Why China’s stock market rout is being shrugged off

The last few weeks have been a rollercoaster for Chinese stocks. Monday saw shares in Shanghai tumble by more than eight per cent to record their biggest one-day loss since 2007.

That followed a 16 per cent rally since their low of July 8th, reached after a rout that wiped $4 trillion from the country’s equities and forced the government to take drastic action.

Following Monday’s nosedive, China’s securities regulator said it would purchase shares to level the market and avoid systemic risks.

Beijing has already banned large shareholders from selling stocks, invited brokers to buy stocks via a direct central bank liquidity channel and halted trading on hundreds of stocks. Monday’s collapse shattered the calm that these measures had temporarily offered.

Nevertheless, European stocks are not following suit. Investors are not overly concerned, at least at the moment, about the risk of contagion.

Lars Kreckel, equity strategist in Legal & General Investment Management’s Asset Allocation team, believes China’s equity market problem is an isolated event that won’t significantly impact international markets.

There are various reasons for this. Firstly, he says, most of the volatility in China has been in A-shares, a category of stock that is dominated by domestic investors. “Few domestic investors have access to international stocks, and so it’s unlikely we’d see redemptions in other markets or assets to shore up losses from Chinese equities,” he notes.

Similarly, foreign investors are not on the hook either, meaning they are unlikely to become forced sellers of global equities as they did not participate in the rally.

Kreckel notes there is “virtually no correlation” between China’s market and the S&P 500 or EuroStoxx, either on the way up or on the way down. It’s also important, he adds, to put the recent rout in perspective. The Chinese market is still up 80 per cent to 90 per cent year on year.

Many analysts and investors have voiced concerns about the prospect of a slowdown in China becoming something worse - a hard landing in the real economy that could have devastating consequences for global growth.

“A small group of high-net-worth Chinese investors may be nursing losses, but many are ultimately sitting on gains from investing in equities over the last year or two. This isn’t to say we aren’t closely watching the behaviour of wider Chinese markets and the economy, and it is certainly one of the risks we keep a close eye on, but a hard landing as a result of the equity bubble imploding looks unlikely.”

So what of other concerns about global equities? Kreckel notes that “bull markets don’t die simply of old age” and that while equity valuations are undoubtedly high, this does not necessarily trigger a market correction.

“There’s a strong link between valuations and long-term returns, but not so strong a link over the short term. It is recessions that cause bull markets to end; 12 of the last 14 have been triggered by or closely followed by a recession, and with a low risk of recession currently, the end of the equity bull market should not be a top concern,” he says.

Greece and the fears of a Grexit have been the top of the pile for investor concerns, but European equities haven’t really suffered.

For investors, the big risk event to come this year is the Federal Reserve’s anticipated interest rate hike. Forecasts are for the bank to begin tightening in September, though it may wait until December to ensure the US economy is ready. Kreckel notes there are “historical precedents” that “point to a drop of eight per cent in equity markets as a likely outcome”.