How to exploit the market situation

During the past week, the Chinese government’s buying interventions in the stock market have slowed down the decline in Chinese stock prices, moving them away from their record lows. However, investors remain skeptical about the duration of this support and highlight how it can make the markets inconsistent and unstable.

Created to respond to the market crash in 2015, the so-called “national team” in China, composed of a group of banks that influence the market through the use of state funds, injected $17 billion into indexed funds during the last month. This move was particularly noticeable on Friday and Monday, during the market crash.

On these two days, the Shanghai Composite Index experienced a sharp decline, reaching its lowest point in five years, before rebounding in conjunction with an increase in trading volume focused on blue-chip stocks.

However, analysts and investors doubt the long-term effectiveness of this strategy, arguing that liquidity support alone will not be enough to generate a lasting turnaround, particularly as long as the real estate sector remains weak, negatively impacting consumer and investor confidence. The challenge is enormous considering that the value of mainland China’s stocks stands at around $9 trillion.

Dennis Yang, a professor of business economics at the University of Virginia Darden School of Business, compares the current situation to the 2015 boom-and-bust cycle, suggesting that a short-term solution may not be sufficient to restore long-term confidence among global investors without addressing the structural issues of the Chinese economy.

In 2015, in a more favourable economic context, the impact of the “national team”‘s purchases was uncertain. Additionally, it took months before the markets found stability and over five years for the blue-chip CSI300 Index to reach its peak once again.

This time, according to analysts, similar purchases have been observed for months – with S&P Global Market Intelligence recording over $17 billion in blue-chip funds in just the last month. However, there is no immediate solution to the core growth problem.

Ben Bennett, Asia-Pacific investment strategist at Legal & General Investment Management, comments that the Chinese economy is changing direction, shifting from infrastructure and real estate investments to high-value-added sectors. “Recent stimuli aim to facilitate this transition, focusing on aspects such as decelerating credit growth and stock market volatility. However, the transition is still ongoing, which means these policies can only have limited impact.”

The undervaluation of Chinese markets is now evident, as is the deteriorating confidence and patience of investors. Despite numerous attempts to revive the market, including short-selling bans and transaction tax reductions, the crash continues. Even government statements about imminent support, without concrete details, have not had the desired effect. Many major investors are awaiting a public spending plan to support families. For now, there are no official confirmations regarding the news, reported by Bloomberg News, of a 2-trillion-yuan stock market bailout plan.

“The confidence crises affecting consumers regarding debt, the real estate sector, and employment highlight the complex challenges that the Chinese economy must overcome,” says Michael Ashley Schulman, partner and CIO of Running Point Capital Advisors.

According to Schulman, the effectiveness of a market bailout is doubtful if it does not address the weakness of aggregate demand or the entrenched problems in the real estate market. “Previous Beijing moves have shown short-term effects,” he adds.

Data shows that international investors sold Chinese stocks for a net value of 18.2 billion yuan (about $2.5 billion) last month, marking the sixth consecutive month of outflows. With a 20% decline in six months, the Chinese stock market contrasts with the 5% gain of global stock markets. Meanwhile, local investors are shifting towards funds that invest in foreign stocks. Some speculate that Chinese stocks, due to their low prices, may be a good deal. State investor interventions may distort the markets, creating investment opportunities by following the moves of the “national team.”

Pang Xichun, research director at Nanjing RiskHunt Investment Management, observes that the bailout mainly favours state-owned companies and blue-chip CSI 300. He recommends adopting long strategies on these companies and shorting smaller companies. Although it is not a genuine investment in the potential improvement of the market, this tactic could prove profitable for now. The CSI 300 closed up 0.7% on Monday, while the small-cap index recorded a 6.2% decline. At the beginning of the week, on February 5, the CSI1000 index closed down 6.16%.

How to take advantage of this market situation?

In a market situation where Chinese stock prices and indices have predominantly fallen in the past two years, it may be interesting to use investment certificates to make the most of this historical period.

As we have seen, certificates can be of different types in terms of capital protection and underlying assets. Certificates allow us to have exposure to the underlying asset, in this case, China, either directly through a replication investment in the Chinese index or exposure to a limited number of stocks, particularly those with higher market capitalisation.

Capital-protected certificates allow investors to take a position on a basket of stocks or ETFs. The return is determined by the certificate’s price, with at least 100% capital protection if held until maturity. On average, with a duration of 3-5 years, the certificate can be sold at any time based on market conditions. In this market situation, characterised by uncertainty about the performance of stocks and monetary policies and considering the latest data on demographic trends (lower than expected) and the real estate market, it is interesting to have a possible positive return due to a market reversal in China due to increased flows from the “national team,” while maintaining full protection in case this trend continues.

This financial product presents a lower level of risk compared to a direct investment in the reference index. This is due to the presence of capital protection mechanisms, which reduce exposure to market fluctuations. However, it is important to note that the potential for gains is also more limited. Participation in potential market increases is often limited by a maximum limit (Cap), which defines the maximum return the product can generate. On the contrary, some issuers have introduced a lever on the positive yield in favour of investors. Conditionally protected capital certificates offer investors the right to receive periodic coupons while also providing capital protection in the event that certain requirements of the underlying asset are met. In this case, the investor has security on their capital up to a predefined threshold called the Barrier, beyond which the certificate’s price becomes linear with the performance of the underlying asset, often at a worse level. The barrier level is often also what determines the payment of the coupon.

In a market situation like the current one, where the manoeuvres of the Chinese government and market expectations are in contrast, it may be interesting to have a small position that offers periodic yield and protected capital up to a further decline of the underlying asset. The CSI300 closed at 3,200.42 CNY yesterday, a value that we can only find at the beginning of 2019, making 50% barriers attractive, providing coverage up to prices equivalent to those of 2008.

There are various solutions in the certificate market that allow for more or less significant exposure to the underlying asset. The important thing is to choose an efficient product with a balance between risk and return. In the market, there are several issuers capable of quoting products with equity or ETF underlying assets related to China and providing investors with interesting products for their portfolios. It always remains in the hands of the investor to weigh the weight that a product with this underlying asset should have in their portfolio. Positive yield is interesting, but it is important not to focus solely on this.

This article has been written for informational purposes only; it does not constitute solicitation, offer, advice, consultation, or recommendation for investment as it does not intend to incentivise the purchase of assets. Remember that any type of assets is evaluated from different perspectives and is highly risky, therefore, every investment decision and its related risk remains solely with the reader.

Continue reading from our blog: