China’s markets primed for extreme volatility in 2023
WHEN China’s securities regulator vowed to reduce market volatility in January, few predicted that this year would be one of the most turbulent in recent memory.
The drama has only increased this quarter, setting the scene for more upheaval in 2023.
Chinese stocks are now moving by 5 per cent a day more frequently than at any time since the global market meltdown of 2008. Volatility in the offshore yuan is near a record level. And the cost of insuring Chinese government debt against default has been at multi-year highs.
While market consensus is that Chinese assets will rise over the next 12 months, catalysts for extreme shifts in sentiment remain everywhere – from the risk of overwhelming infections as zero-Covid rolls back, to the lingering property crisis and a regulatory culture that never ceases to surprise. China’s relations with the US are still fraught, and the economic outlook at home and abroad is more uncertain than ever.
Traders who were burned after placing bets on a China rally this time last year are back. But they are far more cautious. The Hang Seng China Enterprises Index (HSCEI) fell as much as 3.1 per cent on Monday (Dec 12), leading losses in Asia, while the yuan weakened.
“It’s not going to be a one-way smooth ride,” said Keiko Kondo, head of multi-asset investments for Asia at Schroder Investment Management in Hong Kong. “Investor sentiment is still quite fragile – one thing people don’t want to have is too much volatility. That is why we haven’t gone all the way to overweight on Hong Kong and mainland shares.”
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Traders are expressing their caution by piling into derivatives that will pay out if stocks and the yuan come crashing down, while building a hoard of derivatives that should profit if these assets soar.
The HSCEI Volatility Index, which serves as a barometer of fear for the Hong Kong stock market, is up 55 per cent this year and far above its average over the last decade, even after sliding from its October high. While all global markets have seen volatility, the equivalent Chicago Board Options Exchange’s Volatility Index (VIX) gauge for US equities is well behind, with a 33 per cent increase since the start of 2022.
“2023 is not going to be easy,” Kieran Calder, head of equity research for Asia at Union Bancaire Privee, said. “We’re cautiously optimistic on the reopening in China. The big swing factor is how China gets out of Covid and how fast.”
Bulls are building their case on Beijing’s refocus on the economy, as officials consider a 5 per cent growth target for 2023. Achieving that goal would likely require a well-executed exit from zero-Covid, and the scrapping of further de-leveraging in the property market – two policies that have depressed the valuations of Chinese assets for almost two years.
Because valuations are so low and positioning by global investors is light after steep outflows, it will not take much for the recovery in asset prices to continue. But it will not take much to generate volatility with these ingredients either.
The language that accompanies the current chorus of “buy” calls on Chinese assets reflects a degree of caution that was not present a year ago.
“The path will be bumpy,” Morgan Stanley strategists wrote in a recent note upgrading Chinese stocks.
“Activity is restarting, but we see China on a path to lower growth,” wrote the team at BlackRock Investment Institute.
“Things could remain volatile,” said Christina Woon, investment director at Abrdn.
The case from the bears heaps pessimism on top of the same warnings on volatility that come from the bulls.
For them, the confirmation of President Xi Jinping’s third term atop the Communist Party means a continued risk for China’s financial markets, rather than policy stability.
There is little indication that policymaking will become more transparent and predictable. A case in point was health officials vowing “unswerving” adherence to zero-Covid as recently as November, only for state media to claim near victory over the virus this month, agitating markets along the way rather than calming them.
“Although some stock promoters continue to recommend China as a recovery trade for 2023, this narrative has been around since the spring, and many are giving up,” said Simon Edelsten at Artemis Investment Management in London.
For investors who target growth and a market-friendly governance framework, the arguments to avoid China over the longer term have become stronger, he said. Edelsten’s team has cut the exposure to Chinese assets in the two products they manage to a 1 per cent holding in Hong Kong insurer AIA Group.
Still, volatility may be worth the risk for shorter-term tactical traders, as beaten-down assets jump back up. Consider returns of 500-per-cent-plus for Country Garden Holdings bonds, or the rally of more than 200 per cent in shares of Alibaba Health Information Technology since late October.
“The market is likely to be volatile amid a bumpy transition period ahead,” wrote Mark Haefele, chief investment officer at UBS Global Wealth Management. “But we also see opportunities in sectors that will directly benefit from China’s shift to the eventual reopening, including pharma and medical equipment, consumer, Internet, transportation, capital goods, and materials.” BLOOMBERG
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