China’s economy has been re-appraised by the Chinese stock market in the past few months, and sentiment is becoming ever more bearish. Some, such as Jim Chanos of Kynikos Associates, have been sounding alarms since 2009, when he branded China as “Dubai times 1000”.
Wouldn’t it be nice to be able to bet against the Chinese stock market?
The country, and likely the Chinese stock market, escaped a collapse in growth around 2009 by force-feeding the economy with massive amounts of credit, causing a build-up of capacity along with a surge in debt. Last year, McKinsey & Co. estimated that China’s debt stood at 282% of GDP, and now, Michael Every of Rabobank reckons that figure may be as high as 346% of GDP.
When credit grows so rapidly, some of it is bound to be allocated into unprofitable investments, which means there will be trouble repaying the loans. Growth has slowed, but debt still rose in 2015. To keep growth from buckling, the People’s Bank of China cut interest rates six times in 2015, and the fiscal deficit is widening.
Oh, the communist government also unexpectedly devalued the currency in August 2015, causing a swift selloff in the Chinese stock market.
That said, it’s still not too late to hedge against further chaos in the Chinese stock market. Here are four ways investors can prepare their portfolios for turbulence in the world’s second-largest economy.
Chinese Stock Market Hedge #1: U.S. Treasury Securities
U.S. Treasuries are considered a “safe haven” investment, because they are highly liquid and backed by Uncle Sam himself. If China’s stock market continues to get slammed, there will be a flight to safety, increasing demand for safer assets such as government bonds.
Bond prices will go up and bond yields will fall (they’re doing this right now actually) as events in China make investors skittish about riskier assets such as stocks and commodities. Whenever investors become more nervous about global risk, they move their money to the comparative safety of U.S. Treasuries, causing the price of bonds to increase.
If you decide to bet against the Chinese stock market in 2016 by purchasing Treasury securities, you’re in good company. George Soros is long US Treasuries, as he sees a hard landing in China as unavoidable.
Investing in bonds carries some risks. Bond yields are very low, and bond prices are high, by historical standards. While worries in the markets may keep bond prices up for a while longer, there is a risk that the Fed will raise rates, making bonds already issued less attractive and causing bond prices to fall. Long-term bonds are generally more susceptible to interest rate risk than bonds of shorter maturities. There is also the risk of inflation, which is also higher for long-term bonds.
It should be noted that George Soros does not expect any further interest rate hikes by the Federal Reserve, which is why he is investing in government debt.
The yield on short-term Treasuries is quite low by historical standards.
Chinese Stock Market Hedge #2: Gold
The price of gold fell below $1,100 an ounce for the first time since 2010 last July. In August, gold bounced back to $1,160 an ounce, then dropped to $1,054 in November, and now is above $1,200 amidst ECB easing.
China devalued the yuan in August, sparking fears of a currency war in Asia. Devaluing the yuan was seen as a move to gain exports at the expense of its trading partners and to shift deflationary pressure to other countries. Analysts saw the price of gold moving back to $1,200 an ounce. In January this year, there was more talk about a possible currency war.
Gold is an attractive hedge against the risk of competitive devaluation in Asia.
Chinese Stock Market Hedge #3: Bearish China ETFs
There are inverse ETFs that track mainland China’s stock markets, such as ProShares Short FTSE China 50 (YXI), ProShares UltraShort FTSE China 50 (FXP), Direxion Daily CSI 300 China A Share Bear 1x Shares (CHAD), and Direxion Daily FTSE China Bear 3X (YANG). Inverse ETFs go up 1% when the market is down 1%, and are down 1% when the market is up 1%. They do this by trading derivatives to obtain these results. You can read more about how leveraged and inverse ETFs work here.
Inverse ETFs are more practical alternatives to shorting the entire Chinese stock market for bearish investors. Short-selling is riskier, as it exposes the investor to potentially unlimited losses but only finite gains.
However, there are many risks involved with investing in inverse ETFs. Leveraged and inverse ETFs are best used as a short-term strategy by experienced traders. Always read the fine print when investing; the Direxion website states that:
“This leveraged ETF seeks a return that is -100% of the return of its benchmark index for a single day.The fund should not be expected to provide 100% of the inverse of the benchmark’s cumulative return for periods greater than a day.“
In other words, by no means is it perfect.
Chinese Stock Market Hedge #4: Volatility Index (VIX)
The CBOE Volatility Index (VIX) is a measure of volatility expectations; it is known as the “fear index” for this reason. When the market expects more turbulence, the Volatility Index goes up; when the market expects a calmer atmosphere, VIX goes down.
Let’s say the China stock market is plunging for whatever reason: the VIX will likely go up. The VIX spiked in September 2008, in August 2011 during the US debt ceiling crisis, and soared again last August as investors repriced downside risk.
Investors can seek exposure to the Volatility Index by buying futures contracts. However, one should note that VIX futures often underperform the Volatility Index, because of contango. The futures price, the price they pay to buy the contracts, is higher than the spot price, the price at which they sell them, so investors will see a negative roll yield as the futures contract nears delivery.
You can also be long the VIX via ETPs such as the iPath S&P 500 VIX Short-Term Futures ETN (VXX). However, Robert Whaley, the Vanderbilt University finance professor known as the “father of the VIX”, cautions investors here about investing in ETPs that track the VIX. He writes that “for investors looking to hold VIX ETPs for longer than a very short period, these investments have serious drawbacks.”
At the end of the day, there are a number of different ways to hedge against a decelerating Chinese economy, or even indirectly bet on falling Chinese stock markets. Investors will just have to pick the method that works best for them.
As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.