China volatility in January reflects market anxiety, says AlphaShares

Jonathan Masse is a senior portfolio manager at AlphaShares, a China-focused asset manager based in Walnut Creek, California. Before joining the firm, Masse served as an institutional portfolio manager and strategist at Barclays Global Investors, where his team managed $300 billion of emerging-market assets, including $8.9 billion in Chinese equities.

At the end of 2009, AlphaShares had $540 million in assets. The company has exchange-traded funds (ETFs) on its China All-Cap Index, China Real Estate, China Technology and China Small Cap indexes. In addition, it has ETFs in registration based on its China Infrastructure and China Consumer Indexes.  

Concerns seem to be rising over the possibility of China raising its interest rates. What evidence have you seen for this, and do you feel such concerns are justified?
China's central bank sold three-month bills at 0.04% higher than the previous week's auction on January 7. That minute flap of the interest rate butterfly's wings in China caused a put-option-trading storm over the US, as the puts on the FTSE/Xinhua China 25 index traded more puts that day than it had traded options on each of the previous eight days. For the month, the put-call ratio was 2.31 versus 0.42 for the month prior, and AlphaShares' China Volatility Index [Chix] ended January 20% higher than where it started the year. So the anxiety in the options market is certainly evident.

Later that month, the central bank sold one-year bills at a higher interest rate for the first time in 22 weeks and increased the reserve ratio for its banks by 50 basis points. Policy-makers are following through on their pledge to guide credit in order to pre-empt rising inflation and avoid asset bubbles [as others have noted]. As China adopts a more prudent liquidity policy, the moves came much sooner than expected, which spooked the markets.

But overall, the moves reflect that the country's leaders are mindful that growth remains sustainable and not overheated. Fourth-quarter GDP came in at 10.7% to give the country an 8.7% growth rate for 2009, while the government target was 8%. A country growing at a carefully managed 9% growth rate in the current global environment is a good problem to have.

With regard to the recent stock-market corrections in China (and globally) -- alongside poor performance by recent IPOs in Hong Kong and Shanghai -- to what extent are further falls (or a rebound) likely, and what reasons would you cite for that?
With China stocks 19% off of their 52-week highs, valuations are in the mid-to-high teens -- valuation multiples that hardly seem 'bubbly'. While the near-term correction has been sharp, it was certainly expected in an emerging-market economy. Overall, we look at this as a typical correction in an overall bull market in a country that features higher volatile swings.

As for the IPOs in China, it is a great relief to see these actually coming to market. While they are certainly off the prices they debuted at, those sort of drops can be expected when the market corrects as much as it has. No need to go into the old 'all ships in the harbour fall when the tide goes out', right?  Meanwhile, in the US, not many new listings are coming to market, and those that are preparing for listing are getting pulled.

As for the current spike in implied volatilities in China and the US -- as per the Chix and Vix [Chicago Board Options Exchange Volatility Index] -- usually markets trend to be negatively correlated with equity-market returns. The recent spike has gotten the volatility indexes a bit out of equilibrium. When the vols return to more 'normal' levels, it usually coincides with equity markets coming back to their equilibrium levels.

What do you see as the most interesting asset class/sector in which to invest in China for the coming months, and why?
The Chinese authorities have recognised that the rapid pace of the recovery has exacerbated some of the economy's structural imbalances. In the coming year, we feel that policy-makers will focus on rebalancing economic growth, primarily by supporting domestic consumption and distributing more of the growth in the central and western parts of the country. As the government tries to spur the domestic consumer, we like the plays of consumer-sector stocks.

While we are certainly aware that Chinese citizens are considered a nation of savers, as they gain more confidence in the sustainability of the economic growth, we feel savings may decrease as consumers gain more confidence. [Such as shift] can be a very powerful change in demographics in a nation of 1.3 billion people.

Also, the government has committed to a massive investment in infrastructure to help the growth tilt towards the West. Cities in China are interconnected more than ever with state-of-the-art subways, rail systems, and highways. When you increase a country's efficiency, it is able to produce the same amount of output with fewer inputs -- and if you maintain the same level of inputs, well, you have more growth.

The massive stimulus package in China is building infrastructure that is critical for the sustainability of the country's growth, while stimulus here in the US seems to have been just a backstop for bank losses. With the government committed to infrastructure, we like stocks dedicated to that industry category.

What do you see as the asset class/sector to avoid in China for the coming months, and why?
We are very bullish on the long-term prospects of China overall. However, there are some dangerous gaps with how global investors get access to their China exposure. As global indexes are constructed from the perspective of the overall global equity market, when you carve them up into country indexes, this can be a very dangerous way to choose your country investment exposure.

In China, there are a lot of large-cap names that dominate the 'free float' indexes -- so investments based on these are faced with large exposures to single stocks and single sectors. The latter type is dominated by financial, telecom and energy stocks with little exposure to Chinese consumer companies or innovative technology stocks. As for single-stock risk, we like the cash-flow and dividend of China Mobile, but some indexes can hold this one individual name as up to 20% of their China index. So we caution investors to be mindful of the products they use and make sure that they know what they are investing in.

We offer a China All Cap ETF as a solution to investors. We limit the individual holdings to a maximum of 5% and by doing so we get a more small-cap exposure, as well as some of the more attractive investment sectors in China -- consumer, infrastructure, healthcare, etcetera -- as compared to the more concentrated products out there.

Lastly, with implied volatility trading 25-50% higher than their developed-market counterparts, we like strategies that take advantage of higher option-price premiums and turn that volatility into an asset class. An example would be buy-write strategies.