China Equity Bulls Find New Reasons to Get More Bullish: Options

Options traders keep finding new reasons to get bullish on Chinese stocks.

First an acceleration in government spending sent the biggest Chinese exchange-traded fund in the U.S. to a three-year high in September. After that rally faded, bulls turned their attention to the Shanghai-Hong Kong exchange connect. When inflows as the link debuted last week proved disappointing, optimists were redeemed by China’s surprise interest-rate cut.

The result is that options traders are now the most bullish on record, sending the cost of three-month puts on the iShares China Large-Cap ETF to an all-time low relative to calls on Nov. 21. JPMorgan Chase & Co., Barclays Plc and UBS AG say the People’s Bank of China’s first interest-rate cut since 2012 will be followed by further reductions as policy makers act to shore up growth in the world’s second-largest economy.

“There’s a lot of interest in China globally,” Nader Naeimi, who helps manage about $125 billion as the head of dynamic asset allocation at AMP Capital Investors Ltd. in Sydney, said by phone on Nov. 24. “I expect to see more and more demand for Chinese shares. The momentum has turned around.”

The Shanghai Composite Index is set to post a seventh straight monthly gain, the longest winning streak since 2009. Deutsche Bank’s X-trackers Harvest CSI 300 China A-Shares ETF jumped 5.1 percent in New York on Nov. 21 to the highest level since its U.S. debut a year earlier. The iShares China Large-Cap ETF surged the most in nine months.

Strike Price

Puts protecting against a 10 percent slide in the iShares China Large-Cap ETF cost 0.3 points more than calls betting on a 10 percent rally on Nov. 21, and the gap known as skew was 1.4 points yesterday, according to three-month data compiled by Bloomberg. The most-owned option on the gauge was a $55 call expiring in January. That strike price was 37 percent above yesterday’s close.

ETFs are a better way for investors to bet on Chinese stocks than the Hong Kong-Shanghai bourse program that debuted last week, according to Pauline Dan, Hong Kong-based head of Greater China equities at Pictet Asset Management Ltd. The skew on the iShares fund has remained at least 40 percent below this year’s average even as flows through the link stagnated.

China is counting on the bourse link to help open up its capital account, boost local equity valuations and increase global use of the yuan. Stocks fell in both cities as buyers left 76 percent of quotas unfilled in the first five days of the trading connect.

Opening China

“The link is definitely positive for China as this shows the will of the authorities to further open up the market,” Marco Montanari, Hong Kong-based head of passive asset management at Deutsche Bank AG, said by phone on Nov. 19. “International investors aren’t that familiar with the Chinese A-share market so they invest in ETFs to gain macro exposure to China.”

The PBOC reduced the one-year lending rate by 0.4 percentage point to 5.6 percent, effective Nov. 22, the central bank said on its website last week. The rate cut comes amid signs of deepening slowdown in the world’s second-largest economy. Factory production rose 7.7 percent in October from a year earlier, the second weakest pace since 2009, while the inflation rate held at the lowest level since January 2010.

The Shanghai Composite climbed 1.9 percent yesterday, while the Hang Seng China Enterprises Index of mainland companies traded in Hong Kong soared 3.8 percent, the most in a year. The mainland benchmark gauge rose 1.4 percent today, extending a three-year high, while the Hong Kong index gauge lost 0.6 percent.

China Restructuring

“Broad loosening in China will have a huge stimulatory effect to an economy that is already structurally in a far better position than at the beginning of all previous loosening cycles,” said Douglas Morton, head of Asia research at Aviate Global, in an e-mailed note on Nov. 21. “The rally to come should be large.”

The main beneficiaries are business borrowers, Bloomberg North Asia economist Tom Orlik wrote in a note. State-owned enterprises, real estate developers and local government investment platforms will be able to tap new loans at lower rates to refinance existing borrowing and fund new projects, he wrote.

While the rate cut could fuel a short-term rally in Chinese equities, its too early to conclude that the Chinese economy has bottomed, according to Pictet Asset’s Dan.

“The feel-good factor will be there for the next three months,” she said on Nov. 24. “We probably have not seen the worst in the Chinese economy. There are still pockets of weakness that haven’t bottomed yet.”

Rate Cuts

Even as the Shanghai Composite Index climbed to a three-year high yesterday, six of the past seven cuts to interest rates and reserve requirements have been followed by declines in stock prices over the next two months. The last time the PBOC lowered lending and deposit rates, in July 2012, the benchmark index fell 7.4 percent, according to data compiled by Bloomberg.

Valuations on Chinese equities are among the lowest in major markets, with shares on the Shanghai Composite Index trading today at 10.5 times estimated earnings and the Hang Seng China Enterprises Index at 7.4 times, according to data compiled by Bloomberg showed. That compares with 17.2 times for the Standard & Poor’s 500 Index and 16 times for the MSCI All-Country World Index, the data showed.

The Hang Seng Volatility Index, which measures the cost of options on the Hong Kong benchmark measure, jumped 10 percent yesterday after falling to a two-month low last week.

Implied volatility, used to gauge the cost of options, for three-month contracts with an exercise price 10 percent below the Hang Seng Index was 16.7 points yesterday, compared with 15.4 points for those with a strike 10 percent above, according to data compiled by Bloomberg.

No Hard Landing

While China’s economy is poised for the weakest expansion since 1990, investors shouldn’t be too concerned as along as the world’s most-populous avoids a hard landing and pursue further financial reforms, according to Macquarie Funds Management.

‘The market’s hand is off the risk-off button and now leaning firmly on the risk-on button,’’ Sam Le Cornu, senior portfolio manager at Macquarie Funds Management in Hong Kong, said by email on Nov. 24. “We’re always going to get volatile monthly data. We don’t think we’re going to get a hard landing as there would be a lot of stimulus. The stock connect is a landmark development. People need to be patient and have a long-term view to see its full effect to be realized.”

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