small-cap shares: China’s small-cap crash shows what happens sans market rescue

China’s smallest stocks are flashing a warning about the potential downside for the world’s second-largest equity market if Beijing fails to follow through on a highly anticipated rescue campaign. While the country’s large-cap CSI 300 Index eked out a 0.7% gain on Monday after a renewed pledge from regulators to support the market, a gauge of small-cap shares sank more than 6% to the lowest level since 2018. That took the CSI 1000 Index’s losses to 27% this year after the measure underperformed larger peers by the most in more than nine years in January.

The stark underperformance suggests investors are throwing in the towel on small-cap shares out of belief that policy support will be focused on rescuing blue-chip stocks. Some exchange-traded funds tracking the CSI 300 gauge have seen record trading volume in recent weeks, leading to speculation that state funds have stepped in to put a floor under the rout.

“The market currently relies on support from the national team and investors see the big caps as their buying target,” said Vincent Chan, China strategist at Aletheia Capital Ltd. “This discourages small-cap investors from holding onto their position as they don’t have the downside protection.”

In a sign of how fragile market sentiment has been, the CSI 300 has wiped out all its gains since late last month when policymakers were said to be mulling 2 trillion yuan ($278 billion) of support as part of a stock stabilization fund.

Investors are bracing for losses to deepen before markets close for a weeklong Lunar New Year holiday. Stocks may be sold off further as traders seek to reduce positions out of concern that risks ranging from geopolitical tensions and sluggish consumption may deepen the market’s freefall once trading resumes.

Some $7 trillion has been erased from the value of equities in China and Hong Kong since their peaks in early 2021 as Covid lockdowns, tech crackdowns and a property slump crushed investor confidence.”Its looking very difficult for the next few days as sentiment is extremely fragile and many in the market would choose to cut positions before the Chinese New Year,” said Daisy Li, fund manager at EFG Asset Management HK Ltd. “The market is waiting for more forceful policy stimulus to restore confidence and the economy, which we think is more likely to come later in the second quarter.” Margin calls, forced liquidation faced by shareholders and selling pressure associated with so-called snowball derivatives have emerged as new risks as the slump deepens.

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