Right timing for Credit Suisse’s buffered notes on Hang Seng China Enterprises, contrarian says

By Emma Trincal

New York, Aug. 10 – There haven’t been many structured notes solely tied to emerging markets and even less so to China, noticed contrarian and value investor Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments. The few offerings coming up have captured his attention as he tends to like “unloved assets,” preferably amid selloffs when he spots value and sound fundamentals.

Case in point: Credit Suisse AG, London Branch’s 0% buffered notes due Aug. 28, 2019 linked to the Hang Seng China Enterprises index offer such an opportunity over a one-year period.

“By picking China, they provide a good opportunity to trade an asset at a relatively good entry level,” Kaplan said.

‘Scary Assets’

“I wish there would be more structured notes based on scary assets.”

The payout at maturity is par plus any index gain in the index, up to a maximum return of 17.1%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index declines by up to 15%, the payout will be par.

Otherwise, investors will lose 1.17647% for each 1% decline beyond the 15% buffer.

“Having the downside protection doesn’t hurt.

“I like the notes. There should be more emerging markets notes in general.”

Turmoil in China

The Hang Seng China Enterprises index tracks 40 stocks of Mainland China companies listed in Hong Kong.

“I much prefer to participate in a market that’s out of favor like China because you get stocks at a bargain. After a pullback, the market is likely to rebound,” he said.

Currency moves and geopolitical events have put China under pressure this year.

Market declines both in China and in the emerging markets are partly driven by the strong dollar, said Kaplan.

“But I think it’s just temporary,” he said.

The Turkish lira is an acute example of foreign currencies plunging. On Friday, the lira fell 20% against the U.S. dollar, bringing to the forefront fears of a global currency crisis as many European banks have exposure to this country, analysts said.

Risk perception

But for Kaplan, the fears are overblown.

A lot of the volatility hitting emerging markets is psychological because the strong dollar caught many by surprise.

“It has a lot to do about perception,” he said.

“People move out of emerging markets to buy U.S.-denominated assets in a classic flight to safety. A stronger dollar creates a certain perception of risk-taking. The market turns risk off.”

For Kaplan, this behavioral factor is just as important as other macroeconomic driving down the stock markets of these countries.

Outflows of capital indeed make it harder for emerging markets nations to service their dollar-denominated debt and finance their deficits.

The lazy 20%

Trade tariffs and geopolitical concerns have of course amplified investors’ concerns about placing money in non-U.S. markets, especially China.

For Kaplan, an even bigger contributor to the turmoil has been the news headlines.

“China has been under a lot of media pressure,” he said.

“At the end of June, every news media obsessively talked about China entering a bear market because all of a sudden prices were down 20%.

“It turns out this lazy definition of a bear market is useless and misleading.

“The media are fixated on round numbers: 10% for a correction, 20% for a bear market. When they report those figures, people get scared and the downward pressure accelerates.”

Kaplan cited Tom McClellan, a well-known technical analyst, who went into a “crusade” against the 20% definition.

“McClellan reminded the public a few years ago that the true definition of a bear market is when stock prices make lower highs and lower lows for a certain stretch of time. Of course, this chart pattern requires a little bit more work. But it’s much more accurate and helpful to investors,” he said.

McClellan in a commentary published in 2015 gave the example of a 20% decline in the S&P in the summer of 1998 lasting for a six-and-a-half-week period, noting that it was not a bear market but merely a “scary pullback.”

“I think Chinese stocks have been hurt not just by the dollar but perhaps also by those headlines. Fear breeds fear. As soon as investors see the word “bear market” on TV, they sell.”

Not the worst decliner

Kaplan likes China as it is an unpopular market. But he likes the “hated” assets even more although he does not necessarily invest in them.

He pointed to Brazil and Turkey.

Turkish stocks are down 40% this year.

The stock market in Brazil is down 10% for the year after plunging 31% in the first half of the year.

“Brazil and Russia have fallen into their lowest levels in a long-time and haven’t really rebounded yet,” he said,

“Turkey is down to the extreme right now.”

Kaplan did not say whether he has invested in these markets.

In comparison, China does not appear to be much of a laggard.

“The Hang Seng China Enterprises index is down 23.8% from its January high. It’s still a fair drop. It can do anything in one year and there’s certainly room for upside,” he said.

“I’d rather buy something like this at those levels than a ridiculously overvalued S&P that has been in a bull market since the beginning of 2009,” he said.

Buying China in the beginning of 2016 would have been even better than today, he noted.

“Then Chinese shares were at their lowest prices in nearly 20 years. Right now, it’s not really a bargain but it’s not overpriced like the U.S. market,” he said.

Commitments of traders

If Kaplan’s outlook on emerging markets is rather upbeat it is not just due to bargain prices. He also believes that the dollar rally will be short-lived.

“The dollar has been rising so much, I expect it to stabilize soon and even to drop next year, which will benefit China but also Brazil, India and even Russia as well as non-U.S. assets in general,” he said.

Kaplan adopted this view in part from doing his own research on currencies futures, studying weekly reports from the Commodity Futures Trading Commission on Commitments of Traders or COT.

The reports provide open interest for futures and options on futures markets. It breaks down positions between merchants and speculators.

“Merchants’ net long positions on a number of currencies such as the Swiss Franc and the British pound versus the dollar are at all-time records high since 1973,” he said.

“This means they expect the dollar to drop against their currency.

Kaplan said he placed a lot of faith in the data for two reasons. First the positions set all-time records over a very long period of time. Second, the positions do not come from asset managers or hedge funds – speculators – but from merchants using futures to conduct their business activity.

Buffer

Reviewing the Credit Suisse notes based on his market outlook, Kaplan said the product offered an attractive structure.

The downside protection was obviously the selling point, he said.

Having a geared buffer is better than having a barrier, he added as investors do not incur losses from the initial level.

“If the index went back to its low of the beginning of 2016, it would be a 32.5% drawdown. At least you’d have a protection. You may lose a huge amount of money but it would be 20%, not a third. And that’s an extreme scenario,” he said.

But price action remained the determining factor in his assessment.

“It’s one thing to get a good buffer. But buying something at a bargain gives you both a cushion against your losses and more upside potential.”

Cap, tenor

The 17.1% cap was not a major drawback.

“It seems like a reasonable return. I’d prefer not to have a cap at all but at least this one is not too low,” he said.

“If this market rallies you can participate in the recovery,” he said.

Finally, Kaplan said he was comfortable with the timeframe

“I like the one-year term. You don’t want to be too long and hit a downturn. The narrowing of the spreads between short and long-term Treasuries indicates we’re heading in that direction,” he noted.

“Even shorter would be better. But you wouldn’t get the same cap and buffer of course.”

J.P. Morgan Securities LLC and JPMorgan Chase Bank, NA are placement agents.

The Cusip number is 22551L3V0.

The notes will settle on Wednesday.

© 2015 Prospect News.
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