 billion yuan ($83.25 billion) in long-term liquidity. RRR represents the amount of cash that banks must hold as reserves and the cut is effective from April 25.

While there are some policy responses, investors tend to view such measures as insufficient because, historically, the central bank cut RRR rate by 50bp each time. The latest 25 bps cut was the first mild cut in the past 10 years. Investors also expected a large stimulus plan by the government.

There are much speculation and many explanations for the mild supportive policies year-to-date, the most common one is that the government needs more data to evaluate the outlook, and any policy may only come in later months. As such, we have not seen a strong A-share rebound. Without strong policy support, the economy will continue to slow and drag the stock market lower. This does not seem to be the type of market a retail investor should be in.

Weakening fund inflow

Apart from the economic indicators, fund flows also provide insights on whether or not this is a good time to invest in the A-share market.

In 2021 when the market was booming, a Chinese stock fund attracted a record of $37 billion in first-day subscriptions, which demonstrated the hot sentiment of the market back then. The tide has reversed in 2022, with slower new private fund launches, suggesting less new money entering the market. Money raised by newly-launched hedge funds was only $15.2 billion in January, down 44% on a sequential basis, while money raised by newly launched mutual funds plunged by 61% on a sequential basis, or 76% from a year earlier.

Not only do onshore funds face pressure, China-focused foreign funds also face pressures from fund flows. China’s central bank data shows that foreign investors held $600 billion each of shares and bonds in December of last year. However, foreign investors sold $9.5 billion of equities last month on the back of weakening sentiments. Such outflow, via Stock Connect, is the second-largest monthly drawdown since the program began in 2014.

With weakening new onshore fund inflows and growing foreign fund outflows, the selling pressure in China’s A-share market may not be over in the near term. We note that this month the Chinese regulators gave guidance to mutual funds not to net-sell stocks to try to put a floor on the market. While such measures may be able to alleviate the selling pressure in the market in the short term, we think they will not work in the longer term if the economy keeps slowing. As the father of value investing, Benjamin Graham, put it, “in the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

Recommendation

We suggest the retail investors wait for three things to happen before bottom-fishing in China’s A-share market: 1) the end of COVID-19 lockdowns in key cities; 2) strong economic stabilization policies announced by the government and central bank; and 3) the A-share fund flows turn more favorable.