Accessing China, Differently

Accessing China, Differently

Summary points:

• Calamos Evolving World Growth Fund (CNWIX) was advantageously positioned to capture the rally in the Chinese equity market that kicked off last month.
• Our approach differs from our peers, and we believe our participation in China's unexpected advance demonstrates the opportunity of our active management and broader toolbox.
• We always seek to build portfolios with more upside participation than downside risk-and that is what we believe we are achieving within our Chinese equity exposure via the use of large-cap, investment-grade China convertible securities.

The move in Chinese equities has been parabolic since China's central bank eased monetary policy and Beijing announced a series of coordinated stimulus measures. However, during the five years before the cut, the Chinese equity market significantly underperformed global equities. Most emerging market managers who outperformed during this period-including us-underweighted Chinese equities, deploying capital to outperforming areas of the emerging markets universe. This consensus positioning has contributed to the violent rotations we've seen in the early stages of this rally.

Active management within emerging markets is a critical part of the asset allocation decision. Emerging markets are not one homogenous asset class but a collection of countries with idiosyncratic drivers on which active managers can capitalize. Some managers are more active than others or have a larger "toolbox" to navigate this volatility with an eye toward risk management and upside participation. We count ourselves in this group. (For more see our post, "Emerging Markets, Done Differently.")

Monetary and Fiscal Stimulus Fuels a Rally in Chinese Equities-CNWIX was Ready

Source: Bloomberg. Past performance is no guarantee of future results.

Our Use of Convertible Securities Gave Us an Edge

In May and June of 2024, several Chinese companies came to the market with large convertible offerings. For decades, Chinese companies have turned to the convertible market to raise capital for growth initiatives, but what made these issues unusual was the issuers themselves. These cash-rich blue-chip companies didn't necessarily need capital for new investments. Instead, proceeds were used for large stock buybacks because the issuing companies viewed their equities as being very "cheap" at the moment. By issuing convertible bonds, these companies raised billions of dollars in capital, which they used to buy back their stock.

And we bought the convertibles. From our perspective as investors, these convertibles came to market with very attractive structures. They were investment-grade credits (so, high-quality fundamentals, including low default risk). The underlying equities were, in our view, very cheap following a couple of years of an extended overhang for some of China's leading growth companies. They lacked a catalyst, but the convertibles offered small coupons, which meant we were paid to wait for the catalyst to materialize. It was also comforting to know these companies' management teams also viewed their respective equities as cheap and had the confidence to embark on significant share buyback programs with the proceeds.

We purchased several convertibles around par, with our credit work suggesting our maximum downside was approximately 10-20%, while our upside was initially approximately 0.5x the underlying equity move, with the participation level increasing as the equity appreciated. We see these as ideal structures for volatile asset classes like emerging markets. Currently, more than 10% of Calamos Evolving World Growth Fund's portfolio is in Chinese convertibles, and our global portfolios are also participating.*

From issuance until mid-September, these securities were fairly boring, but we liked boring. The equity markets were volatile during the third quarter, as the markets gravitated between cyclical rallies and defensive corrections (see our outlook, "Global Markets Weather Report: Calamos Evolving World Growth Fund Edition"), but these securities did their part and provided some stability. We added to CNWIX's positions in August as their underlying equities started to outperform and the structures remained very attractive in our view, trading within a few points of par.

When the rally began on September 20, we were already there, thanks to our ownership of these Chinese convertibles. And given their structures, we like the math from here: we believe as the equity rally persists, our upside participation should increase while our exposure to the downside remains less than the upside. This is the positive skew we always seek to achieve across our portfolios, whether it be via structure (as is in this case), valuation, or our timeliness tools.

Options: Another Tool in our Toolkit

We have also augmented our Chinese convertible positions with additional upside participation potential that leverages our experience in the equity options market. When the news came out that China had adjusted its monetary policy stance, were we able to quickly increase the upside participation in our favored names via synthetic convertible positions, while still maintaining downside risk mitigation if this became yet another head-fake. Our level of confidence in the rally has since increased, supported by the fiscal policy measures China added to the mix just days after reducing rates. This has led us to increase equity exposure to our portfolios, including CNWIX, to better participate in further market appreciation.

Where to from here?

Our outlook for the Chinese equity market is positive, albeit not unreservedly so. This is China-there's every reason to believe what we're seeing is coming from the top, with all agencies being directed to promote stronger economic recovery. In particular, the government has cited the support of property and equity markets among its key targets as it seeks to reverse the incredible damage done to consumer and business psyches over the past five-plus years. While it's reasonable to assume this will work, the government faces a much more difficult task compared to prior stimulus cycles that relied on local government and SOE directed infrastructure and property projects.

Calamos Evolving World Growth Fund and most of our portfolios are positioned with a small overweight to the Chinese equity markets but continue to have what we see as a favorable risk/reward skew. In other words, we believe that if there is a correction in the Chinese equity market, our portfolios will be structured with greater potential resilience, but if this rally persists, we may be well-positioned to outperform.

The next signposts to monitor will be further details on fiscal stimulus measures and the implementation of these measures, and then most importantly, indications of improving consumer and business confidence. It will likely be months before we have all of these answers but given what we know now, we believe it's prudent to maintain our exposure to the Chinese equity market-ideally in structures that provide that positive risk/reward skew we seek-which is what we are currently finding in many investment-grade Chinese convertible issues.

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