From Deutsche Bank:
Chinese stocks rallied strongly in Shanghai since mid March, and the Hong Kong market soared in last week. We believe the rally in Shanghai was driven by macro policy stance shifting from tightening to loosening in March (ZH: …and quite possibly by sheer insanity). Some may argue policy has already loosened in Q4 2014 and Q1 with two interest rate cuts and one RRR cut. We disagree. We believe the monetary policy stance has been tight, as the RRR was cut to offset capital outflows, and inflation dropped faster than the benchmark interest rate, which suggests monetary policy may have actually tightened as real rates rose. In particular, the 7-day repo rate was above 4% for most of Q1. Moreover, fiscal and exchange rate policies have also been tight in Q4 2014 and Q1 2015…
The market rally in Hong Kong was due to capital account liberalization, which will allow mutual funds and insurance companies in Mainland to invest in Hong Kong. We highlighted that China may take significant steps opening up capital account in Q2 and Q3 (see our report RMB may become convertible in 2015 April 7). We notice that the PBoC’s Governor Zhou said explicitly that RMB will become convertible in 2015 several times in March, and he did not make similar statement before March. We therefore believe the market may be surprised by how fast China move to allow cross-border investments.
Having spelled out what triggered the meteoric rise in equities (and having neglected to mention margin debt and the 4 million new stock trading accounts opened on the mainland last month), DB proceeds to tell us what factors might conspire to turn happy traders into sad traders.
We see four factors that may end the rally. The first and second factors are rising CPI inflation and signs of economic recovery. As the rally was driven by a shift of policy toward easing, the end of policy easing may end the rally. If the CPI inflation goes into a clear upward cycle, investors may start to worry about policy stance shifting toward tightening. The dynamics of CPI inflation in China is dominated by food prices, which is volatile and difficult to forecast. If monetary policy loosens significantly in Q2 as we expect, we may see CPI inflation rising in H2. Economic recovery may end policy easing as well. We believe a significant policy easing in Q2 will lead to better economic data in Q3. Once the PMI and industrial production data start to rebound, the M2 growth may stop rising.
The third factor is credit event. The economic slowdown will heighten credit risks. If a high profile default case happens, it may trigger market sentiment to worsen and market liquidity to dry. We acknowledge that the loosening monetary policy helps to reduce such risks in Q2, but we cannot rule it out, as financial risks are highly localized in some cities (see our report China’s unexpected fiscal slide on January 5). Higher M2 growth on national level does not necessarily lead to ample liquidity in cities with financing needs.
The last factor is prudential regulation. The market rally has been so strong that it may lead to concerns on financial instability in the policy circle. The government may choose to implement some prudential measures as they did in late 2014, to slow the pace of market rally. We do not think the government will intentionally end the rally. They likely prefer to see a bull market but with a more gradual upward trend. Hence, this factor is more likely to cause temporary volatility in the market rather than the end of the bull market.
Although we doubt this needs to be spelled out, we would be remiss if we did not point out the sheer ridiculousness inherent in the fact that in the new paranormal, one factor cited as likely to derail an equity rally is “signs of economic recovery.”
By the way, “you are here”:
