The Irresistible China Trade That Keeps Burning Investors

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The Hong Kong Exchanges & Clearing Ltd. (HKEx) flag flies outside Exchange Square in Hong Kong, China.

The Hong Kong Exchanges & Clearing Ltd. (HKEx) flag flies outside Exchange Square in Hong Kong, China.

Photographer: Lam Yik Fei/Bloomberg

It looked like a no-brainer for buyers of Chinese shares in Hong Kong.

Valuations in April were 25 percent cheaper than in the mainland, monetary stimulus was just getting started and money was pouring in through Hong Kong’s new exchange link with Shanghai. Bulls snapped up funds tracking so-called H shares at a record pace, while analysts at some of the world’s biggest banks predicted big gains to come.

The only problem, though, is that the trade hasn’t worked. Dragged down by weak Chinese economic data, a crash in mainland markets and signs of an imminent lift-off in U.S. interest rates, the MSCI China Index has tumbled 21 percent since the end of April -- the biggest drop among global benchmark indexes tracked by Bloomberg.

It’s the latest setback for a market with a long history of investor disappointment. The MSCI China gauge has returned less than 1 percent annually since 1992, versus about 9 percent for the Standard & Poor’s 500 Index. Strategists at CLSA Ltd. and Chart Partners Group Ltd. who predicted this year’s sell-off say H shares have further to fall.

“You will only get a bull case in H shares when there is stability or positive momentum in the economy,” said Francis Cheung, the head of China strategy at CLSA in Hong Kong, who turned negative in early June. “The bear case would be the economy continues to slow. The bear case is more likely.”

Economic Slowdown

The MSCI China index rose 1.6 percent at 2:46 p.m. in Hong Kong.

China’s latest economic data suggest growth in the world’s second-largest economy is still weak. Profits at industrial companies declined by 0.3 percent in June and a private gauge of manufacturing in July sank to a two-year low. Data due this month will probably show declining imports and exports, according to economist estimates compiled by Bloomberg.

Meanwhile, the flood of money into H shares through the exchange link has slowed to a trickle as China’s government encouraged domestic funds to shore up the local market instead. After an $8 billion influx in April, net buying since then has amounted to just $966 million.

International investors have also been cutting their holdings amid speculation the Fed will raise interest rates as soon as next month, making riskier emerging markets less attractive. The Hang Seng H-Share Index ETF, which lured record inflows in April, has recorded withdrawals for the past two weeks.

Too Cheap

China’s H shares will probably drop about 10 percent over the next two months as slowing economic growth and collapsing commodity prices boost the chance that indexes will fall below key support levels, according to Thomas Schroeder, the founder and managing director at Chart Partners. He advised investors to sell in April as H shares were peaking.

For Roger Xie, a Chinese equity strategist at HSBC Holdings Plc in Hong Kong, valuations are too cheap to ignore after the slump. The MSCI China index trades for 1.4 times net assets, versus 2.1 for the MSCI All-Country World Index, near the widest gap since 2003.

“Value-oriented and long-term focused investors should look at some high-quality H-share companies,” said Xie, who predicts a 26 percent rally in the Hang Seng China index by year-end.

Value Trap

H shares are also attractive relative to their mainland-traded counterparts, according to Bin Shi, a managing director at UBS Global Asset Management in Hong Kong. The valuation discount on dual-listed shares in Hong Kong is still around 25 percent, according to the Hang Seng China AH Premium Index. Aluminum Corp. of China, the largest mainland-listed aluminum smelter, trades at a 67 percent discount.

Hong Kong-listed shares may be cheap for good reasons, said Daniel So, a strategist at CMB International Securities.

Benchmark indexes are dominated by banks and raw-materials companies, which are coming under pressure from bad loans and falling commodity prices. On top of that, foreign investors are concerned about increased government intervention in markets as policy makers seek to prop up mainland equities, according to So.

“H shares are deemed a value trap by some investors,” he said. “There is not much upside or re-rating potential.”

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