Rise of the household investor

Stronger financial regulation from the government is giving the average person a fighting chance in China's stock markets

We often think of market moves as simply getting from one level to another, but in China the debate seems to have turned to concerns around the quality of the underlying move.

There is little doubt that what we are witnessing in China is a portfolio rebalancing from institutional and retail investors. Household asset allocation has been trending in favor of a higher weighting toward equities since hitting a trough of 5.7 percent of total assets in 2005. With the exception of a huge spike of 27 percent in total assets in 2007, we have seen a steady climb each year to the current level of around 17 percent.

Household allocations toward cash and bonds have always generally been low, but it's the weighting toward investments in property and to a greater extent deposits that are being reduced in favor of equities. Investment in deposits have traditionally held a 60 percent weighting of the Chinese household portfolio, but I feel this figure will be closer to and even below 50 percent in 2016. This is a cultural shift, driven by a realization that Chinese equities are cheap, but also premised on a belief that Beijing views a higher stock market as having significant benefits for the real economy.

It must be said that this is not the first time a central bank or government has impacted a stock market through a range of market friendly policy initiatives. The US Federal Reserve, Bank of Japan and now the European Central Bank have all targeted base money and balance sheet expansion, which in turn has led to excess liquidity funneling its way into the stock market. These moves are based on the common shared belief that a higher stock market boosts the real wealth effect, increasing discretionary spending and pushing the economy closer to its full potential. In China, there are also qualitative measures being undertaken that are really helping the equity market.

Since the fourth quarter of 2014, we have seen two cuts to the benchmark lending rate, a 150 basis point reduction to the level that reserve banks have to hold (reserve ratio requirement or RRR), various liquidity initiatives and a reduction in the level of down payments for first- and second-home buyers. Adding to investor confidence and as part of the reform of local government debt, the Ministry of Finance has offered local governments the opportunity to swap a portion of existing debt maturing this year into longer-term maturities. This debt swap should save local governments around 40 billion yuan ($6.45 billion; 6 billion euros) to 50 billion yuan a year in interest payments and has removed some of the concerns surrounding the sizeable debt local governments are shouldering.

It is a widely held view that further easing measures will be seen. We could even see a cut to banks' RRR in the coming weeks given the recent money and credit data and the subdued monetary base growth. An RRR would increase the money multiplier (the amount of commercial bank money that can be created by a central bank), with commercial banks able to increase lending and help the People's Bank of China achieve a 12 percent growth target in its M2 money supply, which includes cash, checking and savings deposits, money market mutual funds and other time deposits.

The explosive moves in equities really started in July 2014, with the Shanghai Composite and the CSI 300 rallying 110 percent and 114 percent respectively since then. The explosive moves have become much more pronounced since March and it's interesting to see just that over 7.4 million new A-share accounts have been opened in that time. What's more, many of these new investors are young enough that they won't have been too negatively affected by the 72 percent crash in the Shanghai Composite between 2007 and 2008.

What we are seeing right now is a household portfolio rebalancing, with what seems like a fear of missing out and a growing view that equities are going higher. The authorities have even allowed individuals to have 20 separate A-share accounts, providing greater flexibility to investors on where they trade. The number of accounts being opened also suggests there is a wall of capital that has not yet fully been invested in the market (rumor has it that nearly $20 billion currently sits in Chinese bank accounts). So in theory this supports the notion that pullbacks should be limited.

Some investors have also looked at using margin financing, in which an investor borrows money to buy securities. Margin financing really started in March 2010, but has grown in popularity recently. Purchases of stock using margin financing as a percentage of turnover has pushed up to around 16 percent, which is at a historically elevated level and helped by some innovations from brokers, who have designed various products to help high-net worth individuals achieve greater leverage ratios.

Greater regulation does seem to be picking up around margin financing. This feeds into the idea that while Beijing wants higher stock prices, officials want a healthy capital market and to dampen excessive speculation.

The moves to allow mutual funds full access to H-share listed stocks through the Shanghai-Hong Kong Stock Connect was clearly one method of keeping equities supported. But importantly this should help channel capital into a market that has been trading on a growing valuation discount to A-share listed firms. There is speculation that we could shortly see lower barriers for mainland retail investors to take part in the Stock Connect, although margin financing is currently not permitted to buy H-shares through this channel. This will give a more diverse range of retail investors (and not just high net worth individuals) even more opportunity. The H-shares index currently trades at ten times forward earnings, so I would expect reasonable outperforming over the coming 12 to 24 months.

This newfound ability for retail investors to look at arbitrage opportunities will also likely see increased flow through the Stock Connect program and keep trading volumes in Hong Kong elevated.

It is also worth highlighting that some 44 percent of Shanghai Composite stocks trade on a current price to earnings multiple of 50 and above. So providing increased opportunity, amid tighter regulation, should be seen as a positive thing for the long-term, although as we also saw on Jan 19 and April 17, talk of increased regulation in margin financing does increase short-term volatility. Still, these pullbacks seem to be used as an opportunity to accumulate.

Chinese markets are not only interesting because the evolution from a bull market into a red hot bull market, but there is a cultural shift underway, one that involves a strong household portfolio rebalancing. This is a market that will undergo bouts of elevated volatility, but the longer-term prospects remain positive.

The author is chief market strategist at IG, a multinational financial services firm based in Australia. The views do not necessarily reflect those of China Daily.