Why China stocks are back in favor for Wall Street

by Bernard Goyder

Since slumping to a four-month low in April, Chinese equities have rallied nearly 25% as US-China trade tensions eased. According to 22V Research, that’s left the stocks vulnerable to yet another selloff in coming weeks and months.

The end to a temporary trade truce in August, an upcoming meeting of China’s Politburo and the potential passage of the US president’s tax-and-spending package all risk reigniting turbulence in the market, 22V’s strategists say. That means now is an opportune time to buy protection against any declines in the form of three-month puts on a popular US-listed proxy for the Asian nation’s biggest publicly traded companies, the roughly $6 billion iShares China Large-Cap ETF (ticker: FXI). 

“The US-China outlook is now likely to be noisier and messier in coming months,” 22V’s strategists wrote in a note dated Friday. “If Congress passes the fiscal bill by its August recess, Trump will have less incentive to keep trade tensions in check.”

While measures of market volatility are currently subdued, the ETF’s recent history suggests some caution is warranted. In the past year alone, the FXI has weathered five swings of around 25% or more in either direction.

Meantime, cracks in the rally have started to appear. On Tuesday, US-listed shares of PDD Holdings Inc., the owner of e-commerce website Temu, took a 14% plunge, driven by an earnings miss on slowing growth.

US warnings on the use of Huawei Technologies Co. chips for artificial intelligence signal more tension could be on the way as the Trump administration looks to blunt Chinese tech advances. 

“When I look at the index and I see the realized volatility that you’ve had, you have potential events coming up and you have vol back at the lows, it just seemed to line up,” said Jeffrey Jacobson, 22V’s head of derivative strategy, in an interview Tuesday. 

Continued demand for bullish calls is in turn making puts relatively cheap, given the clear downside risks. 

Kicking the Can

Amy Wu Silverman at RBC Capital Markets said while both upside and downside options on FXI look “notably cheap,” investors are wary of hedging too far ahead into the future, given Trump’s habit of delaying tariff implementation. 

Investor sentiment appears evenly divided as skew, a common metric for measuring the cost of puts versus bullish calls, remains well balanced in global equity markets. FXI calls are in demand from investors who are the using bullish options to ensure they benefit from the upside if trade talks are successful, according to Wu Silverman.  

“If President Trump, at any given time, can add T+60 days, how can I think about the mechanism of hedging that?” she added. “That’s one reason you don’t see this massive pick up in skews.”

Pain Trade

Of course, Chinese stocks could quickly jump higher if trade talks end with a grand bargain between the US and China. 

“The risk I actually see is the idea of the pain trade being to the upside,” said Wu Silverman.  

JPMorgan Chase & Co. equity derivatives strategists see the worst of trade uncertainty in the rear view mirror, while Goldman Sachs Group Inc. is expecting the yuan to strengthen versus the dollar, boosting Chinese equities due to stronger earnings.

But others argue that China still faces significant tariff-related risks. 

To Chang Shu, chief Asia economist at Bloomberg Economics, the mood among Chinese corporates remains dour, as a final deal is unlikely to change the significant levies China now faces on exports to the US. Trump’s sheer unpredictability makes it hard to guarantee the long-term fate of any US trade detente with China, she said.

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