Shanghai Composite Index Slips Again, But Large Cap Stocks Outperforming

The Shanghai Composite fell 5.49 points today, or 0.17 percent, slipping below the 3,200 mark to close at 3,197.54, and into negative territory over the past five trading days. It’s still up 2.14 percent for the month and up 3.03 percent year to date.

The Chinese stock market is lower over the past couple of sessions, having also declined 0.17 percent on Tuesday. Trading has been relatively quiet, with many investors holding positions pending widely anticipated 2nd quarter GDP numbers, expected to be released next week by the National Bureau of Statistics.

Earnings are rolling in, with some solid improvements: Poly Real Estate reported preliminary earnings up 10.6 percent in the first half of 2017 compared to last year, while Yonghui Superstores is reporting earnings growth of 56.9 percent. Tangshan Sanyou Chemical expects earnings to be up by 227 percent year over year for the first half of the year, while Shanghai Flyco Electrical Appliance expects earnings to have improved 50-60 percent compared to the first half of last year.

Rounding up other Asia markets, the Nikkei lost 97.10 points, or 0.48 percent, but still managed to stay above the 20,000 mark, closing at 20098.38. The Australia S&P/ASX also slipped 0.96 percent. The Shenzhen Composite joined the Shanghai Exchange in negative territory, falling 0.11 percent. The Hang Seng index gained0.64 percent.

Winners & Losers

Tibet stocks dominated the market today: The biggest winner on the Shanghai Stock Exchange today was Tibet Tianlu Co., which gained the 10 percent maximum allowable under exchange rules. Tibet Urban Development & Investment Co. was right behind with a gain of 9.97 percent today, and Tibet Tourism Co., Ltd. gained 8.81 percent.

The biggest losers today were Fujian Start Group, Co., down 9.65 percent today and Antong Holdings, which lost 7.07 percent. Luenmei Quantum Co. lost 4.85 percent, Maoye Commercial Co. fell 4.8 percent and Yunnan Bowin Technology Industry Co. declined 4.75 percent. Changyuan Group Ltd. A shares fell 4.54 percent and Xinjiang Yilite Industry Co. stock slipped 4.19 percent.

Chinese Economy

Profits at Chinese central government-owned enterprises are way up, climbing 18.6 percent from January through June, compared to year-ago figures. Chinese car sales have also rebounded in June, albeit thanks to a series of price cuts.

The trend lately has strongly favored large cap stocks in the Shanghai Composite Index. The Shanghai 50, a benchmark that captures the performance of the 50 largest stocks traded in the Shanghai Stock Exchange, has substantially outperformed the broader Shanghai Composite index all year.

The underperformance of smaller-cap stocks has been severe enough to put a crimp on the number of new stock investors entering the Chinese market. The smallcap doldrums have discouraged retail investors, who account for about 80 percent of the country’s stock transactions.

The ChiNEXT, a Nasdaq-like board of Chinese startups and tech-industry companies, has lost 8.9 percent thus far this year.

Specifically, the Shanghai 50 is up 0.67 percent over the past five days, 3.55 percent over the past month, 7.83 percent over the past three months, 12.17 percent year to date, and 16.71 percent over the trailing twelve months.

The outperformance tracks the tremendous increases in profitability for large state-owned firms over the past year, thanks in part to a resilient Chinese economy and a brightening outlook for exports, but also to a series of successful supply-side reforms over the past year.

One of those key reforms was a massive cutback in steel production capacity. The capacity rollbacks are proceeding ahead of schedule, with Chinese steelmakers meeting the government-imposed cutback quotas for the entire year in just the first six months, rolling back max production capability by 5.95 million tons. The cutbacks have eliminated unprofitable plants while boosting the price of steel. Rebar is now 15 percent higher than it was at the beginning of the year, setting profit margins of about 1,000 yuan per ton of rebar sold.

China has also slashed coal production capacity by 6.59 million tons and reorganized many struggling mine companies.

Chinese companies now lead the world in clean energy production, according to a new report from BP’s Statistical Review of World Energy. Renewable power, excluding hydro power, increased by 14.1 percent, according to the BP report. Global hydro power only increased 2.8 percent, worldwide, but over 40 percent of that growth came from China. Nuclear power expanded 1.3 percent globally, but China accounted for nearly all of the growth. Meanwhile, China managed to cut its carbon emissions by 0.7 percent over the previous year.

We now have a timeline for the integration of Chinese stocks into the MSCI emerging markets index: 5 percent of an initial 222 companies will be included as of August 2018. MSCI will gradually add more shares until all 222 initial stocks will be included by 2025. By the year 2030, MSCI will include 500 Chinese stocks.

Overall, China investors will benefit from increasing liquidity and openness thanks to the MSCI emerging markets inclusion, the recently opened Stock Connect between Mainland China and Hong Kong, as well as the eventual launch of the Bond Connect, further tying Chinese markets to overseas investors.

China’s Economic Outlook

The bifurcation of the Chinese stock market reverses conventional wisdom of a year or two ago, which vastly favored new-economy stocks over smokestack industries, even though new-economy stocks and service industry stocks tend to be smaller in China than the industrial giants at the large-cap end of the Shanghai Composite.

In retrospect, playing on valuation improvements and profitability increases at these large companies paid off over the last year. But the lower prices go in the ChiNext world and in the smallcap range of the Shanghai and Shenzhen indexes, the more income and value-focused investors may find opportunities to pick up bargains. China has a lot of promise in financial technology, health care, pharma and green energy, and the quality of Chinese manufacturing and engineering is increasing rapidly.

Donald is a strategist for economiccalendar.com. He specializes in a fundamental approach while informing traders of relevant economic data. Actively trading since university, Donald trades indices and commodities. He earned his Bachelor's in Finance from Baruch College's Zicklin School of Business in New York City.