When Kevin Smith realized late last year that China was getting serious about defending its currency, his first move was to dial back bearish bets on the yuan. His second move: double down on wagers against Chinese stocks.
Smith, whose global macro hedge fund has returned about 350 percent over the past decade, says China’s attempts to prop up its currency are tightening domestic monetary conditions and making a credit crisis increasingly likely. To him, that means shares of banks and other “zombie” companies may be the first dominoes to fall as China faces a reckoning after years of debt-fueled growth.
“These recent monetary tightening measures point to the increased risk that Chinese officials will trigger the credit crisis first,” said Smith, the Denver-based founder and chief executive officer of Crescat Capital, whose China bets in the global macro fund returned about 3.4 percent last quarter. “It really only increases our conviction that there are opportunities on the equity-side short, particularly if they continue to defend the currency.”
While Smith’s pessimism clashes with consensus calls for a soft landing in Asia’s largest economy this year, his bearish view on stocks appears to be gaining traction. Speculators in the U.S. have boosted short sales of an exchange-traded fund tracking China’s domestic equity market to a one-year high, while the CSI 300 Index has slumped more than 6 percent since the end of November. In the latest sign of investor nervousness, shares in Shenzhen and Shanghai dropped suddenly on Monday afternoon, before recovering into the close.
A deeper slide would re-focus global attention on a $6.5 trillion market that proved remarkably resilient in the second half of 2016 as the yuan sank to an eight-year low. Stocks have gotten support from purchases by state-run funds, along with China’s broader effort to backstop the economy with fiscal and monetary stimulus.
Smith says the era of easy money in China may be coming to an end. The nation’s three-month interbank lending rate, known as Shibor, has climbed for 62 straight days, while the average yield on top-rated, five-year Chinese local corporate bonds just posted the biggest quarterly jump since end of 2013. The move was partly explained by rising interest rates globally, but government efforts to support the yuan have accelerated the trend by removing liquidity from the banking system.
The People’s Bank of China didn’t immediately reply to a faxed request for comment.
Smith, who oversees about $96 million and has been betting against the yuan for most of the past two years, said he exercised two bearish options at a profit before a short squeeze on Jan. 4 sparked record gains in the currency offshore. He decided not to roll over the contracts, opting instead to increase his short sales of Chinese exchange-traded funds.
He has bets against the iShares MSCI China ETF, the iShares China Large-Cap ETF and the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF, which all have heavy weightings in Chinese lenders and other state-owned companies. Short interest in the CSI 300 fund climbed to about 13 percent of shares outstanding on Jan. 12, the highest level since the start of 2016, according to data compiled by IHS Markit and Bloomberg.
While Smith expects the yuan to fall below 8 per dollar by year-end (a nearly 14 percent slump from its level on Monday) and still has some wagers against the currency, he’s holding off on new positions for now. If a crisis in Chinese debt markets forces authorities to flood the banking system with cash, that will be the time to go “heavy” on bearish yuan bets, he said.
“Clearly China is taking extreme measures to defend the currency,” Smith said. “They are making a strong statement, but I don’t think it’s sustainable.”