China's No-Brainer Stock Trade Goes Awry as Hong Kong Gaps Widen

Updated on
  • Dual-listed price gaps widened about 40% since link started
  • Foreigners' stock sales via connect extend to record 16th day

One year after the Shanghai-Hong Kong exchange link opened for trading, the disconnect between stock investors in China and the rest of the world shows no sign of going away.

Defying predictions that the cross-border connection would narrow price differences between dual-listed shares, valuations on the mainland are growing more expensive versus their Hong Kong counterparts. The gap was the widest in two months on Tuesday and about 40 percent bigger than when the link began last November. Foreign investors have sold stocks in Shanghai for 16 straight days, even as local buying propelled the benchmark index into a bull market.

The persistent price disparities highlight the hurdles faced by Chinese authorities as they seek to professionalize a stock market dominated by individual investors, who tend to pay less attention to corporate fundamentals than their international peers. The gaps also reflect growing pessimism among foreigners amid weaker-than-projected economic data, an eighth straight quarter of disappointing earnings and lingering concern about the government’s interventionist response to a selloff earlier this year.

“Ongoing sales through Shanghai-Hong Connect, with the background of a bullish A-share market, is a classic example of the disconnect,” Gerry Alfonso, a sales trader at Shenwan Hongyuan Group Co. in Shanghai, said in an e-mail on Monday. “Foreign investors tend to focus on valuations and fundamentals. In the Chinese market, that’s only half of the equation.”

International investors have sold Shanghai shares through the link every day since Oct. 16, unloading more than 18 billion yuan ($2.8 billion) in the longest stretch of outflows since the program began. That contrasts with signs of renewed enthusiasm among mainland investors, who opened new accounts at the fastest pace in two months at the end of October and increased bets with borrowed money to the highest level since August.

Local buying has fueled a 24 percent rally in the Shanghai Composite Index from this year’s low and pushed the average premium on mainland shares over dual-listed counterparts to 127 percent, according to data compiled by Bloomberg. A Hang Seng index of price gaps weighted by market value shows a 41 percent gap, up from an historical mean of 17 percent.

In one of the most extreme examples of the same company fetching completely different valuations in the two markets, Guangzhou Automobile Group Co. shares trade at a 281 percent premium on the mainland. The stock has jumped 49 percent in Shanghai since the end of June on increased government support for the auto industry, versus a 3.8 percent gain in Hong Kong.

The Shanghai Composite climbed 0.3 percent on Wednesday, while the Hang Seng China Enterprises Index of mainland companies in Hong Kong fell 0.7 percent.

The stock connect, which authorities plan to expand to China’s smaller exchange in Shenzhen, is part of the country’s effort to link its financial markets with the rest of the world and boost global usage of the yuan. The link has been a success from an operational standpoint, handling more than $320 billion of turnover through October without any notable technical glitches, Hong Kong Exchanges & Clearing Ltd. Chief Executive Officer Charles Li said in a blog post last week.

Outflows from mainland shares may reflect a broader exodus from emerging markets, rather than specific concerns about China, according to Sandy Mehta, the chief executive officer of Hong Kong-based Value Investment Principals. The MSCI Emerging Markets Index has dropped 13 percent this year as growth in developing-nation economies slowed and the U.S. Federal Reserve moved closer to raising interest rates.

“Global investors are increasingly looking at mainland stocks as a large asset class, current flows notwithstanding,” Mehta said. “If there is a sustained rebound in the A-share market with decent macroeconomic figures, foreign investors will become bullish.”

Weak Economy

So far, there’s little evidence of economic recovery in China. Data on Tuesday showed the country’s consumer inflation waned in October, while factory-gate deflation extended a record streak of negative readings. Overseas shipments dropped 6.9 percent in dollar terms last month, the customs administration said Sunday, a bigger decline than estimated by all 31 economists in a Bloombergsurvey. Third-quarter earnings trailed analyst estimates at 68 percent of companies in the Shanghai Composite.

“The economy continues to see downward pressure,” said Francis Cheung, a senior strategist at CLSA Ltd. in Hong Kong. “It is a good time to take profit.”

Even if global investors were to turn more bullish on China, they’d probably shun local shares in favor of Chinese companies listed overseas, according to Khiem Do, the Hong Kong-based head of multi-asset strategy at Baring Asset Management, which manages about $45 billion. Not only are overseas shares valued at cheaper levels, they offer investors more transparency than can be found on the mainland, Do said.

During the Chinese stock rout that erased $5 trillion of value from mid June through August, authorities allowed hundreds of companies to halt trading in their shares and banned major shareholders from selling stakes. Policy makers also ordered state-owned companies to buy equities and compelled brokerages to commit shareholder capital to a market-rescue fund.

“Foreign investors care more about fundamentals,” said Ken Chen, a Shanghai-based analyst at KGI Securities Co. Their skepticism “is expected to continue until the Chinese economy bottoms out and the market becomes more rational."

— With assistance by Shidong Zhang, Cindy Wang, and Kana Nishizawa

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