How far will Chinese stocks fall?

Not that I’d recommend buying them. The sovereign risk is far too great. And it is too much fun cheering from the sidelines as a self-sabotaging CCP does itself harm.

Still, Chinese equities matters for many other asset prices beyond China. The crunch is a part of the post-COVID return to Chinese economic restructuring. The further Chinese stocks fall, the greater the contagion into other markets will become, including CNY and AUD, as well as commodities and, eventually, DM equities as well.

For context, here are some basic statistics from Goldman:

The other major story of the moment is obviously China, which to my eye is multi-fold: (1)growth peaked in Q4, again perhaps illustrative of what a true V-shaped recovery looks like on the backside; (2) authorities have been tamping down on financial conditions through various mechanisms–and, judging from Shenzhen property prices, they’re now getting what they want;(3) government policy towards their largest and most prolific tech companies is increasingly pernicious.my instinct is these are highly calibrated situations … which suggests the negative impulse should only go so far … and, perhaps things have tentatively inflected to the positive side this week … but, you tell me where the lines are ultimately drawn. What I do know is this: to this point, the China variable has been very compartmentalized and the reaction function of market participants has been to switch out of the “Chinets” and repatriate into US mega captech.I think the magnitude of that technical is very important, given these were the two single best destinations for global equity capital over the past 13 years.

As mentioned, it’s been a very difficult stretch for mega cap Chinese tech names (red line). As you can see, after a structural bull market that peaked in February, an enormous amount of market cap has been destroyed…seemingly to the benefit of their US peer set (green line):

By any measure, this has been a significant selloff in Chinese equities, equivalent to the magnitude of 2018’s selloff:

Morgan Stanley reckons it’s not over yet:

#1-I think the current selloff is only comprised of two parts–(i) negative sentiment on the regulatory tightening, and (ii) lowering growth expectation; and we are not yet having the effect of redemption (i.e.fund outflow) to come in play. The market is now “resuming normal” in valuation, but not yet at discount. Stay vigilant. Below ad hoc charts illustrate why we remain cautious view.#1–the recent selloff is quickly narrowing the valuation gap we have been tracking, but there is potentially another -10% downside to fully close the gap (i.e.there is further downside to fade out all the previously priced-in optimistic premium.)

#2-Market risk sentiment from global asset owners remain neutral. That said although the selloff among Chinese Tech/Growth names have been significant, we are not yet at stage of panic selling. Investors are still selectively trimming exposures by industry.

#3-Redemptions or outflows from China active fund is not yet in effect. But with the big drawdown of Growth names, especially names like TAL/EDU, are commonly OW positions in portfolio, we expect the performance driven outflows will soon becoming in effect. Our clients shared that their CIOs are calling for meeting to discuss how to prevent or to minimize the risk of other large-cap China names would not repeat the story of TAL/EDU.

Lombard offers a sober take:

After an overhaul of the for-profit education sector caused related stocks to plummet almost 70%in two days, thereby triggering a wider move in China tech and onshore indices, authorities have attempted to stem equity market damage. Since Monday, state media have repeatedly emphasized the strong economic fundamentals and “accommodative monetary policy” supporting stocks. CSRC, the securities regulator, has tried to assuage fears by reaching out to leading foreign investment houses. Markets have rallied in response, but the rhetoric does not signify a change in policy stance. Beijing will continue to manage the economy and markets to maximize State-Party objectives. Investors need to price in a more pro-active regulatory position from authorities. This clearly points to both threats and opportunities–particularly in onshore equities. China has always been a policy-driven market. Beijing regulates capital to prioritize policy-favoured sectors and penalize those that detract from national objectives. At a macro level this led to the 2015-16 boom-bust market: Sectoral examples are luxury goods and liquor stocks (anti-corruption) as well as property. The difference now is the unprecedented speed and scope of the regulatory crackdown.

As Table1 above shows, regulatory action since the nownotoriousJack Ma speech inOctober2020 has been wide-ranging but always in line with clear national policy objectives. In December, we outlined the rationale behind crackdowns on Ant Financial and Alibaba, namely financial risk control and improving the position of gig economy workers, SME users of large platforms and smaller tech firms. Both axes of attack have proved successful. Ant and the wider fin-tech sector are restructuring and raising capital buffers, while Alibaba, Meituan et al. haveraised salaries and offered health insurance to gig workers. Tech small caps have handily outperformed wider indices (see Chart 1 below).

The surprise hit to Didi came from the national security realm.InChina’s Push for DataSovereignty, we noted Beijing’s belief that “without data security, there is no national security”. We expect the ongoing cyber security review to leave the state with an effective veto on all future offshore IPOs. Data sovereignty is likely to prove an area of growing friction in China-US relations; at the same time, it will add further complications for non-China firms’ operations ontheMainland. The recently passed Data Security Law provides for a wide degree of extra territoriality, allowing the management of Chinese data to be regulated anywhere in the world. Thesoon-to-be-passed Personal Information Protection Law, a GDPR-type piece of legislation, will significantly increase regulatory scrutiny over personal data collection and management.

With hindsight, a move against private education was foreseeable: Xi Jinping’s had spoken outagainst for-profit education in speeches in 2016 and 2017, while the Committee on Educationmeeting was the only one to be personally chaired by Xi at this year’s National People’s Congress.Lowering the cost of non-state education in an attempt to boost birth rates and reduce inequalityis something other East Asia countries have tried–to little avail.

The knowledge that their losses are part of Xi Jinping’s‘China Dream’will be cold comfort toinvestors.However, the framework for analysis is important to assess future risks andopportunities. Beijing has clearly stepped up the pace and scope of market intervention. Therecent sell-off may provide a temporary reprieve, but the fundamental approach that markets serve the Party and the real economy first and investors last will persist. This means an even greater weight for policy in stock/sector selection. Core national objectives, technology self-sufficiency, advanced manufacturing prowess,green developmentand higher consumption allcover a range of sectors that should benefit from greater state intervention.

The elephant (or dragon) in the room is the VIE structure.Since 2000 Chinese firms havegenerally used a VIE model to list overseas. This convoluted method avoids direct foreignownership of the underlying PRC company. An ADR in the IPO’d company buys exposure to a(shell) company incorporated in the Cayman Islands. Which, in turn, owns a contractualagreement with the nominee shareholders of the China-based business, which confer some powers. What this largely means is all the economic benefits and all the expected losses of theChina-basedbusiness–in short, a controlling interest but not a controlling stake.

The VIE model has never received official approval. Despite their questionable legal position. VIE listings have generally provided good returns to underwriters and investors. VIEs workedbecause prospective profits trumped fear of regulatory scrutiny. The current crackdown hasshifted the equation; and for the time being, fear outweighs greed and investors will need adiscount to buy in to Chinese ADRs. Our EM strategy team has been underweight MSCI Chinasince April this year and was at a maximum underweight going into July.

In short, the uncertainty adds conviction to our RMB depreciation view (we express this via a shortCNY/JPY trade).We also note that China has in effect placed a veto on new overseas listings andis actively favouring Hong Kong as the offshore market of choice. The status of theapproximately US$4trn in VIE-listed China equity isless certain. In the near term, changes in theVIE structure are unlikely. Cancelling US$4trn in shares would severely damage Chinese capitalmarkets, not to mention relations with Washington and Wall Street. Longer term, as pressurefrom regulators on either side of the Pacific mount, scrutiny over VIEs will only increase. We willexamine the prospects for the VIE structure and foreign investment in Chinese equities in a seriesof notes beginning next week.

Recent events are nota signal to disinvest fromChina.It is prudent to run the rule over existinginvestments, and to rotate towards sectors which are more likely to be treated favourably bypolicymakers. But recent events remind us that risk exposure is not worth paying any price for:policy risk premium is set to rise.

The further the bust runs, the more our global growth risk scare thesis will come into play.

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