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China's stock market surge screams danger, but fighting policymakers can be equally as dangerous

Robert Cianflone/Getty Images

If there was ever an example that speculation and government coercion, rather than economic fundamentals, is driving China’s equity bull market, this chart is it.

Posted on Twitter overnight by Nordea Markets Martin Endlund it shows the six-year relationship between the Shanghai Composite Index and the HSBC-Markit China manufacturing PMI gauge.

As you can see up until late 2014 there was a reasonable relationship between the two. As manufacturing activity picked up so too would the equity market, and vice versus. Fundamentals, by-and large, were largely dictating terms.

Then, suddenly, like it had ingested a six-pack of Red Bull alongside a three-month dose of Viagra, the equity market took off, climbing constantly despite manufacturing activity deteriorating sharply over the same time period.

The divergence has got the investment community talking. Can the rally, increasingly built on margin debt and less-experienced investors, continue against a backdrop of deteriorating economic data and stretched market valuations? Or is it merely a sign that a savage correction can’t be far away?

While the fundamentals are hardly compelling, you only have to look at its history to see that there are other factors that are driving the market higher.

When the rally began in August 2014, China’s government began a PR blitz discussing the benefits and patriotic virtues that accompanied equity investment. Then, in November, the PBOC cut interest rates and reduced reserve ratio requirement for banks. They have since followed those moves with additional policy easing and there’s even more expected in the months ahead.

Policy support, both from the government and PBOC, is underpinning the rally.

With households and businesses benefiting from increased wealth and capital availability – two factors that will assist in economic rebalancing – it’s highly unlikely the government will allow it to end any time soon.

While doubts about whether it can succeed will persist, one only has to look at the post-GFC performance of developed markets to see what is likely to eventuate.

When making your own assessment on whether or not it can continue just ask yourself this one simple question: Do you know anyone who made money betting against the Fed, ECB or BOJ in the past six years?

Didn’t think so.

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