The COVID-19 pandemic began in China and has since spread and pulled most of the world into an economic recession. Most equities are down 20-30% this year and are expected to have far lower earnings this year than originally expected. In the U.S., unemployment is already expected to have risen 2% and a wave of debt defaults seems likely around the corner.
One country that has surprisingly withstood the global equity crash so far is China. In fact, of the roughly 50 global single-country equity ETFs I track, the SPDR S&P China ETF (GXC) has had the best YTD performance.
As you can see, Chinese equities hardly declined during the January-February period, when the country was the only one materially impacted by the virus. At the time, it was not clear that the country would stop COVID-19’s spread.
It is true that China’s official COVID-19 data shows that it has stopped its spread, while the U.S. is now the largest carrier. However, the economic consequences remain. Recent data suggest that 5-10% of “recovered” patients in Wuhan have since tested positive again (many without testable symptoms). As the country reopens its economy, it is unclear if it will be able to stop a second wave.
The PBOC’s Power over Chinese Equities is Dying
Comparing these facts and Chinese economic data, it is clear that the country’s equity market performance is an anomaly that does not line up with fundamentals. Of course, many who believe in the power of free markets would likely take this to suggest that “the market believes China’s economic recovery will be quicker”. However, like most markets, China’s is far from free and has been backed by a ¥1.2 trillion yuan cash infusion, primarily into A-shares.
In fact, we can see these cash infusion by taking total return ratios of the Chinese A-shares ETF (ASHR) over the non-A-shares Chinese ETF (FXI) and FXI over the S&P 500 ETF (SPY). The infusion began mid-January, which corresponded with an outperformance spike in both ratios:
Importantly, the total value of the PBOC’s balance sheet declined in February, which is a sign that they did not use printed money. More likely, the PBOC sold non-yuan assets while buying Chinese equities in order to keep the yuan from slipping. As detailed in “Coronavirus PBOC Liquidity Injection May Cause Large Yuan Devaluation“, which I published on February 4th, I did not expect this to last long. Indeed, it appears that the PBOC’s power over the yuan is slipping:
The yuan is the cornerstone that holds China’s financial system together. In fact, China’s financial system is plagued by the same central bank dependency issues like that of the U.S., though perhaps to an extreme. Real estate is the base of China’s economy (nearly 70% of Chinese wealth is property), and whenever property prices fall, the PBOC creates liquidity to stop declines. Over time, this has caused China’s property valuations to be about 4X the global median.
Of course, creating money to stimulate an economy can only last for so long. China has tight capital controls to, quite literally, force demand for the yuan, but there has still been a rise in outflows. The ability of a central bank to create money can be measured by the change in M1 Money Stock (cash in existence) minus the change in inflation. If inflation is rising faster than money, the stimulus must end or else hyperinflation may ensue. As you can see below, the last data showed M1 growth equal to inflation:
(Source: Federal Reserve)
Importantly, Chinese M1 data is lagged since August 2019, and China’s inflation rate has risen from 2.5% to 5.2% over that period, meaning this value has almost certainly turned (quite) negative. The yuan exchange rate is also accelerating lower, adding a signal that the PBOC has lost its ability to stimulate the Chinese economy.
While the PBOC certainly has a few more cards than does the Federal Reserve, it has already played about all cards over the past few years. The PBOC has dropped rates too far below inflation, cut the cash reserve ratio by 40% (from 20% to 12.5%), mandated capital controls, banned short-selling, printed yuan for market stimulus, and is now selling U.S. Treasuries (to try to protect the yuan). Again, these cards have been played since the 2015 crash, and the economy has been on life support since – a life support system that is starting to fail.
Indeed, with its currency falling, there is very little the PBOC can do to protect the country’s equity market from declines. Chinese economic data continues to be abysmal and most of its companies buried in unpayable levels of corporate debt.
I believe that the current setup makes for a great short-term short trade on Chinese equities. While I rarely vouch for leveraged ETF, this is one of the few opportunities where I believe a -3X fund is worth buying. Let’s take a closer look at the Direxion Daily FTSE China Bear 3X Shares ETF (YANG), which I believe is quickly headed much higher.
Short China – One of the Least Crowded Trades
Importantly, very few Chinese companies have high short-selling due to mainland restrictions. Thus, a fund like YANG is a unique opportunity, since it is short Chinese large caps, including Tencent (OTCPK:TCEHY), China Construction Bank (OTCPK:CICHF), and Ping An Insurance (OTCPK:PIAIF). Every day, it is supposed to move -300% of the return of FTSE China 50, which is similar to the popular FXI.
As you can see below, YANG has moved about -3X opposite to FXI. This resulted in a 60% YTD gain weeks ago, most of which has since reversed:
I believe this is a great long setup for YANG and a short for FXI. Chinese equities have staved off declines due to PBOC purchasing, which will no longer work, since the yuan is declining.
Even more, China’s March economic data like PMI, inflation, and vehicle sales are set to come out over the next week and a half. The consensus is a recovery, but home sales data has remained far below past levels despite the “recovery”. Even more, as of March 24th, a quarter of the country is still not back to work. On top of that, a slump in export demand has caused a significant spike in unemployment. Based on this, I believe it is highly unlikely economic data is as strong as the market currently expects. Add on the significant possibility of a second wave as workers come back, and the situation does not look so positive.
I prefer YANG simply because I believe the current opportunity is great in the short run, as I expect a few weeks of sharply negative performance for Chinese equities. Since YANG is levered, one-direction performance like this should result in compounding as opposed to leverage decay. That said, I expect to sell the fund a month from now.
As you can see below, it is possible that YANG has some liquidity issues. Its AUM is OK at $65 million, but it did see a 2% discount during the last sell-off:
Frankly, for most retail investors this is a non-issue, as the ETF has enough liquidity. If AUM were below $30 million, the fund should be avoided. There are also far more long China positions than short, meaning there could be a rush to sell during the next decline, further boosting YANG.
Overall, it seems likely that Chinese equities are headed for another leg lower. So far, they have outperformed U.S. (and global) equities by a considerable degree. In my opinion, this is due almost entirely to PBOC injections, as the economic data coming out of China is increasingly dire.
While China may have seen a stop to COVID-19 cases, the economic consequences of it are far-reaching. Despite extreme efforts by the PBOC, Chinese property sales have declined, as have prices. While many workers are too fearful to come back, others are seeing mass layoffs and zero job openings (outside of the military).
To illustrate the extreme internal consequences, take a look at the February decline in China’s vehicle sales:
(Source: Trading Economics)
The consensus estimate is a “V-shaped recovery”, which is currently being priced into Chinese equities. While theoretically possible, it appears more likely that COVID-19 is the “straw that broke the camel’s back” due to the lasting economic slowdown of the virus.
For now, Chinese equities have staved off declines, but with the yuan dropping, that is extremely difficult without exacerbating a currency crash. Of course, declines in the yuan mean gains for YANG.
Overall, I’m bullish on YANG and expect the fund to rise 25-50% over the next 1-3 months. I would sell the fund at $70.
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Disclosure: I am/we are long YANG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Short FXI.
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