A change in gear

Chinese equities have been thrown into the limelight over the past 18 months following a spectacular price rally. This has been particularly so in the domestic A share market, where the Shanghai Composite index returned approximately 126 per cent in local currency terms in the
12 months to the end of May, far ahead
of other major global indices over the same period.

So what has been driving this rally, fundamentals perhaps? This seems unlikely when you look at the economic growth picture in China. The government has revised it previous annual target of 7.5 per cent to 7 per cent. As one might expect, this was met in the first quarter of 2015 but looking ahead, there are signs that this figure might be optimistic.

The April manufacturing index dropped to a 12 month low, service sector growth slowed (from 11.2 per cent in the last quarter of 2014 to 9.6 per cent in the first quarter of 2015) and exports were down 15 per cent year-on-year in March.

Additionally this slowdown has occurred against a backdrop of rising debt levels, particularly in the corporate sector. According to Goldman Sachs, since 2008, debts owed by China's nonfinancial sector have jumped by more than 90 percentage points, relative to GDP, making Chinese companies the most indebted in the world.

That said, while actual earnings have broadly been declining over recent years, there has been cause for optimism as analysts see room for profit margin expansion, aided by cheaper raw materials prices (including a lower oil price) and cheaper refinancing costs, via structural reforms.

It is possibly the latter that has been a major factor in the price rally, as these reforms have been key to providing positive sentiment to the market, seemingly outweighing the weaker underlying fundamentals.

Economic reforms

The Peoples Bank of China has been loosening monetary policy to combat the growth and debt issues discussed above. The central bank has cut interest rates twice since November and has been reducing banks' required reserve ratios. This has eased fears of a meaningful slowdown in economic activity, as well as reducing borrowing costs for the aforementioned companies with burgeoning debt piles.

Another key structural reform to the market has been the Shanghai-Hong Kong Stock Connect program. Historically Chinese A shares have been a domestic market (over 98 per cent domestic investors) with non-domestic investors accessing these Chinese companies via the H share market, listed in Hong Kong.

The stock market connect program has been designed to gradually open its capital markets to foreign investment, while avoiding 'hot money' flows and, to date, has been successful in boosting flows into the asset class with the potential for more, as investors overcome certain legal ownership rights and settlement issues.

A final driver of sentiment has been the possibility of inclusion within MSCI indices. MSCI is set to announce whether it plans to include A shares to its global emerging markets index from May 2016.

Looking ahead

So while it seems that the majority of the recent rally has been down to sentiment, which could sometimes be a worry long-term, this shouldn't be a great cause for concern in this instance.

The structural reforms appear consistent with a government that has been tasked with creating a stable environment, where the focus is no longer purely on growth maximisation, but sustainable growth and there is great belief domestically that leadership will be successful in steering the economy from investment-led, to consumption-led growth.

Although fundamentals appear to
be weaker (growth is clearly slowing),
this may not necessarily be a disaster in aiding this transition. Investors are likely to look kindly on lower, more efficient growth, than volatile unpredictable economic output.

After all, if China is entering a multi-year deleveraging process, it is likely to weigh on growth in the near term; however the result could be a more balanced economy and financial system.

Consequently with the factors driving the market still seemingly in place and a central government that has a track record of implementing the right policies, it isn't difficult, for the time being, to see the rally continuing for the foreseeable future, although likely at a slower pace. 

Claire Bennison is regional director at Brooks Macdonald in Manchester

She writes a regular in-practice article on asset management for Private Client Adviser