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Hedging the uncertain tail risks in China: In this note we consider how to hedge portfolios against a Chinese hard landing. Using Morgan Stanley’s hard-landing scenarios, we look for the cheapest long-duration hedges with low mark-to-market in non- tail scenarios across equities, FX and credit.
We see the probability of a hard landing as low, but not low enough to make hedging costs irrelevant: China-related assets have increasingly been driven by fears of a hard landing and hopes of policy easing. As a team, we’re not in the hard-landing camp, but we also recognise that a hard landing would have major implications for global markets and particularly for the most China-sensitive assets in equities, credit and FX in Asia. On our estimates, markets are pricing in a 1-in-10 chance of a hard landing in China in the coming twelve months, more in equities, less in FX markets.
How we compare hedges across FX, credit and equities: For a hedge to be worthwhile paying for against a low-probability event, it needs to be ‘cheap’. This is where the value lies in looking beyond a single asset class. Our approach to comparing tail hedges across very different assets is to evaluate the reward/risk based on our team’s fundamental ‘hard- landing price scenarios’.
FX and credit: the best China hedges across all assets: Our preferred hedges are those markets that price in the least hard-landing risk. FX puts (CNY and TWD in particular) and CDS (China sovereign in particular) look most compelling on our analysis, with equity hedges generally more expensive, even though they’re moderately cheaper than at the start of the year. ASX200 puts are the most cost-effective equity hedge.
What the numbers don’t capture: Screening for cheap hedges based on ‘hard-landing scenarios’ may feel like a nice way of transgressing the asset classes, but there are important caveats to consider. For instance, we can easily identify risks with using both CNY FX puts or China sovereign CDS.