Chinese stocks are acting suspiciously.
It has been a madcap money-making jump over the last seven trading days, capped by Wednesday's 1.6% gain in the CSI 300 index. That leaves shares in Shanghai and Shenzhen at their highest point in five years, up 16.2% in the two weeks since June 29.
But do not buy the idea that this is a secular return to risk. The powers in Beijing are manipulating the market higher. The national leadership essentially ordered Chinese stock markets to advance.
A front-page editorial on Monday in the state-run Chinese Securities Journal stated that government policy will support the market. That perceived state guarantee prompted a 5.7% jump in shares on Monday alone. The publication, an affiliate of the state news agency Xinhua, made the case for a "healthy bull" market as a patriotic duty, necessary because power rivalries are intensifying and global supply chains are changing.
The editorial also suggested that Chinese investors should look forward to the "wealth effect of the capital markets."
It's telling that the leading sector here on Wednesday, as it was during Monday's surge, is finance. China keeps its Big Four banks on a tight leash and easily can feed them credit, all the while buying banking stocks through intervention for good measure.
A stock rally is excellent public relations. Chinese shares are now up 16.5% so far in 2020, almost exactly the amount of their rally in the last two weeks. They're the only gainers in Asia, bar the 1.9% increase in New Zealand and the 1.4% gain for the Chinese-influenced stocks in Taiwan.
The state support has led retail investors to plunge head first into Chinese stocks. Mainland markets are notoriously momentum-driven, with retail punters chasing stocks when they're on the rise and complaining that the government needs to bail them out if they lose money. Capitalist concepts don't fit comfortably in a command economy directed by a dictatorship.
This wild-eyed retail participation drives notorious boom-and-bust cycles. Chinese shares more than doubled, up 149.9%, from June 2014 to June 2015. They then collapsed 44.8% by January 2016, whacking US$5 trillion off the value of the market. Excessive leverage and margin trading by retail investors left them wiped out and clamoring for governmental bailout.
Now in the 2020 rally, brokerages say new traders are opening accounts while others are reactivating dormant ones. Investors have boosted borrowing from brokerages by one-fifth, to US$1.2 trillion, in just two months, according to Reuters, while some mutual funds have had to suspend inflows because there's too much demand.
So there's concern that 2020 may be setting the tone for another out-of-control rally. Stock prices have climbed to levels last seen in 2015, during the massive run-up.
The 2015 gains were also turbocharged by official-media statements suggesting the state would support the market. That works for a while, but the Chinese government does not have the wealth to support its entire capital markets for long. It ended badly five years ago; will it again?
China claims to have the coronavirus under control, although quite what the real picture is on the ground is unclear. Still, it is true that East Asia and Southeast Asia generally have avoided the widespread outbreaks seen in India, Brazil and the United States.
In breaking down the Chinese rally, Nomura quant analyst Masanari Takada highlights two sources of speculative capital that are amplifying the state intervention. Margin trading has taken off, as has fund flows from global hedge funds, particularly commodity trading advisors, or CTAs. CTAs have closed out short positions in Hong Kong stocks, the Japanese investment bank explains, and have added to their net long exposure in China-related futures.
Chinese stocks do have it in their favor that they are relatively cheap. The CSI 300 trades at 14x earnings, compared with 27x earnings for the S&P 500.
Takada recommends keeping a "wary eye" on the behavior of CTAs and "trend-following investors taking to Chinese equities like locusts." Takada believes the bigger picture is the recovery in the Chinese economy, which is encouraging greater risk-taking from international investors.
China's GDP is rebounding from a 6.8% drop in the first quarter, the first decline on record. It is the only major economy expected to post a gain this year, with Oxford Economics predicting a 2.0% increase for all of 2020.
However, industrial profits are down to date this year and exports will suffer the rest of the year due to lackluster global demand. Widespread flooding has hit 13 provinces in central China, causing 40 billion yuan (US$5.6 billion) in direct damage so far. And the rain, seasonally strong at this time of year, keeps coming.
Hedge funds have also sold the U.S. dollar and bought the Chinese yuan. The yuan has strengthened after tensions over Hong Kong dented it in late May. Since then, it has rallied, to the point where it is now approaching the 7.00 mark to the U.S. dollar.
The foreign exchange market has developed a kind of immunity to U.S.-China tensions because they have persisted over the last few years, according to Commerzbank foreign exchange analysts Charlie Lay and Hao Zhou. The market has ignored recent negative headlines over China, including pressure over the Beijing leadership's introduction of a disastrous treason-and-sedition law in Hong Kong. The law punishes Hong Kong's free speech if critical of Beijing and brings China's legal system into no-longer-autonomous Hong Kong.
Lay and Zhou think the recent yuan rally makes sense, but the market needs to take a "prudent approach" to yuan trading, they write in a note to clients. "This is a currency that always brings in surprises."
Chinese stocks are not full of surprises when investors think they have a guarantee from Beijing that they are doing their patriotic duty to bid them up. They will surprise to the downside when the state is unwilling or unable to prop up the capital markets any longer.