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Chinese Stocks Get Slammed as Regulators Pull Back Support

Chinese Stocks Get Slammed as Regulators Pull Back Support

2015-11-27 14:09:00
James Stanley, Strategist
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Talking Points:

-Chinese stocks saw huge declines after news of a widened regulatory probe into Chinese brokers hit markets; brokers Citic Securities and Guosen Securities announced they were under investigation.

- This was an extension of the November 6th move in which Chinese regulators rolled back emergency measures; re-allowing Initial Public Offerings and increasing margin requirements.

- The Shanghai Composite was down by -5.48% and the Shenzhen Composite was down by -6.09%, as concerns raged that Chinese regulators may be pulling back emergency measures too soon, as Chinese data continues to disappoint and the Federal Reserve is looking primed to hike rates at their December 16th meeting.

It’s been a relatively quiet three months for Chinese stocks, at least until last night. After the voluminous drop towards the end of the summer that saw as much as $5 Trillion erased from Chinese Market Capitalization, support came in around mid-September as the numerous stimulus actions from China began to show promise (or hope, which can’t quite be differentiated considering that the ramifications of these stimulus actions haven’t completely shown in the data as of yet). But stock prices started going back up, confidence began to show again, and for all intents and purposes, it was beginning to look like the global economy was back to its bullish ways that have denominated the past six years of price action. The low was set on Shenzhen Class-A shares on September 15th, just a day after another batch of abysmal data drove stock prices lower.

But a continual onslaught of government-designed measures to reinvigorate the economy and the stock market provided enough impetus for investors to jump back into risky assets, Chinese stocks included, even though we had just seen a major bruising in these asset classes. As an example, Shenzhen Class A shares were down by as much as 50% from their June highs. But one of the consequences of ZIRP means that there aren’t many attractive asset classes to invest in, given that rates are continuing near record-lows, and as the Federal Reserve appears to be on the cusp of kicking on a rising-rate cycle that will see interest rates drive higher in the coming years, Fixed Income investments look downright disgusting.

Inflation and higher interest rates are a bond investor’s worst enemy, as they eat away real-return and knock-in principal should rates rise. If you buy a 2% bond today, who in their right mind would pay you full par in 5 years when they can get the same type of bond (maturity, credit quality, etc.) with a 5% coupon? They wouldn’t, so you’d have to take a discount on the bond to get the ‘Yield to Maturity’ close to that 5% marker just to make it attractive in the secondary market. This is just another reason that so many people around-the-world jumped back into stocks so quickly; there is a dearth of other attractive areas to store money. This led to a screaming comeback in many risky asset classes, Chinese small-cap stocks no different. On the chart below, we’re looking at the two very different phases that have engulfed Chinese equities over the past 6 months.

Chinese Stocks Get Slammed as Regulators Pull Back Support

Created with Tradingview; prepared by James Stanley

Making matters even more confounding, the past two months haven’t exactly seen a lot of ‘great’ Chinese Data. We’ve seen a massive drop in both imports and exports, which for a still-industrialized economy like China, that’s dangerous. The shocking number was the hit to imports that was printed in Mid-October, as imports into China were down by a full fifth – a contraction of -20.4% from a year earlier. This is really dangerous for an economy like Japan, who is already teetering on the precipice of disaster as three years of heavy QE have been unable to bring inflation back into the Japanese economy. Just a week after that abysmal trade report, we saw Chinese GDP print below 7% for the first time since the Financial Collapse. But for Chinese stocks, at least during October, none of this fear or concern seemed to matter. Central Bankers, once again, had our (investors) back.

However, the month of October appeared to have been a peculiar turning point. We had started out the month with the old ‘bad is good’ theme, under the precipice that additional bad data would mean even more accommodation out of Central Bankers (looser for longer). This was somewhat of the background behind the Fed’s decision not to hike in September, as they wanted to ‘monitor international developments.’ But as asset prices came screaming back, and as some US data appeared to be at least a little more positive (like the blowout NFP report to kick off November), we started to see a shift from the Federal Reserve towards bringing that 2015 rate hike back on the table.

You might be asking yourself, what do Chinese stocks have to do with the Federal Reserve’s decision to raise rates in 2015? It’s all connected: This is globalization. The thought of a major economy like China or Europe going into full-blown recession without so much as a hit to the US economy is an outlandishly outdated prospect that comes from an idea of a world that revolves around the United States (much like people 600 years ago believing that the solar system revolved around Earth). In the 80’s this type of thinking may have led to some proactive analysis in *some* situations, but today, its worthless. We’re all in this together.

At the October Fed meeting, we heard the Fed pull back their concern for international developments, as they removed that critical phrase of ‘monitor developments abroad.’ This led to even higher stock prices as it was taken as recognition of health in the global economy, given that the largest national Central Bank in the world felt bullish enough to bring that 2015 rate hike firmly back in the cross-hairs of markets. This hastened that move higher, and brought stock prices right back up towards that 2,000 psychological level, and once that November NFP report hit markets, the December rate hike looked like it was a fairly certain prospect. As we can see in the chart below, the S&P rallied up to a new, lower-high as this cascade of motivation hit stock prices:

Chinese Stocks Get Slammed as Regulators Pull Back Support

Created with Trading Station II; prepared by James Stanley

In the chart, we can see that this isn’t quite a bull market like 2011; as there are technical reasons that may suggest that a top is already in place off of that 2,137 level that was hit earlier in the summer. We discussed this just a couple of weeks ago in the article, S&P Downward Channel: Bull-Flag or Top in Place?

But what is perhaps more concerning is that as these gains have become further ‘cemented’ in markets by continually rising prices, we’ve seen Chinese regulators beginning to pull back support as they near their bid with the IMF for the Yuan to gain SDR-status. As part of this bid to gain reserve status, China has been attempting to move to a more market-based economy that doesn’t have as large of a role for the government. The major market declines in June, July and August didn’t help that bid at all, as regulators had to roll out stimulus measures to counter the massive declines being seen. In August, the IMF used this as reason to not yet grant China reserve-status; but they did grant an extension to give regulators more time. But after President Xi’s trip to the United States in which Obama backed China’s bid for reserve status, the IMF came to the table with an implicit recommendation to include the Yuan in the SDR-basket. And with support from all major stakeholders in the IMF, the last remaining step is seen as a rubber-stamp approval from the IMF’s executive board.

On November 6th, Chinese regulators made the first overture towards re-opening their markets by lifting a freeze on Initial Public Offerings, increasing margin requirements, and removing a requirement for securities firms to hold net-long positions. These measures have seemed to go off without a hitch, as stock prices have continued going up despite the continued softening in underlying economic data.

But on Friday, we saw even more signs of Chinese regulators changing their tune as they announced a widened-probe into the Chinese brokerage industry. Combined with a report that showed industrial profits contracted by -4.6% in October, stocks sold off as the announcement of this widened-probe was coupled with statements from Citic Securities and Guosen Securities that they’re under investigation for alleged rule violations.

The troubling part of this was that Chinese stocks went down, and did not come back up. The Shanghai Composite was down by -5.48% last night, and the Shenzhen Composite was down by -6.09%. The late-session ramps that have become accustomed in Chinese equities were noticeably missing last night, and the fear is that the state-sponsored buying that many accused the government of in August is coming to an end, as regulators look to exhibit less ‘control’ over markets as this bid for SDR-inclusion nears completion.

The big question is what happens after another 20% move? Will Chinese regulators step back up to the plate? Or are they committed to market-based reforms enough to let stock prices move lower, risking dissension within the populace, in the effort of ‘developing’ their economy.

The one thing that is certain is that the month of December will likely be full of fireworks for investors; and as is usual in markets, the biggest risks are the ones that we don’t yet see. If you want more of a back-ground on the state of the global economy heading into December, check out our article from Tuesday entitled, The Top Three Risks Facing Global Markets Right Now.

--- Written by James Stanley, Analyst for DailyFX.com

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