China’s financial markets, which can be volatile due to heavy turnover driven by the dominance of retail investors, could calm down because of reforms and a more diverse investor base from abroad, a hedge fund manager at Pictet says.

China’s financial markets, which can be volatile due to heavy turnover driven by the dominance of retail investors, could calm down because of reforms and a more diverse investor base from abroad, a hedge fund manager at Pictet says.  

Diversifying the base of investors will play an important role in maturing the Chinese markets, which are in some ways at the same stage of development as Taiwan’s over a decade ago, Lan Wang Simond, head of Greater China long/short equity strategy at Pictet Asset Management, said in a recent note. PAM is part of Pictet, the Swiss bank.

The world’s second-largest economy has been opened up to foreign investors through a slew of quotas related to the renminbi qualified foreign institutional investor scheme, as well as the launch of the Shanghai-Hong Kong Stock Connect equity market link. Separately, China is continuing to push to make its renminbi currency a global reserve unit, with the RMB-denominated offshore bond market growing rapidly. Under the Stock Connect scheme, meanwhile, overseas investors can directly buy Chinese equities worth up to $2 billion a day without the need for a special licence, increasing the convertibility of the renminbi as a currency.

The need for Chinese markets to mature can be seen, the fund manager said, in how turnover velocity in the country’s equity markets is seven times greater than those in the US, the world’s largest economy.

“The Chinese market is indeed prone to erratic price moves. This volatility was most recently evidenced in early December, when the Shanghai Composite Index rallied to a three-and-a-half-year high only to sharply reverse course later in the day to post the biggest daily percentage decline in five years,” Lan said.

“In a way, China’s stock market is at the same stage in its development as Taiwan’s was in the early 2000s, when share turnover velocity was as high as eight times the market's capitalisation, in a market dominated by domestic retail investors. The velocity has since fallen as more institutional investors participate in trading.

"In our view, diversifying the investor base represents a key phase in the evolution of the Chinese market. This is because it would lead to a more sophisticated market where prices are driven less by momentum and more by data and value-based analysis. We believe this would make it more attractive for foreign institutional investors,” she continued.

Asked if decelerating Chinese growth is a concern for equity investors, she replied: “In my view, economic fundamentals do not always translate into stock market performance. As equity investors, we don’t particularly want runaway economic growth. Unsustainable growth is just that – unsustainable. We like a benign economic climate where companies can grow their bottom line – or net profit.”

She continued: “China has never been short of top-line growth – witness the double-digit GDP expansion over the past decade or so. Yet, in order to sustain that growth, companies had been under constant pressure to raise capital, in the form of equity or fund share placements. This is not an environment that tends to reward existing shareholders. Moreover, because of falling margins, companies had little pricing power and many industries suffered from overcapacity; as a result there was no single dominant player who could grab a lion’s share of the markets.”

Lan argued that there is not a strong correlation between growth and equity market returns. “During the late 1980s to early 1990s, Europe – deeply in recession – experienced a decade-long bull market in equities. Industrial consolidation played a key role – at the end only the fittest survived. For example, Switzerland has seen the number of pharmaceutical giants fall to just two – Roche and Novartis – from more than a dozen,” she said.

She added that her fund has turned neutral on banks, having been short [bearish] over the past year. She argued that negative news about banks is already priced in while the opportunities to short financial stocks are becoming rarer. Finally, she is overweight the utility sector, where she says the fund can find a number of high dividend stocks at an attractive price.