A China investor's lessons from 2013
"The road to hell is paved with positive carry."
Just before the Year of the Snake ends, the market is roiled by a dramatic sell-off across the globe.
The Argentine peso plunged 12 per cent in one day last week, the most in well over a decade, and became 2014’s first black swan. This episode reminds us of the gold sell-off in April, the Yen’s surge in late May, the Nikkei’s plunge, and China’s liquidity crisis – all black swans of 2013. As the Fed pushes on and macro liquidity continues to recede, more systematic risks will be exposed in 2014. As Mark Twain put it, "a banker is a fellow who wants his umbrella back the minute it begins to rain.”
The peso’s relative insignificance in global exchanges makes it unlikely to be a funding currency for carry trades. Furthermore, what may have caused the sell-off, such as a fall in Argentina’s forex reserve and a change in its currency regime, are largely country-specific. But the contagion from such a dramatic sell-off will be difficult to ignore. As the peso is small in size, volatility is likely to spread onto other asset classes. We have seen the VIX surge 32 per cent during Friday’s trading, as global markets plunged. There have only been seven prior episodes since 1993 when the VIX spiked more than 30 per cent in one day; these include the 1997 Asian crisis, the "9.11" terror attacks in 2001, and the 2008 global financial crisis. The rarity of such a significant volatility spike carries dark forebodings.
Meanwhile, a 3-billion-yuan trust fund came dangerously close to default in China. The market is divided on whether the trust should pay the investors in full, and CDS and bond yields have surged while Shanghai has weakened (Focus Chart 1-2). Media reports say that one of the coal mines the trust owns has been allowed to reopen, and the trust should now have more than 10 billion yuan in net assets, well able to cover the 3-billion-yuan liabilities. But this event has once more highlighted the prevalent credit problems in China. 2014 is the year when many trusts come due. We would continue to avoid interest-rate sensitive sectors and sectors that leverage heavily on economic cycles, as the tides are turning. Areas with excessive leverage will be the pressure point in a liquidity crisis.
While China's main board struggled in 2013, the ChiNext index did very well. So did the Shenzhen Composite. It is puzzling, especially when the ChiNext is trading at frothy multiples of 6.6x P/B and 66x P/E, and is facing an increasing supply as IPO reopens. Pundits have attributed this strong performance to the prospects of ChiNext companies in an environment of declining growth and tight liquidity. But these retrospections cannot explain why ChiNext’s expensive valuation can persist for so long.
If fundamentals cannot explain the ChiNext phenomenon, we must then turn to behavioural factors. Chinese fund managers are under frequent performance review pressure -- on a weekly basis in some cases. With ChiNext’s strong momentum, more funds will buy in just to keep up with their peers. And to hedge the downside of buying into an expensive index, managers short the main board index futures.
Such a trading strategy may help to explain why there is a significant divergence between the performance of the main board and the ChiNext – similar to the strategies of "long stocks + short bonds" and "long US/Japan + short Yen" in the overseas markets. All of these hedging strategies have performed well.
As John Maynard Keynes once said, "markets can remain irrational a lot longer than you and I can remain solvent.” Of course, in the end the reversal will be brutal when everyone is following the same strategy. For now, the ChiNext has blown the first top seen in December 2010 and the recent top in October 2013. As such, price action has confirmed a long bias in ChiNext beyond the immediate challenges.
On 24 June, our proprietary sentiment indicator flashed a strong risk-on signal at the depth of China’s liquidity crisis, after a clear risk-off signal on February 8 – the peak of 2013. (Our sentiment indicator measures market participants’ expectations, and has guided us through various inflection points in our China Strategy coverage since we started in 2010.)
For the time being, sentiment is only slightly negative, and liquidity conditions have improved due to the central bank's intervention. But growth has disappointed, and global markets face strong headwinds as the Fed convenes on Wednesday. It would be difficult for the Chinese A-shares to stand alone. After all, in a crisis, the only thing that goes up is correlation. We would ignore any non-tradable technical bounce for a better buying point later.
2014 will be a year of Fed tapering and China slowdown. It will be another exhilarating roller coaster ride.
The author is managing director for research at Bank of Communications. Follow him on Sina Weibo.