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Contagion contained

Equity markets Simon Hildrey says the recent Chinese stockmarket falls have not spread to other markets so far but volatility is expected to increase.

The recent falls on China’s Shanghai Composite index did not make comfortable reading. The market started to fall after the Chinese ministry of finance said it was tripling stamp duty on shares. But unlike the previous fall in the Chinese market in February, this time there was little impact on the rest of the world.

Neptune China fund assistant manager Shelley Kuhn says the Hong Kong market has been posting positive returns.

The A shares on the Shanghai market are only open to domestic investors and so UK-based funds were not affected by the falls. Most fund managers say that as only a small proportion of the Chinese population own shares, the fall should have little impact on consumer spending and the economy.

Furthermore, investors have already made substantial profits, leaving them with gains despite the recent falls. A shares rose by 45 per cent from the start of this year to the end of April.

There is wide belief that the Shanghai market is experiencing a bubble. Managers point to differentials in share price movements in Hong Kong to support this argument. From the start of this year to the end of April, the MSCI China index only rose by 1 per cent.

Even though the fall in China has not affected elsewhere in Asia, investors should not be complacent. Jupiter Asian fund manager Philip Ehrmann says volatility in Asia had fallen to around 10-12 per cent before February. Volatility rose to 18-19 per cent in February s China prompted a fall in equities. Now volatility has settled back to between 10-14 per cent.

Ehrmann says the level of volatility will at least partly depend on whether the cost of capital and interest rates rise. He adds that strong liquidity has kept volatility relatively low. Increased cost of capital will reduce liquidity and could push up volatility. US 10-year bond yields, for example, have recently jumped to 5 per cent.

When investors become more risk-averse, emerging markets have historically been hit first and hardest, giving rise to greater volatility. Generally, small caps suffer greater sell-offs than large caps during periods of volatility.

Volatility for UK investors is also a product of movements in currencies. For example, Oliver Bell, senior investment manager at Pictet Asset Management, says an investor could lose 30 per cent in a fall in an emerging market and another 20 per cent in currency movements.

Gartmore head of multi-manager Bambos Hambi expects volatility to increase this year. But some fund managers like volatility as they try to profit from mis-pricing, especially where markets are not overvalued.

Hambi says: “We hold actively managed funds that can benefit from volatility.” These include Resolution Pacific Growth and Invesco Perpetual Asia. “One advantage of these funds is that they have exposure to Australia, typically of 8 per cent to 14 per cent. Australia not only offers investment opportunities but has defensive parts to the market. During the Asian crisis in 1997, those funds with Australian exposure outperformed other Asian funds.”

Bell, however, is confident that volatility will remain relatively low because he does not believe that emerging markets are experiencing a bubble. He says: “We would argue that the risks on a macro level are not in emerging markets but in developed countries. They have the current and trade account deficits.”

He says another reason to be optimistic is the fact that there has not been significant leveraging by hedge funds to invest in emerging markets. Bell argues that such investments would raise concerns about future volatility.

Ehrmann says he would welcome volatility as providing buying opportunities. He believes valuations outside the Chinese domestic market are not stretched, even after four years of a bull market. He says: “Stocks are only trading on 12 to 13 times earnings on average. You have to remember that Asian stockmarkets were badly hit by the bursting of the technology bubble in early 2000 so they have recovered from a lower base than developed markets.”

The best opportunities to profit from mispricing are where there is indiscriminate selling of equities because of a downturn in sentiment if the fundamentals are still positive. Andrew Gillan, investment manager in the Aberdeen Asian equity team, says this leads to “good quality companies being on more attractive valuations”.

Gillan says: “As bottom-up stock pickers, we do not pay much attention to the volatility of stockmarkets but if we have spare capital we may buy if there is indiscriminate selling.

“Share prices in Taiwan, for example, fell when the government announced the introduction of a new tax on foreign investors. The decision was reversed the following day but presented a buying opportunity.

“Another example was after the Indian elections a couple of years ago when a victory for the Congress party led to a stockmarket sell-off.”


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