(Bloomberg) — When China’s securities regulator pledged to reduce market volatility in January, few expected it to be one of the most turbulent in recent memory.

The drama only increased this quarter, setting the stage for more turmoil in 2023.

Chinese stocks now move 5% a day more frequently than at any time since the global market crash of 2008. Market volatility is near a record high. The cost of insuring Chinese government debt against default is at a multi-year high.

While the market consensus is that Chinese assets will rise over the next 12 months, the catalysts for extreme shifts in sentiment are still everywhere: from the overwhelming contagion risk as Covid-Zero recedes, to the ongoing real estate crisis and a regulatory culture that never stops springing. surprises. China’s relations with the United States remain fraught, and the economic outlook at home and abroad is more uncertain than ever.

Traders who got burned after betting on a rally in China this time last year are back. But they are much more careful.

“It’s not going to be a smooth one-way trip,” said Keiko Kondo, head of multi-asset investments for Asia at Schroeder Investment Management in Hong Kong. Investor sentiment is still very fragile – and the one thing people don’t want to own is extreme volatility. That is why we did not go all the way to overweight Hong Kong and mainland stocks.”

Traders express their caution by piling up derivatives that will pay out if stocks and the yuan collapse, while building a hoard of those who should profit if those assets rise.

The HSCEI volatility index, which serves as a measure of fear for Hong Kong’s stock market, is up 50% this year and well above its average over the past decade, even after slipping from its October high. While all global markets have seen volatility, the equivalent measure of US stocks is far behind with a 33% increase since the start of 2022.

“2023 is not going to be easy,” Kieran Calder, head of equity research for Asia at Union Bancaire Privee, said on Bloomberg TV. We are cautiously optimistic about reopening in China. The big swing factor is how China will emerge from Covid and how quickly.”

The bulls base their argument on Beijing refocusing the economy as officials consider a 5% growth target for 2023. Achieving that target will likely require a well-executed exit from Covid Zero and further deleveraging in the real estate market — two policies that have lowered Chinese asset valuations for nearly from two years.

With valuations so low and positioning by global investors light after sharp outflows, it wouldn’t take much for the recovery in asset prices to sustain. But it wouldn’t take much to generate volatility with these components either.

The language accompanying the current chorus of orders to buy Chinese assets reflects a degree of caution not present a year ago.

“The road will be bumpy,” Morgan Stanley (NYSE::) strategists including Laura Wang wrote in a recent note to upgrade Chinese stocks.

“Activity is resuming, but we see China on a path of declining growth,” the team at BlackRock (NYSE::) Investment Institute wrote.

“Things can still be choppy,” said Christina Wun of Abrdn plc.

Bears form pessimism on top of the same warnings about volatility that come from bulls.

For them, confirming Xi Jinping’s third term at the helm of the Communist Party means continuing to risk China’s financial markets rather than policy stability.

There is little sign that policymaking will become more transparent and predictable. Case in point health officials pledged an “unwavering” adherence to Covid Zero as recently as November, only to state media claiming a near victory over the virus this month, undermining markets along the way rather than calming them.

“Although some equity promoters continue to recommend China as a recovery bargain for 2023, this narrative has been around since spring and many are giving up,” said Simon Edelsten of Artemis Investment Management LLP in London.

He said that for investors targeting growth and a market-friendly governance framework, the arguments for avoiding China in the long run are getting stronger. Edelsten’s team has reduced exposure to Chinese assets in the two products it operates to 1% at Hong Kong-based AIA Insurance Group (OTC: Ltd).

However, the volatility may be worth the risk for tactical traders in the short term as battered assets jump back in. Consider returns of more than 500% on Country Garden Holdings’ bonds, or a rally of more than 200% in shares of Ali Baba (NYSE: Health Information Technology Ltd.) Since late October.

“The market is likely to be volatile amidst a bumpy transition period ahead,” writes Mark Heffel, chief investment officer at UBS Global Wealth Management. “But we also see opportunities in sectors that will directly benefit from China’s transition to eventual reopening, including pharmaceuticals, medical equipment, consumer and internet, transportation, capital goods, and materials.”

© Bloomberg LP 2022