By S.R., C.C.W. | SHANGHAI, HONG KONG
AMID the sell-off in global equities over the past month, one market has made for an unlikely safe haven. While American, European and Japanese stock indices have fallen by roughly 5-9% since late September, Chinese stocks have been flat. For a market that often resembles a casino, looking to Chinese stocks for stability might seem a bizarre strategy. But there is one big factor to recommend China as a hedge against other markets: low correlations. That is, stockmarkets elsewhere in the world have little influence on China, and China’s stockmarket, in turn, has little influence on the rest of the world.
This first chart shows correlations between seven important indices since 2000, breaking the relationships into five-year segments.
We examined the correlations on a monthly basis, a long-enough time frame to iron out any short-run lags. We also converted index changes into dollar terms at contemporary exchange rates to eliminate currency effects and create a level base for comparison. The Shanghai Composite Index, China’s main stock index, stands out as the most independent of the markets.
For the past decade, Shanghai’s correlation with America’s S&P 500 has been moderately positive at 0.37, meaning that though they tend to move in the same direction, the connection between the two is quite weak. Contrast that with the correlation between the S&P 500 and FTSEurofirst 300 (Europe’s 300 largest companies by market capitalisation): it has averaged 0.84 over the same time, indicating that the two indexes virtually move in lock-step. (A correlation of 1 would signify a perfect one-for-one relationship.)
There is one obvious explanation for China’s different path: capital controls. Whenever global risk appetite is on the rise and investors pile into equities around the world, they are rebuffed at China’s borders by rules against bringing speculative cash into the country and, furthermore, by rules that bar foreigners from investing directly in its stockmarket unless covered by a special, restricted quota. The same controls insulate China in the other direction, from panic in other markets.
Nevertheless, even with these formidable barriers, it might have seemed reasonable to assume that the gap between Chinese and foreign stock exchanges would have narrowed as China’s financial system integrated more closely with global markets. After all, Chinese capital controls are imperfect, with hot money chasing its currency's appreciation, and regulators have steadily widened channels for foreign investors to buy its stocks. But as this second chart shows, integration is still a long way off. The Shanghai Composite has grown even more independent since 2012, with its correlations slackening across the board.
Why the continued independence? Overseas investors simply have too small a share of the Chinese market for there to have been any meaningful financial integration. The investment quotas allocated to foreign institutions still account for less than 3% of China’s market capitalisation, according to UBS, a Swiss bank. Unsurprisingly, the market that Shanghai most closely approximates is Hong Kong, largely because of Chinese companies that have shares listed in both locations. But even when focusing on the narrower index of Chinese shares listed in Hong Kong and the Shanghai Composite, the relationship is still less substantial than might be expected. Their correlation of just 0.63 over the last five years is marginally weaker than the 0.65 correlation between the S&P and the Nikkei during the same time, even after the big boost to Japanese stocks from Abenomics.
For investors trying to diversify their portfolios, China’s low correlation is a strong selling point. To be sure, it is not necessarily a good thing – the difference for much of the past five years stems from Shanghai's underperformance. But as a hedging proposition, the idea now is that if other markets suffer declines, Shanghai could once again go its own way and rise, or at least fall to a lesser degree.
The temptation is clearly there. Exchange-traded funds that provide direct access to Chinese stocks have been struggling to keep up with demand. There is also much excitement about the Shanghai-Hong Kong ‘through train’ that was supposed to launch this month (it appears to have been delayed but officials say it is almost all set to start). This programme will give foreigners an additional 300 billion yuan ($49 billion) quota for buying Chinese stocks, equating to a roughly 50% increase overnight.
But Shanghai’s lack of correlation won’t last forever. Ultimately, it is self-defeating. The more access that foreign investors get to China, the more its stockmarket movements will resemble those of other countries.
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