Snowballs and the Chinese Market Meltdown
From the midst of a Chinese market meltdown in January, a new villain has emerged – “SNOWBALLS”!
According to Bloomberg, snowballs are structured derivatives sold in China which are tied to the performance of an underlying index — offering to pay investors bond-like coupons and return principal as long as that index stays within a predetermined range.
Simply put, as markets have declined, certain protective features of derivative products sold to retail investors have run out, triggering another vicious cycle of selling as market participants seek to manage risks and limit damage.
Let’s lay a little groundwork first.
Despite a respite in February brought on by the country’s sovereign wealth fund saying it would step up to buy equities, it’s been a rough start to 2024 for Chinese stocks. The Hang Seng Index is down -6.9% YTD through 2/8/24 and the tech-heavy Shenzhen Component Index is down -7.4% YTD. That’s on the heels of a relatively horrible 2023, in which Chinese stocks (as measured by these same indexes) were down -10.5% and -12.3%, respectively, vs. the S&P 500 Index’s return of 26.3% and the MSCI ACWI ex-US Index’s return of 16.2%. (Source: Bloomberg)
Certainly, most of the blame for this poor performance can be laid directly at the feet of the Chinese Communist Party (CCP). Their idiosyncratic intervention into financial markets, politically motivated meddling in business affairs, and toxic regulatory regimes, have led many investors to conclude that the country’s leaders are downright anti-business, especially as it relates to technology companies. This latest round of non-capitalist behavior all really started when Jack Ma, founder of Alibaba, made some critical comments about the Chinese financial system back in October 2020. Almost immediately, authorities shut down the imminent and largest ever $35 billion IPO of its sister company, The Ant Group, at a $313 billion valuation. Jack Ma all but disappeared for months – although, strange sightings were reported including a short so-called “hostage video”, a visit with Putin, and a tropical golf outing. Notably, he recently returned to public life, appropriately chastened, as a sign of the government’s new business-friendly policies.
Since that fateful day in October 2020, Alibaba stock is down -77% and roughly $615 billion of market cap has been wiped away.
As a result of the CCP’s volatile behavior, investors outside of China have lost confidence in the Chinese miracle and capital investment has come to a standstill. To be sure, big brand companies like Apple, Nike, Starbucks, Tesla (and the NBA) still fawn at the feet of Chinese government officials after making massive commitments to their market and relying on the Chinese consumer for a substantial portion of their overall growth. But even they are hedging their bets – moving productive capacity outside of China and refocusing their growth efforts to more business-friendly end markets like India and Southeast Asia. Many of us believe the irresponsible behavior of the CCP combined with unsustainable demographic challenges and an eventual attempted invasion of Taiwan make Chinese stocks virtually “un-investable.”
As the rest of the world restricts access to the most advanced semiconductors and semiconductor equipment, the rise of AI demands that the CCP not only find ways to encourage innovation within these technology companies, but also directly support their efforts in a collaborative way.
Can we really believe that China will continue to hamper the success and impair the growth of its technology “champions”? It certainly seems so – banking on an end to the crack-down has been the equivalent of catching a falling knife.
But we digress — back to our villain—Snowballs.
While it appears that every derivative security is being painted with the same brush — for instance, we doubt they are all using a snowball architecture — a few things about the way these notes were structured can be inferred from some of the reporting:
- Not Enough Cushion (Buffer) — If the index drops below the bottom of the range, then a “knock-in” occurs, potentially putting the coupon and principal at risk. The less downside protection, the higher the coupon. Why? Because the sponsor is willing to pay more nominally, knowing that the likely effective payout (what the investor eventually receives) is probably lower. Without adequate barriers, investors are taking much more risk for a little extra return. That’s why we have conceived of and are building a tool for use in the US that would help delineate an effective barrier and the cost of that protection.
- Sloppy Knock-Ins – A knock-in is when the price of the underlying security reaches a specified barrier during an option’s life. There are two main types of knock-ins: 1) An American knock-in is triggered if at any time up until maturity the underlier falls below the bottom of the range, and 2) a European knock-in is measured only at maturity. From the reporting, it sounds to us like many of the notes issued in China are “knocking-in” prior to maturity for both coupon and principal. From our perspective, this seems shortsighted and reckless.
- Worst-of Losers — Whether it’s with basket of indices or baskets of stocks, investors often add a volatile security and employ a “worst of” structure (ultimate performance of the note is determined by the worst performing security in the underlying basket) in order to achieve better up-front economic terms. Various sources suggest that a large portion of the issued notes are linked to more volatile indexes of Chinese small-cap stocks. Our work suggests that an equally-weighted structure is far better in terms of the ultimate economic realization and we won’t recommend a note that uses baskets without this feature.
According to a Reuter’s article, UBS estimates that roughly 40% of the knock-ins have likely been hit and that a further market declines of 6-7% will snowball into another round of selling.
Unfortunately, many Chinese retail investors are learning another lesson about snowballs. It’s called the “snowball effect”–where something rapidly gets bigger and bigger. Because casually accepting ambiguous terms, and not fully understanding the risk is the like getting chased by a runaway snowball for slightly higher up-front yields.
Validus Growth Investors, LLC seeks to invest in companies at every stage of their growth. From startups to publicly traded companies, our research identifies inflection points that have the potential to produce meaningful growth and income for the clients we serve.
Investment Advisory Services are offered through Validus Growth Investors, LLC (“Validus”), an SEC Registered Investment Adviser. No offer is made to buy or sell any security or investment product. This is not a solicitation to invest in any security or any investment product of Validus. Validus does not provide tax or legal advice. Consult with your tax advisor or attorney regarding specific situations. Intended for educational purposes only and not intended as individualized advice or a guarantee that you will achieve a desired result. Opinions expressed are subject to change without notice. Investing involves risk, including the potential loss of principal. No investment can guarantee a profit or protect against loss in periods of declining value. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Opinions and projections are as of the date of their first inclusion herein and are subject to change without notice to the reader. As with any analysis of economic and market data, it is important to remember that past performance is no guarantee of future results.