Shanghai's Bund area and Lujiazui CBD at night. Photo: iStock
Photo: iStock

Financials outperformed in the Chinese stock market’s melt-up, a fact that doesn’t fit into doomsday predictions about China’s debt issues. Brokers and insurers rather than banks led the market up. The rally has been so violent that it is dangerous to chase it, but it does tell us something about the changes underway in China’s capital markets.

The chart below shows the Shenzhen 300 financial sector versus the overall index from January 1, 2018 to the present. The relationship shifted noticeably, and in a peculiar way: what changed was not the beta (the slope of line on the scatter graph) but the alpha, that is, intercept on the graph, denoting the overall valuation of the sector versus the broad index.

This occurred over the spring and summer as the overall index tumbled from 3,500 to 3,000. The financials held their ground. When the rally resumed at the beginning of 2019, the financial sector moved along with the index, but from a higher base.

The resilience of the financial sector in context of an overall market decline during the middle of 2018 suggests a structural change. China is opening its financial market to the world. Allianz Insurance already has the first license for a 100% owned insurance subsidiary and Union Bank of Switzerland has the first banking license, and many more will follow. China’s stock and bond markets are entering the major world indices (MSCI and Barclay’s Aggregate), and investors are pouring money into China.

M&A activity is likely to spike in the sector as financial firms combine to remain competitive. China is one of the most underbanked countries in the world. Securities comprise less than a tenth of the wealth of Chinese households, and China is the most under-owned large capital market in the portfolios of global investors.

China is opening to the world. That will be the most concrete outcome of the US-China trade war. It might have happened in any case, but the confrontation with the US probably advanced the timetable.

Fears of a sharp downturn in Chinese economic activity meanwhile have abated. The buoyant report on January credit growth helped spur the rally. Last night’s report of a falling manufacturing PMI was balanced by a steady, expansionary services PMI. The fact that China’s service sector has held its own despite the trade-induced contraction in industrial production also is encouraging.

US markets meanwhile continue to trade in a tight range. The US Commerce Department reported fourth-quarter GDP growth of 2.6%, vs. an expected 2.2%, and markets remained skeptical. The Chicago Purchasing Managers’ Index came in higher than expected after a January plunge, but the three-month moving average of Chicago PMI still shows a slight downtrend.

Although most of the regional Federal Reserve districts are reporting a pickup in their current-activity indices, the Chicago Federal Reserve’s widely-followed National Activity Index showed a significant fall during January.

Capital investment plans, Morgan Stanley analysts reported today, plunged for the first half of 2018. They wrote:

“[Morgan Stanley’s] Capex Plans Index is a three-month moving average of a manufacturing-weighted composite compiled from monthly regional Federal Reserve Bank surveys measuring 6-month capex plans and tends to lead growth in equipment investment by about 3 months. The monthly index can be quite volatile, which is why we track the three-month moving average, but it is worth noting that the monthly composite plunged 7.8 points in February to 20.9, the lowest reading since October 2016. That marked the sharpest decline in the monthly index since 2008.”

There was enough bad economic news to outweigh a stronger-than-forecast GDP report, praised as a harbinger of strong 2019 growth by Treasury Secretary Steven Mnuchin and White House Economic Adviser Larry Kudlow in television interviews Thursday.

Despite the higher-than-expected headline number, the GDP numbers were not persuasive. Personal consumption contributed 1.92 percentage points of the overall gain of 2.6 points, less than the 2.37 points in the 3rd quarter and the 2.57 points in the 2nd quarter. With employment gains continuing at around 200,000 per month, one would have expected that consumption would drive growth rather than drag on it.

The contribution to GDP of investment increased, but in an odd way; most of the increase came from “intellectual property,” which the Commerce Department economists have no way to estimate for the 4th quarter. It is unclear what IP means; if a US multinational transfers patents from Ireland to Neva for tax reasons, that would count as a boost to intellectual property. Investment in data processing equipment and industrial equipment fell. It certainly doesn’t look like an investment boom.

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