Bank of America Merrill Lynch: The Shanghai Composite Will Plummet by Nearly 30% in 2016

This time is not different.

Understanding the Plunge in China’s Markets

The early January blues for Chinese stocks will persist through 2016, according to Bank of America Merrill Lynch, which expects the Shanghai Composite index to end the year down roughly 27 percent, at about 2,600.

David Cui, head of China equity strategy, is known to be bearish on the world's second-largest economy—which is to say that he's less sanguine than most of his peers about the consequences of unwinding leverage that has mounted in a short period of time.

For China—which has enjoyed a rapid expansion of debt relative to the size of its economy—this time will not be different, Cui contended in a note.

Bank of America Merrill Lynch

"Historically, any country that grew debt this fast inevitably ran into financial-system problems, including currency devaluation, banking recap, and high inflation, and we do not expect China to be an exception," asserted Cui. "We believe that the government had maintained system stability over the past few years by allowing various implicit guarantees to get firmly entrenched, which has made the financial system fragile."

The fragile equilibrium that has endured, he said, is a function of Chinese policymakers' willingness to trade short-term gain for longer-term pain. (Cui doesn't foresee a full-scale credit crunch—the disappearance of what's increasingly become the lifeblood of the Chinese economy—as a prerequisite for the prophesied carnage in equities.)

The A-shares market, according to Cui, is expensive. And if you strip out banks (for which the quality and sustainability of earnings may be in jeopardy in light of a deteriorating loan book), it only gets pricier, he warned.

It's clear, however, that numerous countervailing forces could support the market and work against the strategist's call for further declines. These include liquidity provided by the People's Bank of China through reverse-repurchase operations,  larger owners being restricted from divesting holdings, direct purchases of equities by government funds, and a known distaste for allowing defaults.

However, Cui believes that a failure by the government to provide any of the major conditions investors are counting on to improve the market backdrop (namely, reaching the gross domestic product growth target, maintaining stability in the currency, a PBoC put in A-shares, limited corporate defaults, and the evasion of a sizable real estate correction) would cause instability in the financial system.

"We believe that the most vulnerable is [the renminbi], followed by A-share market, debt default and possibly housing price," wrote Cui. "Any break of these 'promises' may be contagious."

BofAML's David Woo has separately detailed how this year will be one marked by a "Great Divorce" between the U.S. and China, which will be reflected in the exchange rate.

Nailing the inflection point in the world's second-largest economy, given the attention paid to Chinese economic imbalances since the financial crisis, as well as the relative flexibility enjoyed by policymakers to remedy short-term concerns, will surely prove difficult.

In the strategist's opinion, the irreconcilable goals of Beijing's brain trust "may come to a head in 2016."

Still, following this week's fall in China stocks, there's only 21 percent further downside!

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