To The Moon

“When all the dreams drain, same are loss and gain.” – The Romance of Three Kingdoms

Key Points

- Hong Kong’s selloff and reversal last week were epic, but onshore less so.

- Short sellers onshore are wrongfully blamed, as they have been cutting positions. Net long on margin peaked with the onshore market around mid 2021, and had since entered a deleveraging phase. It will still weigh on indices.

- An onshore leverage cycle is typically ~3 years, consistent with the wavelength of 3 to 4 years in our theory of China’s economic cycle.

- On October 20, 2018, there was a meeting at the Committee of Financial stability and Development. The onshore market eventually bottomed out in early January 2019. It will take more than a meeting and a phone call to end this bear. A second low is likely. But such likelihood is less perceptible now, as the market gets swayed by the near-term momentum.

- Our trading range forecast of the Shanghai Composite continues to holdbetween slightly below 3,200 and slightly below 3,800, with the worst scenario being just below 3,000. We will continue to adjust our risk appetite according to the composite’s position within this range.

One of the Most Oversold Markets

Last week was epic. The change of index points in the past twenty days ranked among the second steepest in more than four decades, together with October 28, 1997, during the Asian Crisis, and March 20, 2020, during the pandemic. The worst twenty-day selloff occurred two weeks preceding October 27, 2008, at the depth of the global financial crisis (Figure 1).

The selloff and its dramatic reversal came at such speed that it stunned many young traders and analysts in the market. For those of us, who started covering markets since the Asian Crisis twenty five years ago, the epic volatility had spurred an innate crisis reflex attained after decades of market watching. In our report titled “The Ides of March”on Monday, March 14, we warned of the impending plunge. Then in our pre-market report titled “Another Technical Reprieve: Who Is Still Sellling?” on Wednesday, March 16, we presaged the epic short squeeze. After emerging from the vortex of trading fury, we must pause to ask why, and where to from here.

The Russian-Ukraine conflict is still raging on. And the stance of a US-led alliance is toughening. Russia is confronted by significant resources constraints and reported flagging morale. As the U.S. keeps warning of the possibility of World War III should the war drag on, all eyes are on China, an important balancing piece in this War.

Within China, opinions are split, and the debates are intense. But one can probably draw wisdom from one of China’s ancient classics “the Romance of Three Kingdoms” to understand the strategic dynamics between the US, Russia, and China. In the novel, the second and third most powerful kingdoms (the Kingdom of “Su” and “Wu”) at times joined forces to resist the dominant kingdom. At times, Su and Wu bickered with each other to maintain boundaries and balance of power, while separately growing their own military power to prepare to challenge the dominant kingdom to unite China.

It is a fascinating classic full of strategies, games, and wisdoms. I could go on if this were not a market strategy piece. For Chinese well versed in this novel, the current delicate balance in the battlefield can be appreciated.

Figure 1: All major China indices are oversold, close to their historical extremes

Source: Bloomberg, BOCOM Int’l

As Russian central bank’s forex reserve overseas was sanctioned by the US soon after the war broke out, all US rivalries must have started to ponder the safety of their USD assets. If the USD system can be weaponized, a small and open economy such as Hong Kong that is also an important financing channel for many Chinese companies must have apprehensions about being cut off. No wonder, the short-selling interest and the put volume ratio in the Hong Kong market had been at their records (please refer to “Another Technical Reprieve: Who is Still Selling?” on 2022-03-16). After the sanctions on Russia, Hong Kong appears even more strategically important for China in the overall grand schema.

The Important Meeting

on 16 March

The onshore market had also sustained substantial volatility this week, albeit to a much lesser extent when compared with the Hong Kong market. While the Shanghai Composite plunged over 4% in one day during last Tuesday’s trading, the point loss over the past twenty days was not uncommon in the past twenty years.

After lunch break on Wednesday, Xinhua announced that vice premier Liu He chaired a work meeting at the Committee of Financial Stability and Development. During the meeting, vice premier Liu addressed many market’s concerns, most notably the US-listed Chinese companies versus the HFCAA, the support for the platform companies, and the reform of the property sector, as well as monetary and fiscal policies. He also mentioned that China had been working closely with the SEC and the HKEx regarding the US-listed Chinese companies, and had been making progress.

The market immediately jolted into action. Interestingly, the Shanghai Composite initiated its rebound at 3,023, a touch below its secular trend line of 850-day moving average at 3,160 on Wednesday. From trough to peak, the Shanghai Composite recovered almost 8% in three days. And there were whispers about some hedge funds engaged in short selling had been targeted. A quick search of Soro’s books, the infamous manager who made a fortune during the financial crisis, returned no results from many of China’s online bookstores. It is odd, as Soros is worshipped by many Chinese traders as the “God of Trading”, same as the underground triads worship General Guan Yu, one of the main characters in the Romance of Three Kingdoms. Anecdotes such as this invoke the memories of the summer of 2015, when short sellers were rounded up to save the market.

Yet our data analysis suggest that the short sellers have been in retreat – since mid 2021 indeed (Figure 2). Meanwhile, China’s USD junk bond continues to plunge, together with the short positions outstanding in the onshore market. That is, short selling is not the instigator of this selloff. While the market recovery since Wednesday has been impressive, it has a different cause from what is being understood by the market.

Figure 2: On-shore short selling has been retreating since last year, together with USD junk bonds

Source: Bloomberg, BOCOM Int’l

Peaked Cycle and

Waning Confidence

We believe leveraged traders are the smarter money in the onshore market. At least, they are confident and committed. By studying their trading behaviors, we will get a glimpse into market confidence, and gauge the future direction of the onshore market.

Our data analysis shows that net buying activities in the Shenzhen Stock Exchange has peaked around mid 2021, and has been declining since. We note that the net buying activities peaked at the same level seen during the summer of 2015 – just before the stock market bubble burst. And the Shenzhen Composite has been falling in tandem (Figure 3, upper panel). We have found similar patterns in the Shanghai Stock Exchange (Figure 3, bottom panel).

Figure 3: Shenzhen/Shanghai net long on margin has peaked for the current cycle

Source: Bloomberg, BOCOM Int’l

Further, we have found a 3-year cycle in the margin trading activities in China, roughly consistent with the wavelength of our theory of China’s economic short cycle of between every three and four years. It seems that on a six-year cycle consisting of two sub-cycles of three years, the first three years are the period of substantial leveraging up then deleveraging down in margin trading, then followed by another three years of steadier margin accumulation – before the eventual violent deleveraging process, such as early 2016 and the entire 2018. Right now, it seems that the deleveraging process is continuing. If the most confidence and the smartest money is retreating, the onshore market will likely feel the pinch.

The unwinding of leveraged positions is a sign of waning confidence. It is not atypical at the end of the cycle. Indeed, such deleveraging trades will magnify the volatility that tends to be concurrent with the cycle’s end. It is just a usual part of the market cycle, and it will come and go – like the turn of the seasons.

In our 2022 outlook, we outlined our macro framework this year by examining China’s external-related macro accounts to gauge the change in dynamics between China and the rest of the world, most notably the US. We believe that exports and the current account surplus, as well as the forex deposits in China’s commercial banks have been an important source of liquidity to sustain the performance of the onshore market.

As 2022 progresses, we find that the strength of Chinese exports is starting to wane (Figure 4). This should not have come as a surprise. As the western world gradually achieves crowd immunity, production capacity is recovering and the dependency on Chinese exports is lessened. Based on this macro framework, we have been a near lone cautious voice on the onshore market. Meanwhile, Hong Kong’s export growth continued its slide for a third quarter, and Chinese exports will slow in tandem (Figure 4).

Figure 4: China mainland and HK’s exports will continue to slow; US cycle peaked

Source: Bloomberg, BOCOM Int’l

At the end of the cycle, all growth assets tend to be affected. For instance, CATL, China’s biggest new energy play, finds itself closely correlated with the NDX, the biggest 100 tech companies in the US Nasdaq (Figure 5). It is not a coincidence. After this technical reprieve, investors will once again focus on decelerating fundamentals typically featured at the end of the cycle.

Figure 5: CATL vs. NDX – both growth assets at the end of the cycle

Source: Bloomberg, BOCOM Int’l

Conclusion

Last week’s technical reprieve in offshore markets was epic, but onshore less so, as suggested by points loss over the preceding twenty days before the market rebound. Onshore, short sellers were wrongfully blamed for the selloff. Indeed, they have been retreating since mid 2021, in tandem with plunging USD Chinese junk bonds.

While Wednesday’s important meeting has addressed many market’s concerns, China does not have much sway in the outcome of the negotiation with SEC. For the past ten firms named by the SEC under the HFCAA, all had handed over the audit drafts -- with China’s approval. While Hong Kong is a natural market for the return of Chinese ADRs, Hong Kong is much less liquid than New York. Upon returning, the ADRs will suffer a liquidity discount, and will likely be roiled by the change of investor base. The sheer volume of the ADRs’ return will likely overwhelm HKEx. Of course, a special gateway can be open in the HKEx for these best-of-breeds Chinese firms to return home.

The net long on margin in the onshore market has peaked for the cycle in tandem with the onshore indices, and deleveraging appears to be in progress. The pressure on the onshore market cannot be easily dissipated by one meeting or a phone call, as important as these communications are. On October 20, 2018, during the depth of the trade war and as the US market plunging into its worst Christmas since the Great Depression, the Financial Stability and Development Committee had a similar meeting, too. But the onshore market eventually bottomed out in early January 2019. We continue to believe a second low is likely -- if history is a guide. But such likelihood will not be immediately apparent, as the market gets swayed by near-term momentum.

In our 2022 outlook published last November, we forecasted the trading range for the Shanghai Composite to bebetween slightly below 3,200 and slightly below 3,800, and the worst scenario to be just below 3,000(“Outlook 2022: Shadow Fed Tightening”, 2021-11-15). Last week’s selloff almost got us to 3,000. Our forecast range continues to hold, and we continue to adjust our risk appetite according to the composite’s position within our forecasted trading range.