Booming Chinese Stocks Show Power of Low Interest Rates

When panic took hold of Chinese stock markets back in August, you’d have been forgiven for thinking investors learnt a valuable lesson. You’d be wrong.  Markets never learn. Despite losing trillions in value, stocks are back in vogue among Chinese investors.

Since August, the Shanghai Composite Index has gained 20.3%. The smaller Shenzhen Composite, too, is up 32% since hitting a low in September. And while both indices are down by a third from June peaks, confidence is surging.

This renewed wave of optimism is down to one thing: interest rates. Last month, the People’s Bank of China lowered rates to a record 4.35%. It’s the sixth time the bank has slashed rates in the past year.

While the rate cuts targeted economic growth, things aren’t always that straight forward. Every action, however directed, has unintended consequences. Lower interest rates, in this case, led to cheaper lending standards. Which, inevitably, leads to more borrowing. Returns hungry traders don’t need any more incentives than that.

Surging stock market: margin lending on the rise

This isn’t just a hypothesis either. We’ve seen it reflected in official data. Margin lending, which are bank loans invested back into shares, are soaring. They’re sitting at two month highs, amounting to over $220 billion.

Invariably, stock investors see interest rates like a tap. The lower that rates go, the faster that capital flow into stocks. It’s an unwritten rule of financial markets.

But you’d think that people adapt when they witness a market correction. That they become more discerning about their investments. When you see how quickly markets can turn, you become more sensitive.  Or at least that’s how it should be. Perhaps that would be far too logical though. After all, markets are anything but impassive. They’re emotional playgrounds.

Despite realising this, investors often repeat the same mistakes. They cotton onto a rising tide, and forget about what came before. They tell themselves that things can only get better. It’s a prevalent way of thinking. And it’s dangerous. This latest bull market is just history repeating itself. And we’re not even four months out from the last crash…

It’s worth remembering that Chinese markets tanked because of overpriced stock valuations. The correction, more than anything, was a return to normality of sorts. The price of stocks fell to a level better reflecting their true value. Yet the way investors see it, that’s also what makes stocks so attractive.

Newton’s Law says that what goes up must come down. But what goes down also has scope to rise back up. It just needs something to catapult it back into the air. Something like, say, cheaper borrowing costs.

So we can’t overlook the pulling power of stock markets. Not when there are solid gains to be made. And in the eyes of investors, that’s all that really matters. Yet it’s the logic behind these moves that leaves a lot to be desired.

The rationale currently spurring stocks is based on a government promise. Policymakers have assured markets of hitting 6.5% growth up to 2020. The way investors see it, that’s a golden handshake. For me, it’s a guarantee that major reforms are on the way. The kind of reforms that could lead to improvements in services and consumer led businesses. These are the kind of buzzwords investors love. And they show their love by pushing up asset prices.

But we know for certain that economic growth is slowing in China. Whether rising stock valuations reflect this weaker growth is questionable. It wasn’t the case over the last few years prior to the August correction. Chances are little will change this time around either.

Rate cuts aimed at supporting housing market

China’s housing market is another big benefactor of falling interest rates. In fact, probably more so than stocks. Lenders know this. And they’re aware of the importance the housing market plays in the broader economy too.

Housing related activity remains a pillar of the Chinese economy. Even if the housing boom has slowed appreciably since 2013. It still accounts for 30% of China’s GDP. That’s a figure that requires little context. It shows how dependent the economy remains on this sector.

Housing activity also impacts household expenditures as well. If the market is going strongly, then households tend to spend more freely. Low interest rates are important too here because they free up disposable income.

Yet the opposite of this holds true as well. When the housing market contracts, spending habits change. Households tend to cut back on non-discretionary spending. That’s something the government wants to avoid. Especially in an economy that’s increasingly reliant on consumer spending for growth.

Roselea Yao, of Gavekal Dragonomics, explains the effect of this on the economy:

Strong housing sales help China deal with its supply-side problems in construction, by digesting inventories and bringing forward the time when the construction cycle can turn around.

The growth in official nationwide property sales volume slowed to 9% year on year in September, from 15% in August and 19% in July.

‘In this context, a softening of housing sales is indeed worrying, as it creates the risk of an even deeper downturn in construction, and consequently even more pain for the already-stressed heavy industrial sectors.

The solution to this growing problem? Yao notes:

To deal with its big overhand of unsold housing, China’s government will increasingly move toward measures to subsidise home ownership’.

Just what these measures look like remains to be seen. But we know that looser lending requirements will feature in their plans. Which means you can expect to see even more rate cuts over the next six months.

The end of the Hukou system?

Another measure the government is looking at is the so-called hukou system. Think of it as a household registrar. At its simplest, it determines eligibility for benefits like social welfare in urban areas.

The hukou is, for all intents and purposes, a class based system. If you’re a city-born dweller, you receive benefits that rural folk aren’t entitled to. Yet loosening these rules might help attract more migrants into the cities. Which should help fill some of the void with China’s oversupply.

Alongside stocks, we could very well see a medium term rise in Chinese assets. From shares to property, the stage is set for both to grow in the coming months. Ultimately, the seeds of this will be its downfall too.

No one bothers learning the lessons from the past. Not when there are quick gains to be made anyway.

Mat Spasic,

Contributor, Markets and Money


PS: In the long run, the fallout from a Chinese market crash will have big repercussions for Australia. As domestic demand falls, so too will China’s need for Aussie resources. Selloffs could grip the materials sector, the second largest on the ASX.

Markets and Money’s Vern Gowdie predicts a major correction for the ASX in the future. Not only does Vern predict a major crash, but he’s convinced the ASX could lose as much as 90% of its $1.8 trillion market cap.

Vern is the award-winning Founder of the Gowdie Family Wealth and Gowdie Letter advisory services. He’s been ranked as one of Australia’s Top 50 financial planners.

He wants to help you avoid this coming wealth destruction. That’s why he’s written ‘Five Fatal Stocks You Must Sell Now’. As a bonus, this free report will show you which five blue chip Aussie companies could destroy your portfolio. You almost certainly own one of them. To find out how to download the report, click here.

Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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