BAML: Sell into the rally, the Shanghai Composite is going to tank

While it has rallied hard today, it’s unlikely China’s Shanghai Composite has seen the bottom, with recent monetary policy easing only likely to provide temporary relief for the beleaguered stock index.

That’s the bearish view provided by David Cui, Tracy Tian and Katherine Tai, Bank of America-Merrill Lynch’s China equity strategy team, who believe that investors should look to sell into any near-term rally on expectations of further losses for the index.

Here’s why they’re not convinced that any near-term rally will last, based on recent monetary policy easing.

“The combined rate and RRR cuts announced Tuesday, clearly targeted to boost A-share market sentiment in our view, may provide some temporary sentiment relief, especially considering that SHCOMP had declined by close to 26% since Aug 17. However, we doubt that this represents the bottom of the market – it appears to us that the government has significantly reduced its direct purchase in the market in recent days and is now trying to replace the direct intervention with the softer, more market oriented, and indirect support. We doubt this will work beyond a few days. As a result, we recommend selling into any rebound”.

While there was some evidence government-backed entities – known as China’s “national team” – were actively buying banking stocks on Wednesday, fitting with the view of Cai, Tian and Tai, it was not enough to prevent the index from suffering yet another substantial fall.

The trio note that the glow from the combined cut to interest rates and reserve ratio requirement on Tuesday will likely fade, pointing to the failure of previous policy easing since late 2014 to sustain market gains.

Instead, they believe stretched valuations and high levels of leverage will continue to weigh on the index, suggesting the only way that the government can hold up the market is by being the buyer of last resort. If they step back from being aggressive buyers as BAML suggests, it points to the likelihood for further market losses.

Should that eventuate, Cai, Tian and Tai believe the key risk is for financial system instability. Given the surge in financial services growth over the first half of the year – something that helped underpin Chinese GDP at 7.0% per annum – further declines would also create downside risks for future economic growth.

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