Thursday, June 3, 2010 0 comments ++[ CLICK TO COMMENT ]++

Shorting China... more complicated than it seems

I ran across a brief article in The Economist (from May 27, 2010) describing various ways to short China. One of the readers of this blog commented on this topic recently and I thought I would quote the article:

Futures and options markets for equities either do not exist locally or barely trade. It is possible to buy credit-default swaps (CDSs), a form of insurance against default, on China’s sovereign debt, but few think that would really go belly-up anyway. A pair of widely circulated reports on how to hedge a downturn, written in April by Goldman Sachs (stamped “highly confidential”) and Morgan Stanley respectively, spell out some of the alternatives for investors. In each, the underlying idea is similar: if shorting China is impossible, find things tied to China.

In Morgan Stanley’s view, that means starting with various financial assets—shares, credit instruments, and currencies—in South Korea and Australia (see chart [not included]), the two countries with the strongest connections to China after adjusting for re-exports. Both places offer numerous financial products, such as exchange-traded funds linked to indices, that can be shorted. The report also cites three commodities that are particularly tied to China’s growth: copper, above all; then soyabeans; and oil.

In its hedging scenarios, Goldman’s report concentrates on some different products. It looks at the value of buying CDSs on Hutchison Whampoa, a telecoms company in Hong Kong with deep ties to China; an index of Asian (excluding Japanese) CDSs; and a combined option structured to benefit from a decline in the Australian dollar, Goldman’s own commodities index and the Hang Seng China Enterprise Index, comprising Chinese companies listed on the Hong Kong stock exchange.

I don't think I will take a short position against China. I am not skilled enough on these macro shorts. Furthermore, the upside is only 100% unless you use derivatives such as options, futures, or CDSes. Nevertheless, it's interesting to think about it. At a minimum, it may prevent you from being overly exposed to the problem areas if the bear case does unfold.
The tactics outlined by Goldman Sachs aren't really suitable for amateur investors (you would have a hard time getting access to the CDS market.) But the Morgan Stanley suggestions are worth paying attention to. I'm not really surprised by any of the suggestions, except for soybeans (it makes sense but I never stopped to think that China drove that market.)
Even if one didn't attempt to profit off a bust, it may be helpful to be cognizant of various outcomes if a bust does materialize. For instance, if you a concentrated investor in commodities, I would pay greater attention to the three commodities mentiond by Morgan Stanley. There are numerous factors that can impact commodity prices but one should be prepared for big long-term declines in copper, soybeans, and oil if there is a bust in China.
Are These Crowded Trades?
On another note, the same article quotes a hedge fund manager as saying that the China short case is a crowded trade. I find this interesting. In my opinion, this is definitely not a crowded trade. I say that because the worldwide consensus (in regards to Chinese GDP growth, auto sales, oil consumption, real estate prices, corporate profits, etc) appears to be firmly behind the bullish case.
Yet, the hedge fund manager, who is likely exposed more to the assets in question than I am, clearly feels it's a crowded trade. I suspect he/she thinks that because the tactics to short China may indeed be crowded. For instance, it wouldn't surprise me if there is quite a lot of money bet in the CDS market on a real estate bust in China. But does this really mean the overall stance is crowded?
I would say no. I think what matters is the overall picture and not necessarily individual pockets. If you look at past bubbles, some bearish bets have always looked crowded but turned out to be right. A few years ago, near the peak of the US real estate bubble, it wasn't uncommon to see bearish stories and even some bearish investment suggestions (such as going long gold) appear to be overly crowded. Yet it was the correct move because the overall market maintained a bullish view of real estate.
Similarly, those shorting financial stocks in 2007 and 2008 (after the start of the crisis but before the Lehman bankruptcy) looked like they were in a heavily crowded field. There were many months when it seemed like every bear was short one financial or another. Yet, as crowded as that trade was all throughout 2008, it was the correct move. Many of the financials are still way off from their 2007 prices and may never get back to those levels for years. In fact, if it weren't for government bailouts and transfers of wealth to those financial institutions, those shares would be far lower than where they are priced now.
So, even if a trade looks crowded, I think what matters is the general consensus. Right now the consensus is still very bullish on China IMO. One just needs to look at oil prices to see what I mean. So even if the China-short tactics look crowded, it doesn't necessarily mean they won't work.


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