We spent a lot of time talking about the health of China’s economy in 2015, whether they would successfully avoid a hard landing, manage a currency devaluation without massively disrupting the bizarro financial world order that currently exists, and be spared from what appears to be a rolling credit crisis that started in the U.S. in 2007, spread to Europe in 2010 and is now affecting emerging markets. The volatility in Chinese equities in the first half of 2015 had little effect on global markets, until the country’s currency devaluation in early August, and then as you will likely remember the shit hit the fan in almost every risk asset on the planet. Things have most definitely chilled a bit, at least on the worst case scenarios, but it is important to note that the Shanghai Composite is down 14% in 2016, and down 41% from its June 2015 high, and remains in a fairly visible downtrend, despite the recent gains and apparent stabilization:
Shares of many of the so called H Shares listed in Hong Kong on the Hang Seng, which consists of many of the state owned enterprises that are in the FXI etf, has performed less bad ytd, down 2% and down only 25% from its 2015 highs, but also in a well defined downtrend after last year’s breakout of a long consolidation:
Why China today? Well this post on Barron’s online got me thinking (emphasis mine):
The iShares MSCI China ETF (MCHI) has risen over 22% since its mid-February low, but now the benchmark index is fairly priced and has no more major catalysts to move beyond the current level, according to UBS.
MSCI China now trades at 10.9 times forward earnings, broadly in line with its long-term average of 11.6 times. Analysts expect Chinese companies to report 4.1% and 13.7% earnings growth this year and next, respectively, but have been steadily revising down their estimates in the last two months.
The Chinese economy is a combination of loose monetary supply and weak real economic growth. This has resulted in excessive liquidity in the financial system, pushing up asset price bubbles in either the stock market, the bond market or lately the property market.
“Part of the excessive liquidity may eventually spill over from financial assets to infrastructure and industrial projects. However, the investment-led, instead of consumption-led, growth pattern has proven to be unsustainable. Moreover, it could delay, or even impede many structural reforms,” wrote strategist Wenjie Lu.
Meanwhile, a global commodity price rebound could be delaying China’s “supply-side reform” – its resolve to cut excess capacity in crowded industrial and material sectors such as steel and coal. Indeed, daily production of major steel mills has already picked up by about 10% since the end of 2015. Large steel producers such as Baosteel have announced their intent to increase output this year.
So international investors looking for structural reform will be disappointed. The MSCI China is unlikely to re-rate.
Which leads me to the FXI, the iShares Large cap equity etf with the the top 10 holdings making up nearly 60% of the etf’s weight:
You can see that aside from Tencent, the internet outfit, these are for the most part SOEs, which are heavily indebted, financial and commodity related, two of the most sensitive sectors to a potential re-rating. The FXI has risen 25% from its mid February lows, and has now paused at what could be a technical inflection point, just below its 200 day moving average at $35:
Short dated options prices look cheap relative to the 2016 and 52 week highs, with 30 day at the money implied vol (the price of options, blue below) just a couple ticks above realized volatility (how much the stock has been moving, white below). While there is clearly more room to move lower, a pick up in realized would cause options prices appear cheap on an outright basis for those looking to express defined risk directional views:
So what’s the trade?
Despite options prices looking cheap, cheap can certainly get cheaper in this sort of environment, so much like most of our recent trades detailed in the site, we want to look to finance owning longer dated options.
*Trade: FXI ($35) Buy May / Aug 33 put calendar for $1
- Sell to open 1 May 33 put at 33 cents
- Buy to open 1 Aug 33 put for $1.33
Break-Even on May Expiration:
– Max profit at $33, max risk of $1 with a sharp move above current levels, or below $33
We will look to toll the calendar or turn into a vertical put spread as we get closer to May expiration.