China stock market suffers worst three-day run since 2013

Chinese stocks headed for their worst three-day run in nearly two years on Thursday, prompting worries that the world-beating rally that began late last year was poised for a reversal.

Since hitting a seven-year high on April 28, the Shanghai Composite Index has lost 9 per cent, most of it in the past three days. Even after the recent drop, the index is still up 71 per cent since November.

Several news items have spooked the market in recent days, but analysts say that profit-taking - fuelled by a sense that the rally is due for correction - is the main factor.

"The fundamentals haven't changed significantly. In the long term it's still a bull market, but this correction isn't over yet," said Zhu Zhenxin, equity analyst at Minsheng Securities in Shanghai.

"We expect the market will recover later this month, as expectations for another interest-rate cut start to strengthen."

But other analysts see a more fundamental shift under way. Morgan Stanley on Thursday downgraded the MSCI China Index from overweight to equal weight, its first downgrade in more than seven years. 

Unlike the Shanghai Composite, MSCI China covers Chinese equities that are fully accessible to global investors, with Hong Kong shares as the main portion. MSCI China has risen 24 per cent since November but is down six 6 per cent since April 28. 

"Dramatic recent outperformance has led to a deterioration in absolute and relative valuations and a technically overbought situation," wrote Jonathan Garner, Morgan Stanley's head of strategy for Asia and emerging markets.

"It is probably fair to say that we are known in the market for being bullish China - some might say perma bulls - so for us this is a big call."

Indeed, in 1993 Morgan Stanley's then-strategist Barton Biggs sparked a rally in Hong Kong when he declared himself "tuned in, overfed and maximum bullish" on China, sparking a rally in Hong Kong.

Beyond valuations, other concerns are also pressuring the market. Many Chinese securities brokerages have tightened margin lending requirements in recent weeks, requiring bigger haircuts on the face value of securities that clients pledge as collateral for margin loans.

The changes follow repeated warnings from the securities regulator that brokerages should control risk from margin lending, which has exploded in recent months alongside the market rally.

Credit Suisse estimates that in addition to the Rmb1.7tn in officially disclosed margin lending by brokerages, Rmb1.4tn to Rmb1.7tn worth of loans have flowed into the stock market through other channels.

These include "umbrella trusts", in which trust companies sell wealth management products to investors and channel the proceeds into loans to hedge funds. Major shareholders in listed companies have also raised funds to play the market by pledging their shares as collateral.

Vincent Chan, China equity analyst at Credit Suisse, warned on Thursday that mainland-traded "A shares" are poised for a fall, though he remained positive on Hong Kong-traded "H shares", which are less richly valued,

"After such a big rally in the past 12 months, we think it is time for the A-share market to have some correction," he said.

Additional reporting by Ma Nan

Twitter: @gabewildau

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