Chinese Intervention Produces Volatile Results

Chinese stocks have taken the helm as some of the most volatile globally traded assets with the slowdown in the economy contributing to downside woes in regional equity benchmarks.  The Shanghai Stock Exchange 180 Index has been one of the harder hit indices since peaking in June when optimism and sentiment stood at highs.  Policymakers at the People’s Bank of China were quick to implement measures to stem the outflows but not before permanently denting sentiment and sparking a global ripple effect that spread through asset prices like wildfire.  While the Central Bank is gradually becoming more effective at sustaining equity valuations, results have been mixed, eliciting volatile outcomes.  Continued success is difficult to fathom in light of the considerable headwinds to a brighter outlook.
 

The Fundamental Perspective

No Chinese stocks have been immune from the anxiety that has spread through markets.  Policymakers firmly intent on reducing the impact and restoring confidence in financial markets have largely fallen short of success when it comes to intervention.  A great example would be yesterday’s end of session rally which saw manic buying in the last hour of trading not long after another Yuan devaluation.  While Central Banks are known to participate in equity markets across the globe, nowhere was this more evident than yesterday’s price action where the SSE 180 Index gained 6.63% from the day’s lows to close in positive territory after spending most of the session firmly in the red.  While effective no doubt, the level of intervention raises fears of a step backwards for the Chinese economy opening up further to capitalist reforms.

Added Restrictions Adding to Volatility

Measures such as bans on short-selling and prohibition of certain language when it comes news media have largely been ineffective at quelling the volatility that has plagued the domestic Chinese equity markets for weeks now.  Arrests and probes of leading Chinese financial firms has led to renewed belief that trying to mix capitalism with a centrally planned economy might not be the best strategy for policymakers overseeing the development of capital markets.  In any event, frequent interventions are known to have explosive results.  Most of the time, short-selling bans are especially ineffective because it often results in increased volatility.  In the case of certain holders, such as pension funds and other longer-term holders, prohibitions on selling holdings also exacerbate swings.  These actions reduce overall liquidity, generating even more volatile swings in stock indices. 

The subsequent plummet and larges swings in valuations left many newly minted equity investors running for cover, with margin-debt trading continuing to fall as more leveraged investors exit.  Much of the rally earlier in the year was attributed to the sensationalism surrounding trading that lured inexperienced retail investors to take unreasonable risks.  However, the losses that followed has permanently dented confidence, seeing the retail flock exit quicker than it entered, in true correctionary form.  A look at the 1-year SSE 180 Index chart shows a benchmark that had gained as much as 130% before falling nearly 38% from highs, right into bear market territory.  The current correction underway could see additional downside of over 20% based on the pace of capital outflows currently underway.  The loss of confidence in largely reflected by the paring of margin trading debt.

Real Liquidity Conditions Remain Fragile

When taking into the stock market and the real economy, equities typically serve as a leading indicator and both are invariably intertwined.  If recent price action has anything to say about the real economy, a deceleration in economic momentum has already arrived and is not being softened by the raft of policy adjustments including devaluation, interest rate cuts, and slashing bank reserve ratio requirements.  While the measures have temporarily restored liquidity conditions and buoyed growth, the long-term impact of these policies and sheer expense are leaving many in doubt as to whether policymakers will be ultimately effective in preventing further market drops.  The slump and continued contraction in imports coupled with sliding exports is tantamount to the weakness spreading through the economy as a whole.  This is likely to be further reflected in equities as valuations slip further.

Bearing these factors in mind, it is not unreasonable that the benchmark corrects as much as 60% to reflect the softness in both the real economy and investor sentiment.  With the mounting costs of intervention likely to raise some eyebrows in Beijing, maintaining current levels of direct involvement is neither sustainable nor probable.  Eventually, market forces are likely to overpower the Central Bank’s war chest, akin to what was witnessed in Switzerland, destroying the notion of complete omnipotence.  The sooner the People’s Bank of China lets the market correct and shakeout the weaker players, the stronger the outlook for all investors.  In the meantime, rallies and upticks should be viewed as opportunities to take Put positions targeting recent lows at 6457 and 6231 on the downside over the medium-term as intraday volatility is likely to prevail.  Aggressive intraday positioning might be better substituted with counter-momentum strategies that play off the volatility instead of chasing after limited momentum.

Conclusion

Central Bank intervention works on a limited timeframe, but is not designed to be a permanent activity.  Taking off the training wheels will have to occur if China wants to restore orderly flow in its financial markets.  Despite the fact that it will have the impact of boosting investor confidence, the outlook is still grim and volatility will naturally persist as long as policies are prolonged.  The Shanghai Stock Exchange 180 Index is likely to bend to the same fate of other regional peers as the market remains firmly in bear market territory with risks remaining biased to the downside.  The medium-term outlook remains lower, meaning that Central Bank induced rallies should be considered as excellent Put position entry points.