Counterintuitive

If stock markets are forecasters of the future rather than reflectors of past performance, there is reason to worry about China’s corporate outlook. The Shanghai Composite Index is down on a year ago while many of the world’s markets, particularly in developing countries in Asia and Latin America, have been bounding ahead.

The China market’s modest return is at odds with the stellar performance of the economy. In itself that is not surprising. Stock markets often only reflect economic outperformance in the long run, as high growth also normally creates demand and thus a higher price for capital.

Stuck in a rut

But in the recent case of China, capital has been abundant thanks to a high savings rate and a massive increase in cheap bank credit. Corporate profits have been rising and it is not as though stock prices were coming off hugely inflated past levels. The average price-to-earnings (P/E) ratio is about 13, or much in line with the global norm.

Even the average dividend yield – 2.5% – is attractive relative to bank deposits and bonds, particularly as inflation rises. Excess money has surged into property, but why not stocks?

One reason is that property is more easily leveraged as banks tend to see it as the best collateral. Another is that individuals find it much easier to assess the value of land and buildings than of stocks, where much must be taken on trust. Clearly, trust in the integrity of management and the competence or honesty of auditors is limited. Then there are fears of an equity glut, either from the enormous pipeline of new issues or, in the longer term, from the potential sell-down of the great overhang of shares controlled by the state at national, provincial and municipal level.

All these factors suggest that a P/E ratio closer to 10 would not come as a surprise, at least when current and future tightening measures take effect.

But don’t China’s medium- to long-term growth prospects all but guarantee a sustained lift for shares? Maybe not. The happy combination of strong sales, easily accessible capital and cheap labor that has buoyed profits – and stimulated massive re-investment, a key driver of the country’s high overall investment ratio – appears to be under threat.

Most visibly, the supply of new labor is slowing dramatically as the working age population nears a plateau and migration from rural to urban slows sharply because so many young people have already left. China is probably already more urbanized than official figures suggest because many urban migrants are officially rural residents, and because of the growth of small cities close to rural communities.

In short, new urban workers are becoming scarcer and more valuable. Wages will rise regardless of official policy.
This is good for the overall balance of the economy. The wage share of national income has fallen as the profit share has risen, which has held down consumption and led to over-investment. Demand for labor will reverse the trend, causing real wages to rise faster, at the expense of corporate profits. So it is quite possible that the economy can continue to grow steadily – though at 6-7% rather than 8-9% – but that profits will stagnate.

A significant rise in interest rates – a common sense move designed to provide real returns to savers – would also hold down profits. Again, it effectively means a transfer of income from the corporate sector to households, which should boost consumption. Much of this new expenditure would flow into the service sector. Family businesses like hairdressing and restaurants tend to be more labor-intensive, and this would reinforce the shift to relative labor scarcity.

Trouble at the bank

Finally, a quirk of China’s stock markets is the strong banking industry representation. Financial sector predominance characterized the US market before the 2008 meltdown, Japan in 1989 and Thailand in 1997. China’s banks are almost certain to face sharp rises in loan losses following the 2009-2010 credit binge, and although the state will as usual find ways to ease the burden, public shareholders are likely to have to suffer at least some pain. This will hold down the overall market.

The message is clear: Regardless of how well China’s economy performs, there are fundamental as well as immediate reasons why its stock markets could continue to underperform.