China’s Small-Cap Crash Shows What Happens Without Market Rescue

(Bloomberg) -- China’s smallest stocks are flashing a warning about the potential downside for the world’s second-largest equity market if Beijing fails to follow through on a highly anticipated rescue campaign.

While the country’s large-cap CSI 300 Index eked out a 0.7% gain on Monday after a renewed pledge from regulators to support the market, a gauge of small-cap shares sank more than 6% to the lowest level since 2018. That took the CSI 1000 Index’s losses to 27% this year after the measure underperformed larger peers by the most in more than nine years in January.

The stark underperformance suggests investors are throwing in the towel on small-cap shares out of belief that policy support will be focused on rescuing blue-chip stocks. Some exchange-traded funds tracking the CSI 300 gauge have seen record trading volume in recent weeks, leading to speculation that state funds have stepped in to put a floor under the rout. 

“The market currently relies on support from the national team and investors see the big caps as their buying target,” said Vincent Chan, China strategist at Aletheia Capital Ltd. “This discourages small-cap investors from holding onto their position as they don’t have the downside protection.” 

Quantitative hedge funds are seen to have amplified the recent selloff, and authorities have banned some of them from placing sell orders completely along with other measures, Bloomberg reported late Monday. 

In a sign of how fragile market sentiment has been, the CSI 300 has wiped out all its gains since late last month when policymakers were said to be mulling 2 trillion yuan ($278 billion) of support as part of a stock stabilization fund. Liu Yuhui, an academic at a government think tank, told a local media outlet that the nation should set up a stocks stabilization fund as soon as possible to boost market confidence, with an aim to get its size to 10 trillion yuan or more.

Investors are bracing for losses to deepen before markets close for a weeklong Lunar New Year holiday. Stocks may be sold off further as traders seek to reduce positions out of concern that risks ranging from geopolitical tensions and sluggish consumption may deepen the market’s freefall once trading resumes. 

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Some $7 trillion has been erased from the value of equities in China and Hong Kong since their peaks in early 2021 as Covid lockdowns, tech crackdowns and a property slump crushed investor confidence.

“Its looking very difficult for the next few days as sentiment is extremely fragile and many in the market would choose to cut positions before the Chinese New Year,” said Daisy Li, fund manager at EFG Asset Management HK Ltd. “The market is waiting for more forceful policy stimulus to restore confidence and the economy, which we think is more likely to come later in the second quarter.” 

Margin calls, forced liquidation faced by shareholders and selling pressure associated with so-called snowball derivatives have emerged as new risks as the slump deepens.  

The CSI 1000 gauge, frequently used as the underlying benchmark for snowballs, has nosedived as the products hit so-called knock-in levels that incur losses for investors. 

Overseas funds snapped up 1.2 billion yuan ($167 million) worth of mainland equities via trading links with Hong Kong on Monday, extending their net buying run to the fifth session. Some traders see this as another sign of national team’s action as state-backed funds can use offshore accounts to buy onshore equities. 

The China Securities Regulatory Commission pledged on Sunday to prevent abnormal fluctuations, saying it would guide more medium- and long-term funds into the market and crack down on illegal activities including malicious short selling and insider trading.     

Still, downward pressure is likely to remain strong unless bolder steps are taken to address a dearth of confidence plaguing markets. 

“Actions such as state buying are not conducive to restoring confidence which is the key here,” said Sat Duhra, portfolio manager at Janus Henderson Investors. “We are not adding or reducing current position - which is about 9% underweight.” 

(Adds details on selling by quant funds in the fifth paragraph.)

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