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EQD Research: Executive Order Impact On China Index Derivatives

May 15, 2021

By Russell Rhoads,
head of research

Recently I was catching up on the goings on in the equity derivative space and came across an article discussing the impact of President Trump’s executive order banning investment in companies tied to the Chinese military. In Trump ban on Chinese stocks sinks demand for index options in Hong Kong the author highlights a dramatic drop in option volume during the first quarter of 2021 which was an ancillary result of the ban on certain Chinese equities. The indexes that include these banned stocks fall under the executive order which results in many market participants being excluded from this market.

The timing for many investors is less than ideal as economic conditions are recovering in China and equity valuations are low relative to both history and when compared to other emerging and developed markets around the world.

There are several indexes that measure the performance of Chinese equities and most have been impacted by the executive order, but not all have been.  A prime example is the FTSE China 50 index which changed membership in order to exclude any companies that fall under the executive order.  The chart below shows the performance for the FTSE China 50 index compared to several other major indices focused on China.

Data Source: Bloomberg

The FTSE China 50 is highlighted on the chart showing how it fairs performance wise relative to other China focused indices for the first four months of 2021. This period has been very volatile for all these indices with gains of 10% to 25% in the first few weeks of the year and then a reversal that pushed all lower by about 20% from their highs and many into negative territory for 2021.

The common price behavior is pretty obvious and it also shows up in the correlations as for the first four months of 2021 between the FTSE China 50 and the other indexes ranged from +0.70 and +0.97. This indicates the FTSE China 50 index and related derivatives offer similar performance to those other indices while assuring compliance with current US stipulations around investing in China.

There are some other differences worth noting with respect to some of the other major indices included in the previous chart.  First the Hang Seng China Enterprises Index (HSCEI) is an index that represents mainland China stocks listed on the Hong Kong exchange, however, there are members of this index that fall underlying the investments falling under the US sanctions.  The Hang Seng Tech Index (HSTECH), as the name indicates, is considered similar to the Nasdaq-100 in the US with a focus on technology stocks.  HSTECH performed very well over the past few months, but recent performance has suffered a bit due to recent sector rotation.  Finally, the MSCI China index offers broad exposure to Chinese equities, but includes shares of firms not trading on the Hong Kong market.

The reversal in performance of Chinese stocks is not justified due to any change in fundamentals. There was no economic factor that impacted earnings or growth estimates for 2021. In fact, earnings growth for Chinese stocks is expected to rival that of US stocks in 2021. While major indices focused on China are well below their all-highs, comparable US indices such as the S&P 500 are near their highest levels on record.

A sporadic trend related to Chinese companies involves raising money though listings on the Hong Kong exchange as opposed to raising money in the US markets. This shift from the US to Hong Kong is expected to provide a tailwind for Chinese equities as this trend continues.

Long term growth trends for China should remain strong for several years to come. Also, the Chinese economy has been transitioning from manufacturing to focus more on the consumer. This transition will benefit consumer related firms and three of the top five firms in the FTSE China 50 index fit this description. Communications focused firms also thrive in a consumer driven economy and two of the top ten companies in the FTSE China 50 fall in this sector.  The top ten components of the FTSE China 50 as of the end of April appear in the table below.

Top 10 FTSE China 50 Components As Of April 29, 2021

Data Source: Bloomberg

FTSE Russell rebalances and reconstitutes this index each quarter. In addition to any appropriate changes to the constituents, based on new issues or changes in market capitalization, any stock representing more than 9% of the index is reduced to a 9% weighting in order to assure the China H50 offers a diversified look at listed large cap Chinese companies.

For those that need exposure to Chinese equities, SGX introduced futures contracts on the FTSE China 50 in November last year and options on futures in March. The SGX FTSE China H50 Index Futures contracts are gaining traction with open interest across all contracts recently coming close to 1,000, a pretty impressive number for a market that is less than six months old. There are monthly futures contracts with three near term expirations on the screen as well as longer dated quarterly contracts available through March 2023. SGX FTSE China H50 Index Options have also gained some traction with traders focusing on a shorter term outlook with both bullish and bearish trades hitting the tape.

This year has been very volatile for Chinese stocks with a huge rally followed by reversion to what amounted to a correction for all indicators of equity performance in China. Based on the state of the world it is quite possible this sort of volatile price action will continue over the course of 2021. Regardless of your jurisdiction, there is one place where hedges or speculative positions can be implemented based on a short or long term outlook through the SGX FTSE China H50 Index Futures and Options.