A few thoughts on Chinese equities

Photo by Hanny Naibaho on Unsplash

We started writing this blogpost on Monday morning before all the fireworks from the CCP arrived so we thought we’d just adapt it a bit and put it out anyway. It was going to be a review of short term trends and why we think it’s possible we are reaching an inflection point. It was going to discuss positioning, sentiment and all those other wonderful things. But then some interesting developments happened this week and it triggered a thought about the long term too.

It’s easy to intellectualise when analysing the state of Chinese equities today. China is COMPLICATED. We would argue that an analysis paralysis only ends up making an investor more confused. Doctorates and papers can be (and are) written on every single aspect of the system of governance, the economy, the effect of global macro, the liquidity environment, the geopolitical environment and that is before we even get to the various sectors and company fundamentals. It’s a massive amount of detail to wade through.

Regular readers will know that our approach to investing in China is very simple. Just listen to what government is telling you. They always do. The shift from investment to consumption? They told us that. The shift to smashing the internet companies? Loud and clear. The government has never been interested in promoting its stock market to the same level of mind space in the heads of its citizens as we see in the US given the differences in governance systems. The CCP has never been interested in creating a stock market culture. Further, the state-governance model is not conducive to companies maximizing profit for shareholders. This is a lesson that most investors have learned the hard way over the past decade or so. It is a lesson that Russian investors also learned – likewise, the hard way. This has been our view since the very beginning. Having had the benefit of being short Russian stocks for many years before, we were ready when Chinese inflection point came (and also able to swing trade the cycles along the way).

We have been thinking that another one of these inflection points is looming based purely on instinct and the extent of the selling and negativity on China but without any real evidence and with price action being very weak. So when this week’s series of announcements came out, we saw the usual suspects: some kind of liquidity stimulus for the market, restrictions on short selling, cutting the RRR for the banks etc. Rinse and repeat. All very important in trying to work out the direction for a swing trade long. But nothing game changing.

Or was there?

One particular announcement really did get us to stand up and take notice. And this was the announcement regarding state-owned enterprises. SOEs are the bedrock of the Chinese economy. The announcement amounted to something along the lines that Chinese SOEs would be incentivised according to stock price performance by introducing a number of market-friendly measures. This all seems rather innocuous and wordy but we know from history that when Chinese politicians through the hierarchy are incentivised to do something, they do it. Want them to invest in tech? They will overinvest. Want them to invest in chips? They will overinvest. They will do whatever it takes to make sure they impress whoever is above in the hierarchy and do so with zeal. And its possible when they are told to make sure their stock price goes up, they do.

This is why it is so important to understand who the market participants are in the Chinese markets. Who are the marginal buyers of stocks? In China, even today it is overwhelmingly retail! And we saw immediately after this announcement a rally in Chinese listed SOEs as retail investors punted immediately. Foreign investors set the prices in the US-listed stocks but this generally is a following act on what happens locally.

So does this make us bullish on Chinese equities long term? Not yet, as not enough time has passed to see what this means, even just as a starting point. But it’s possible we see a ray of hope. And coupled with the short-term stimulus measures, the extended short trade, the dramatic under positioning in stocks and the depressive sentiment, there is enough there for a large move.

And just as we complete typing this short post, Goldman released a piece about China flows and positioning including this chart showing how this past week saw the biggest week of inflows to China equity funds since June 2015. This hints to us that whatever is happening could well be different to anything we’ve seen in the many false starts over the past 9 years.

Here is another chart from GS’s note, showing Chinese allocations in GS’s prime book as well as in active funds globally

Is it possible that it’s another head fake? Absolutely! And that’s why the price action is so critical to monitor. But it sure is food for thought. Nothing of course happens in a straight line but to us the risk/reward for a swing trade is better than it has been in some time. And who knows, maybe there is even hope for something more than that? As the famous market saying goes: One makes more when things go from very bad to just bad than when things go from bad to good.

Maybe that’s where we are with China.