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This Crisis in China Could Be Worse Than COVID…

This Crisis in China Could Be Worse Than COVID…

I took a look at the iShares China Large-Cap ETF (FXI) this weekend, and noticed something surprising…

Chinese stocks have declined more as a result of recent moves by the Chinese government than they did during the COVID crisis.

FXI is an ETF that tracks Chinese stocks but is priced in dollars. I prefer to analyze FXI because that’s what we can trade in the U.S. The Shanghai Composite Index is priced in yuan, and so comes with that context. Using FXI, we get a much clearer picture.

As the global economy shut down in the first innings of the COVID pandemic, FXI fell about 27%. The S&P 500 dropped more than 35%.

The better performance in China was a vote of confidence from traders that the Chinese government could contain the economic impact of COVID.

Yet for most of 2021, FXI has fallen more than 30%. Just check out this chart:

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For U.S. investors in Chinese large caps, this decline shows less confidence in the Chinese government than there was with COVID.

It all comes down to two important moves the Chinese government has made since last August…

These Two Changes Have Crippled Chinese Stocks

Two key moves from China from the past year have impacted its stock market.

One, they cracked down on their public companies listing on U.S. exchanges. And two, more critically, in August of 2020 they introduced a new “three red line” system to penalize unhealthy real estate developers. Essentially, the financial standing of a Chinese real estate company now impacts its ability to grow debt. Under these new rules, companies with large debt loads suddenly weren’t able to grow their debt at a certain rate, if at all.

China Evergrande Group is one of the largest property developers in the world. It’s also one of the most indebted companies in the world. As I mentioned last week, its debt clocks in at about $300 billion. Backing that debt is property and other assets valued at about $220 billion.

Safe to say it didn’t pass the “three red line” test. In fact, it got the worst score. This means it legally cannot accrue any further debt. And it’s about $80 billion short of paying its current debts.

To understand the scale of the debt, consider that New York has the highest debt of any U.S. state, with total debt of about $205 billion. Behind Evergrande, the most indebted company seems to be AT&T with debt of about $150 billion.

The Evergrande crisis appears to be in the early stages. Last week, the company missed a deadline to make an $83 million payment to foreign investors. This comes after the company had started selling its properties much more cheaply than before, throughout 2021.

It’s clear Evergrande could go bankrupt, unless the Chinese government steps in.

But according to The New York Times

“The Chinese government doesn’t want to move in yet because it hopes Evergrande’s struggles will show other Chinese companies that they need to be disciplined in their finances, say people with knowledge of its deliberations who insisted on anonymity. But it has an array of financial tools that it believes are strong enough to stem a financial panic if matters worsen.

“The government is ‘still going to provide a guarantee’ for much of Evergrande’s activities, said Zhu Ning, deputy dean of the Shanghai Advanced Institute of Finance, ‘but the investors are going to have to sweat.’”

And the Chinese government has more than enough financial tools to address the crisis…

“For months, local governments have been issuing directives urging Communist Party officials and companies to look out for budding protests related to China’s troubled property developers. Some notices warn officials to monitor aggrieved homebuyers, unpaid contractors and even laid-off real estate salespeople.”

This is a crisis that could roil global markets…

But is it already priced into the U.S. stock market?

How to Play This Crisis

It helps to look at the most similar scenario in recent memory: the collapse of Lehman Brothers.

In the 2008 financial crisis, Lehman Brothers declared bankruptcy on September 15. In its bankruptcy, the firm declared $639 billion in assets and $613 billion in debts, making it the largest bankruptcy filing in U.S. history.

However, traders didn’t initially realize Lehman’s assets would cover the debts. The S&P 500 had been falling for weeks and was down more than 27% when Lehman filed.

Some, looking at Lehman’s situation, thought the worst was behind us and bought… But Lehman’s bankruptcy was the early stages of the crisis. Six months later, the S&P 500 was down another 41%.

The first signs of trouble were an opportunity to profit on the downside. Evergrande could be the same situation.

And compared to Evergrande, Lehman was healthy. Evergrande is in an $80 billion hole, and the Chinese government isn’t eager to bail it out.

A put option on FXI could be profitable as news comes out of China. The December 17 $40 put is trading for less than $300.

It could double if the crisis worsens. And if the Chinese government manages to contain the crisis, the risk is just the $300 paid to open the trade.

Regards,
Michael Carr signature
Michael Carr
Editor, One Trade

Chart of the Day:
Downside Ahead for Fintech… or Blockchain?

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Today we’re taking a look at the ARKK Fintech Innovation ETF (ARKF), which looks to have some downside ahead…

The past couple months’ price action in ARKF has formed a classic head-and-shoulders pattern. The highs in early August and now in late September are both lower than the high in early September, which appeared to buck the trend.

If this pattern plays out, ARKF could fall over 8% from these levels, revisiting prices not seen since May.

It makes sense that ARKF isn’t performing too well right now. The ETF has significant weighting toward companies involved with the chief “financial disruptor” of the moment — blockchain.

Tesla (TSLA), with its large bitcoin holdings, has nearly an 11% weighting in the ETF. Cryptocurrency-trading platform Coinbase (COIN) comes in close to 5%. And Square (SQ), a more traditional fintech making a push into bitcoin payments and custody, carries a 4% weighting.

With the recent ramping-up of talks from the SEC about regulating crypto, these three companies are vulnerable to quick, emotional reactions. And should some big news come out on the SEC’s stance that isn’t favorable, that could quickly resolve ARKF’s head-and-shoulders pattern to the downside.

Regards,

Mike Merson
Managing Editor, True Options Masters

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