Should You Worry about China’s Stock Market Volatility?

The volatility of the Chinese stock market has been viewed by U.S. investors with a mixture of concern and fascination. As of August 4, the Shanghai market is still up 16% year to date even after a nearly 30% decline from its June 12 peak. This roller coaster ride has received a great deal of attention; however, the research department at LPL Financial and some other investment firms believe that the impact on China’s economy will be limited.

Shanghai 323Until recently, the Chinese stock market was walled off from the global financial market. Chinese investors could only invest in “A-shares” traded in Shanghai or Shenzhen, and non-mainland investors were not allowed to buy shares in these markets. Though there are now options for non-mainland investors, these investors represent less than 2% of the Chinese stock market.

The link between China’s economy and its stock market is not as strong as it is for the U.S. Chinese investors prefer to hold cash and real estate relative to stocks; only 9% of Chinese household wealth is invested in the stock market, compared with nearly 30% in the U.S.

Most of the money in the Chinese stock market comes from a relatively small group of wealthy (by Chinese standards) investors. Looking historically, regardless of the performance of the equity market, there appears to be very limited correlation between consumer spending and stock prices.

We believe the recent decline in the Chinese stock prices is likely a reaction to a 60% rise in less than six months and the rapidly changing government policies. In April, the Chinese government limited margin lending before quickly reversing course as equities sold off sharply. It has worked to prop up stocks in July and August. These moves, including banning short selling and restricting trading, have been viewed as evidence of panic by policymakers.

While the slowing Chinese economy may be having some impact on the equity market, China’s overall economic outlook is largely unchanged. The small role the market plays in the economy is unlikely to have a material impact on economic growth.

The LPL Research Department and some other investment research organizations continue to recommend that investors who desire exposure to the Chinese market achieve it by investing in the so-called “H-share” market, shares of Chinese companies that trade in Hong Kong.

The Hong Kong market has a more traditional regulatory structure and less intervention than the mainland Chinese market. This market has been less susceptible to wild swings and is more attractively valued than the “A-share” market based on price-to-earnings multiples. This fact does not eliminate the volatility inherent in any China-related investment, but it does offer investors a better risk-reward balance.

As always, if you have any questions, please email me at bill.pollak@lpl.com or call me at (925) 464-7057.

Definitions:
The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.

Short selling (also known as shorting or going short) is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than the seller received on selling them.

Margin debt is debt used to purchase securities within an investment account. Margin debt carries an interest rate, and the amount of margin debt will change daily as the value of the underlying securities changes.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. The economic forecasts set forth may not develop as predicted.

Investing in foreign and emerging markets securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.

This research material has been prepared by LPL Financial. Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by Any Government Agency | Not a Bank/Credit Union Deposit

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