China ascending - I think not

Chinese equities rebounded spectacularly today, with 30% of China A50 components hitting the 10% limit and more than half advanced over 9%. 

Shenzhen building
Source: Bloomberg

Likewise, more than 100 of CSI 300 constituents limit up, although we reckon that around one-third (96) has suspended trading.

Even the embattled ChiNext Index rose a nice 3%, with a further upside capped due to the fact that all 24 companies that are still trading have reached the upper limit (+10%).

The remaining 76 counters had suspended trading. As a whole, around 50% of A-shares are still under trading halts, which suggests that there may be considerable selling interest still pent-up despite the barrage of government action to stave off the rout.

This made me wonder whether the rally has any legs to stand on. I feel that a great deal of caution should be exercised.

The mass suspensions is complicated by the fact they could go on for weeks or months, based on complex rules specifying suspension periods. What was so crazy is that most of the firms who halted trading cited ‘significant matters’ as the reason.

This is usually taken as the company is in the midst of a restructuring, or an impending acquisition, or merger. This balderdash suggests China is on the verge of having an M&A boom. It is unlikely for that to take place when the stock market is on the precipice of shambles, having lost around 30% of its value in the last three weeks.

Real reason for trading halts

There were reports that the real reason for the trading halts was because many controlling shareholders have used their equity as collateral for loans. This means that they may be forced to liquidate their stocks when the share price dropped far enough. The implication is that another massive sell-off may be triggered.

Nomura estimated such structured loans at around CNY 500-600 billion ($80-96 billion), which is about 1% of total lending to Chinese enterprises. For these firms, the path of the least resistance is to halt trading of their shares altogether.

Most of the companies that suspended trading are not particularly large and definitely not the blue-chips. The larger-cap stocks have benefitted from the ‘government put’, where much of the recent measures was geared towards supporting the blue-chip shares.

State funds and large brokerages are buying blue-chips to hopefully stabilise the markets. Furthermore, suspension of the blue chips will severely damage China’s credibility in the financial markets, as we have seen already has taken quite a beating.

However, I believe that the regulator and the two mainland exchanges are cognizant of the huge reputational risks they are taking by allowing the trading halts. This is also why investors should take today’s rebound with an enormous pinch of salt.

Overall, the potential big sell-off, when (or if) the suspended stocks resume trading, may be slowed by the circuit breakers, which restricts a daily stock movement on either side by 10%. Therefore it could take a while to see a market collapse. Although I feel that is scant comfort if investors feel a strong conviction to cut their exposure no matter what.

Of wider concerns are fears that the tumbling stock markets may have a contagion effect on the broader financial system. Apart from margin financing being a key factor behind the China bull run, banks have also found ways to participate in the stock market, despite clear restrictions on equity investments.

A lot of the worry is focused on the umbrella trusts where banks sell wealth management products (WMP) to retail clients. The Financial Times reported that although there is so far few signs of default risks in stock-linked WMP, the fact that most of them carry a maturity of at least one year means the problem would only surfaced months later. Generally, the circuitous manner in which they are involved in the equity market means it is difficult to assess the systemic risks triggered by a market collapse.

China authorities are finding themselves in quite a sticky situation and they may, arguably, have themselves to blame for allowing fairly unbridled surge in the equity markets. It is anybody’s guess to what they may do next, but what is certain is that we are likely to see more downsides before a period of stabilisation. Put differently, extreme volatility is here to stay for a while longer.

STI makes new 2015 lows

The Straits Times Index (STI) has seen a strong move to the downside today, testing the 3250 support briefly. The Index made a new 2015 low at 3249.89, the lowest since 18 December 2014. The failure to convincingly break under 3250 may precipitate a quick and modest rebound, with 3300 support-turn-resistance targeted.

On the daily period, the STI is trading at three standard deviations below the 20-day simple moving average. Nonetheless, the trend is still on the downside, with the weekly MACD line still below both the signal and zero line. So it may be a good idea to keep position sizing small.

Share prices of Singaporean banks dropped lower, weighed by relatively cautious market undertones, as well as some chatter that the Fed rate hike may be pushed back given current global conditions. According to the Morgan Stanley Index, which calculates the number of months to the first rate increase based on analysis of futures trading, the Fed is unlikely to raise interest rate until the first quarter of 2016.

The Index showed a jump to 7.5 (months) as of 7 July 2015 from a low of 5.6 three weeks ago. This corroborated with the FOMC minutes released overnight, where the tone was incrementally more dovish than the post-meeting statement. The minutes suggested that the Fed needs to see more signs of a pickup in economic growth before tweaking the rate lever.

Only two more months of jobs data and one quarter of GDP reading will be available ahead of the September meeting, which is still the consensus’ favourite for a rate lift-off. But this could be changing soon, and fast.

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