Credit Suisse’s knock-out notes tied to Hang Seng offer play on Chinese rebound, traders say

By Emma Trincal

New York, Sept. 28 – Credit Suisse AG, London Branch’s 0% capped knock-out notes due Oct. 17, 2019 linked to the Hang Seng China Enterprises index give short-term investors a tool to bet on a Chinese stock market recovery with some downside protection, traders said.

The question is whether the timing of the trade is appropriate, they added.

A knock-out event will occur if the final index level is less than the initial level by more than the knock-out buffer amount, which is expected to be 20% and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If a knock-out event has not occurred, the payout at maturity will be par plus the index return, subject to a minimum payout of par and a maximum return that is expected to be 26.3% and will be set at pricing.

If a knock-out event has occurred, investors will lose 1% for every 1% that the final index level is less than the initial index level.

Already up

Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments, said the underlying investment theme is a vote of confidence on Chinese stocks. But the timing of the trade was not as good as it was a short while ago.

“This is a play on the rebound of the Chinese market. At least we have something somewhat unpopular and the one-year timeframe is reasonable,” said this trader, who specializes in value and contrarian investing.

“But getting into the trade now is not quite as favorable or as good as it was in the middle of September.

“We’ve seen a rebound earlier this month although it’s still reasonably priced compared to January.”

In January, the Hang Seng China Enterprises index rose to a three-year high of 13,724. But it dropped 25.4% from that level on Sept. 12 to 10,239. Today, at 11,018, the index is up 7.6% from this recent low. However, it’s still down 19.7% from its January peak.

“The Hang Seng has recouped about 3/8th of what it lost since January. So I guess there may be some potential on the upside,” he said.

Not a bargain

However, Kaplan likes to look back to longer periods on the chart.

“It’s certainly not quite as good a bargain as it was in early 2016. We’re still nearly 50% above that level,” he said.

The Hang Seng Chinese Enterprises index closed at 7,505 in February 2016, its lowest point since the financial crisis.

Downside

“The potential upside is not huge, which is why the 26% cap doesn’t bother me too much,” he said.

“The 20% barrier protection is good to have. However, since it’s a barrier it may not be enough. If we were to revisit the low of February 2016, it would be a 32% drop from now.”

Such a scenario however was not likely, he said.

“If the U.S. dollar drops – as I’m guessing it will – you may get some gains,” he said.

Typically, a weaker dollar benefits emerging markets, which tend to export commodities whose price is rising when the dollar depreciates. Additionally, it deflates the U.S. dollar-denominated debt of countries that have borrowed from the United States.

“At the very least, there is a high chance that you would get your money back,” he said.

Underlying theme

This is a good way to “play a rebound in China,” he said, citing a combination of views, which may justify buying the notes.

“If you believe that the dollar is going to weaken because its appreciation is overdone, if you think Chinese stocks are undervalued and if you expect relationships between China and the U.S. to improve, then it makes sense,” he said.

Kaplan agreed with two of those assumptions.

“Personally, I subscribe to the view that the dollar is going to fall. The bull trend has run its course,” he said.

Despite the worsening of the U.S.-China relationship, Kaplan said “a lot of it is the result of negative headlines,” dismissing their fundamental impact.

However, he questioned the valuation issue.

Not scary enough

“I don’t think Chinese equity markets are as undervalued as other emerging markets,” he said.

“I would want to see more fear around an asset class. China is not unpopular enough.”

Turkey, he added, was a better example of a well-timed contrarian trade.

Since mid-August, the iShares MSCI Turkey exchange-traded fund has jumped 27.75%.

“That’s close to a 30% move in a month-and-a-half,” he noted.

Hitting bottom

An equity trader looked at how much and how fast the index is able to drop.

“It’s a bet on the recovery of the index. The whole thing is a directional play,” he said.

The trade would make sense for someone who is convinced that the index price hit a confirmed bottom. But he said he sees some danger if the market continues to trade sideways.

“We know that it can drop through the barrier,” he said, pointing to the 25.4% index drop from January to September.

Another big decline occurred between August 2015 and February 2016, when the index fell 48%.

“You guys have to ask yourself: can it happen again?”

Each of these drops happened in less than a year, he observed.

“It’s a directional bet. Whoever buys this note doesn’t think we can drop further from where we are now. We’re already down 20%,” he said.

Discounted noise

Along with Kaplan, this trader did expect a significant threat from the current trade tensions between the United States and China.

“All the trade war stuff is already discounted. The market anticipates things. The market is a forward-looking entity. Can we see more happening? Yes. But with all that has already happened, what more can it be? The market has gone through the scare and things have come down a bit.”

More importantly investors in the notes should “make up their minds” on the direction of the index.

“You have to decide if the Sept. 12 low will hold, if it will provide support,” he said.

“If you think that, you want to buy this note. If you don’t think that, then don’t.”

A support is a price level below which an asset has not been able to fall easily historically.

A resistance level is a price above which an asset cannot increase easily.

Testing support, resistance

However, looking at the chart more closely, this trader raised one issue: before the Sept. 12 drop, the index had reached a series of “small highs” very much below the January levels (near 11,000) but in a series of failed attempts to go higher once in July and twice in August.

“What would be a concern for me is that the market looks like it’s trading sideways. We’re still below the highs of the summer. I would feel more comfortable if it had broken through those recent highs. It seems to be stuck below the 11,000 resistance level,” he said.

That was for the index price not moving above recent highs. But the chart revealed a more serious concern on the downside.

“If you get more granular looking at the very recent chart, there is another problem,” he said.

“The September low broke through the August and July lows.

“In other words, it’s having problems breaking through on the upside.

“But it broke through the support on the downside.

“It looks like the index could be weaker. It doesn’t look like the market is fully convinced about where the support and resistance levels are.

“That leads me to believe there is a risk if you buy this note. You probably want more downside protection.”

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

The notes will settle on Wednesday.

The Cusip number is 22551LD49.

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