Some froth, but no bubble in Chinese stocks

The Shanghai Composite index has soared in recent months, but investors can expect more growth to come.

We've often pointed out that stockmarkets don't always reflect the economic fundamentals. China's is a classic example. Annual growth is running at its slowest pace since 1990. But stocks have rocketed. In the last three months of 2014, the Shanghai Composite index leapt by 37%. This quarter it has gained another 6%, to hit a six-year high.

As with most markets right now, the promise of easier money, along with past liquidity injections, has underpinned the feel-good factor. Last week, after a nasty run of data suggested that growth could well undershoot the official 7% target for this year, the government stepped in to pat worried investors on the hand. It promised to keep growth in "a reasonable range" and step up stimulus efforts if the downturn hurt employment and incomes.

Recent cuts in the reserve requirement ratio (which governs how much cash banks must set aside) have boosted credit growth, notes Capital Economics. Outstanding credit growth is running at 13.7% a year, from 13.5% in January.

But the government won't want to encourage another debt binge: it is trying to wean the economy off credit-fuelled investment, and debt is still rising faster than growth, even though it has slowed from an annual pace of 20% in the past 18 months.

Still, in the short-term, monetary policy is set to remain loose, while there is another tailwind: the Stock Connect. This scheme allows foreign investors access to China's domestic stocks and has already lifted foreign investment in China's markets by more than 10% since is inception last year, says Lex in the Financial Times.

Opening up China's market also means it should become eligible for inclusion in international benchmarks, such as the MSCI. "That would prompt a massive influx of passive funds," says Patrick Ho of AMP Capital. The Chinese property downturn has also made stocks more attractive to those looking for a home for their savings.

Given the strong run, the market looks vulnerable in the short term, especially as many new investors have borrowed to buy: margin debt has hit a record $141bn. But valuations still look reasonable enough to discount further turbulence as China's economy evolves.

The market trades on a cyclically adjusted price/earnings ratio (a decent measure of long-term value) of 14. The JPMorgan Chinese Investment Trust (LSE: JMC) is on an 11% discount to net asset value.

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