China Stocks Surge, Extend Rally

Chinese stocks rose on Monday despite growing fears in the west that an unsustainable equity bubble is ripe to burst in the largest Asian economy.  China’s Shanghai Composite Index rose 1.75% by late afternoon trading, extending the index’s rally. In the last twelve months, the index has risen nearly 138%, or 44% year-to-date.

Illiterate Investors

Chinese stocks rose on Monday despite growing fears in the west that an unsustainable equity bubble is ripe to burst in the largest Asian economy.  China’s Shanghai Composite Index rose 1.75% by late afternoon trading, extending the index’s rally. In the last twelve months, the index has risen nearly 138%, or 44% year-to-date.

Illiterate Investors

The strong growth has been a target of extensive criticism in the United States and Europe, with several analysts and financial publications arguing that the price growth is a result of sheer demand for stocks, and that trend has extended valuations too far.

In a recent report to subscribers, a European investment bank with a substantial Chinese presence cautioned investors that a Chinese bubble was forming in stocks. In the note, the bank said median earnings multiples for public technology companies were double what the U.S. saw at the height of the dot.com bubble, implying that valuations were far over-extended and likely to collapse.

Additionally, the note argued that the many retail Chinese investors fueling this bubble are too unsophisticated to understand their investments.  According to the paper, 6% of retail equity investors in the country cannot read. A separate study saw that about two-thirds of Chinese retail investors left school before 15, and virtually none of them had formal financial training.

Defaults, Falling Manufacturing

While equity values are rising, several other indicators of weak Chinese fundamentals are urging more investment banks and economists to urge caution.  One worrisome trend is a rise in defaults and difficulties in making debt payments across both Chinese corporations and municipalities.

According to Bloomberg, Chinese bottle maker Zhuhai Zhongfu Enterprise told the Shenzhen Stock Exchange that it would be unable to repay its full debt load, saying it will only pay 148 million yuan, or about $24 million of a 590 million yuan, or $96 million, bond that is due. That bond was originally issued at a 5.28% rate in 2012. The bond’s rating was A+ at the time. According to Bloomberg, the firm is trying to “raise funds for the bond payment until the last moment.”

The relatively unsophisticated and value-driven company had little difficulties raising capital just three years ago, as investors expected demand in China to continue unabated. In reality, the growth rate has slowed by nearly a third since then, with more slowdown expected in the future.

This marks the fourth Chinese company to default on its debt in recent months, and some analysts expect more to come. At the same time, manufacturing output in China continues to fall. According to the Purchasing Managers Index compiled by HSBC and Markit Economics, China’s PMI has contracted for all but one of the last six months, falling to 49.2 in April, far below expectations.