Chinese Stocks Tumble At Open As Morgan Stanley Warns "Don't Buy This Dip"

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Is it time to step in and buy the dip in Chinese mainland shares after last week’s harrowing 13% decline on the SHCOMP? Absolutely not, Morgan Stanley says.
Beijing is fighting desperately to keep the country’s stock market miracle alive, as China needs a distraction to deflect attention from the flagging economy and bursting real estate bubble. But aggressive policy rate cuts and an abrupt 180 on LGVF financing for local government projects are working at cross purposes with efforts to deleverage the economy (which is laboring under a $28 trillion debt load) which include allowing for more defaults, reining in shadow financing, and restructuring a local government debt pile that amounts to 35% of GDP.

In addition to contradictory policy decisions, Beijing is also struggling to reconcile slumping exports with accelerating capital outflows, a combination which makes currency devaluation both necessary and impossible at the same time.

In this context, it’s easy to see why a stock market collapse would be a particularly unwelcome event and until last week, the music was still playing thanks to anticipation surrounding A share inclusion in FTSE and MSCI EM benchmark indices. Now, with China’s millions of newly-minted day traders having recently discovered that stocks can go down as well as up, and with a contraction of margin financing via umbrella trusts beginning to weigh, there are renewed questions about the sustainability of the rally. Here’s Morgan Stanley with more:

Our stance on China A shares is that this is probably not a dip to buy. In fact, we think the balance of probabilities is that the top for the cycle on Shanghai, Shenzhen and Chinext has now taken place. We remain concerned over four factors: a) increased equity supply, b) continued weak earnings growth in the context of economic deceleration, c) high valuations, and d) very high margin debt to free float market capitalization. Our Shanghai Composite Index EPS forecasts for 2015 and 2016 are significantly lower than consensus (5% vs. 9% for 2015, and 8% vs. 16% for 2016). 

We set a new 12-month Target Price range for Shanghai Composite of 3,250-4,600. This range is -30% to -2% below the current level of the index (4,690 as of June 24 close). Our base case EPS integer forecast for Shanghai for June 2016 is 259 versus consensus' 279 (7% lower). 

We forcast 5% base case EPS growth in 2015 and 8% in 2016 for the Shanghai-A index, which is significantly lower than the current I/B/E/S consensus numbers of 9% for 2015 and 16% for 2016. Recent earnings growth trends continue to be poor. Trailing EPS y-o-y growth rate for the Shanghai Composite Index in June has dropped to -1.3% from 7.3% a year ago. For the Shenzhen Composite Index, yoy growth has dropped to 6.8% from 11.5% a year ago. This poor momentum in EPS in a forecast continued weak economy is the primary reason why we have modeled for below-consensus EPS growth.

In summary, we project that China's economy will continue to struggle over the next 12 months as it transitions towards consumption- and services-led growth in the face of the legacy of the rapid build-up in leverage in recent years and significant excess capacity in the 'old economy' sectors. As a result, our base case June 2016 12-month EPS forecast is 259, 7% lower than the consensus number of 279. 

We have often heard in recent months that the Chinese authorities would not allow a market decline as we are now forecasting. The implied move from the peak on June 12 – if that is the peak – to the lower end of our new Target Price range for mid-2016 would represent a decline of 37%. Certainly, it is true that the Chinese authorities have been more vocal in their support for the development of the market in this cycle than in previous cycles, where major declines occurred within one year after the peak. However, our general view is that governments are not able to exert direct control over stock market behaviour, in particular where trading volumes, valuations and margin leverage are as stretched, as they are now in China. For us, ultimately this argument against a sustained bear phase for China A shares over the next 12 months sounds almost as dubious as what we were hearing in late 2007. Then, it was frequently argued that the Chinese authorities would not let the A share equity markets decline before the major international prestige event of the Beijing Olympics in August 2008. The Shanghai Composite fell by 57% from the peak in October 2007 to the opening days of the Beijing Olympics. 

• *SHANGHAI COMPOSITE SLUMPS 3.5% AT OPEN

With CHINEXT in a bear market - they are trying something else:

• *HIGH-TECH COS. ACCOUNT FOR ABOUT 90% OF CHINEXT FIRMS: XIAO
• *CHINA TO START EQUITY CROWDFUNDING TRIAL: XIAO GANG

and the rest of Chinese stocks in correction at best, one wonders if the PBOC will stand idly by as the bubble they unleashed crashes and burns bringing down most of rural China's wealth with it...