By Fang Zheng, CIO Keywise Capital and PM of the Milltrust Keywise China Fund

The?Hong Kong and China markets have been hard hit amid the double whammy of intensifying global uncertainties and negative drags from A shares.?The Greece vote against the proposed EU austerity measures in the referendum put the country and the Greek banking system under scrutiny.

At the beginning of the 2015 aside from fundamental reasons such as monetary easing and market reforms, the market rally has been driven by new liquidity from retail investors.

The rampant growth of margin financing and non-transparent and unregulated nature of OTC margin transactions significantly augmented the overall market leverage. The China Securities Regulatory Commission (CSRC) began to tighten margin financing regulation, stepping up supervision of over the counter margin financing and prohibiting securities companies from facilitating OTC margin finance including participation in umbrella trust products and provision of data and IT service. By mid June the Shanghai composite had risen by 152% ?since July 2014 and close to 60% since 2015 while the Shenzhen SME board has risen more than 1x year to date. The sell off initially was triggered by stretched valuations and tighter regulation, has been exacerbated by the unwinding of margin positions. After the recent days sell off, margin financing via brokerages has already fallen to RMB 1.7 trillion from its peak of RMB 2.4 trillion but it is still +60% higher than at the start of 2015.

During the past few days there had been a few factors which exuberated the market sell off?: First of all, there have been tighter restriction on index futures as the index futures exchange CFFEX caps the daily limit of one way new positions to 1200 lots for the mid/small cap CSI500 index, and raised the margin requirement to 30% from 10% for non-hedging short positions.?The second reason is there has been increase in trading suspension. For instance today 8th July 2015 there are over 40% of companies applied for trading suspension after losing 30% to 50% in three weeks, leaving close to 40% of A share market cap non tradable. Though these measures may have pushed back speculative shorts, yet these have promoted more selling pressure in the cash market in China and extended to Hong Kong as institutional investors cannot properly hedge their long positions.

We have been seeing a lot of effort spent during the past few days as the central government is coordinating between various authorities which implies even stronger policy support.?The People?s Bank of China (PBOC) cut the benchmark interest rate and the banks? reserve requirement ratio (RRR) simultaneously on 27th?June. The China Securities Regulatory Commission (CSRC) set up a market stabilizing fund of at least RMB 120 billion and ordered a suspension to any IPOs. The CSRC also announced that the Chinese Securities and Finance Corporation (CSFC) will step up, tasked with stabilizing the equity market and the liquidity backup by the PBOC.? Other measures included?21 securities companies?to?invest >15% of their net asset to stabilize market, with total amount no less than Rmb120bn?and the?Central Huijin announced that it will start to buy into the market via ETF.

The latest measures included that People?s Bank of China confirmed liquidity support to China Securities Finance Corporation and the PBOC will proactively help China Securities Finance Corporation to get liquidity through various channels such as interbank lending, financial bond issuance , collaterized financing etc. China Securities Finance Corporation will also expand its buying list to mid and small caps in addition to large blue chips. While there has been concern of the effectiveness, we reckon that this may be a necessary move to curtail the sell off in the A and B shares small caps sell off.

We do not anticipate the stock market turmoil to lead to system problem for China?s financial system as financial institutions such as brokerages and mutual funds total assets account for only 5% of the assets in the overall financial system and the CSFC backed up by Central Bank?s liquidity facility will likely stand ready to provide the necessary liquidity support. We believe the economic stabilization incentives and the State Owned Enterprise (SOE) reform will continue. Chinese SOEs should be key beneficiaries of a slowing, de-leveraging, re-balancing China. Steady economic growth should drive revenue growth and enhance asset utilization. We reckon that China?s rate cut cycle is still on-going , over medium long term we remain positive in China. Keywise has always been a fundamental driven house and our investment approach focuses on evaluating the companies by business model, management and the valuation.

After the recent sell down, our cash level has been approaching the UCITS required limit of 20%. We are seeing more opportunities in?Hong Kong and China?large capitalization stocks?.?We are keeping close to maximum cash available in hope to capture opportunities to re-enter to large cap stocks upon stabilization of market?conditions. The fund has been affected by the across the board sell down of the market, especially of the few fundamental driven mid-large capitalization play including China Harmony Auto, Greenland Hong Kong, , Travelsky and Chinasoft?that mainland Chinese investors also actively participated in. Our thesis on our holdings remain firm and we look forward to build further positions in existing positions while also with large capitalization counters.