(Bloomberg) -- A virtuous circle is forming in Chinese assets as gains spurred by signs the nation is rolling back Covid Zero drive more investors to chase the rally.

November’s rotation-driven surge in Chinese stocks and credit has made them among the globe’s best performers. An index of the nation’s US-listed shares climbed a record 42%, the Hang Seng China Enterprises Index gained the most since 2003, property stocks have jumped 61% and high-yield dollar bonds rose 20%. The yuan spiked up on Wednesday as Beijing said it will allow some residents to skip mass Covid Tests.

Despite the gains, swaths of Wall Street’s investing elite are yet to be drawn in. Long-only equity funds remain unconvinced, retail investors reluctant, and speculators are only in it for the short haul or simply covering shorts, data appear to show.

US hedge funds are still selling with outflows from Chinese stocks of almost $3 billion this quarter, Morgan Stanley says. Mom-and-pop investors have mostly stayed on the sidelines, with exchange-traded funds such as KWEB, MCHI and FXI attracting only a trickle of inflows.

Optimists say the light positioning sets the stage for more gains in coming months as global investors are forced to rebuild their weightings in China. Long-only actively managed funds cut their Asian stock exposure to an eight-year low before November, with China seeing the biggest reduction, according to Bank of America Corp.’s analysis of 1,300 funds managing $1.8 trillion. 

“Right now there are low-hanging fruits in China,” Daniel Lam, head of equity strategy at Standard Chartered Wealth Management, said on Bloomberg Television on Wednesday. “The market had a great November but started off at a very terribly low base -- don’t forget that.”

Investors have for months been struggling to find reasons to turn more positive on China. A shift away from the strict Covid Zero policy would have such huge ramifications for the economy that the fastest-moving funds want to get ahead of the news. They bought in early November on the basis of screenshots of unverified documents on anonymous social media accounts suggesting officials were preparing to wind back some of the restrictions.

They’ve gathered more evidence since. China’s top official in charge of the fight against Covid-19 said on Wednesday the country’s efforts to combat the virus are entering a new phase with the Omicron variant weakening and more Chinese getting vaccinated.

Authorities are also seeking to minimize the economic and social costs, this week criticizing excessive containment measures. The central government in November also delivered a plan to rescue the property industry, suggesting a pivot to a more supportive economic policy.

‘Desperately Needed’

November’s rally was “desperately needed,” said Carl Wong, a managing director at Gopher Redwoods Asset Management in Hong Kong.

First in were the short sellers, who covered their bearish positions so rapidly they snapped up Country Garden Holdings Co.’s share placing solely to lock in profits. Options dealers started buying after getting caught needing to boost hedges when stocks rallied. Ownership of Alibaba Group Holding Ltd.’s derivatives, for example, climbed above 1 million contracts in Hong Kong for the first time since June.

For some quantitative traders, rare chart indicators were a call to action. The market was so downbeat that buying signals were flashing just about everywhere you looked. Every major Chinese stock benchmark started November at or near oversold territory, while an index of Chinese junk dollar debt was yielding on average 31%. 

Taking Profit

For bears, the lack of conviction underscores the rally’s precariousness. Some of the Asia-based hedge funds who bought in November are already looking to take profit, Morgan Stanley said in a research note this week, citing conversations with clients. 

At the same time, a lack of long-term buyers may leave the market vulnerable to swings. 

There are economic risks too. Manufacturing and services activity both contracted more in November than economists forecast, data published on Wednesday showed.

“I’ve derisked a considerable part of the portfolio,” said Brian Quartarolo, a money manager at Lighthouse Investment Partners. “It will be some time before the macro data improves, so buying China is going to be a tricky leap of faith for foreigners like me for a while.”

Some took that leap in November. Others plan to follow in the coming months.

“Despite near-term market volatility, we are more optimistic about Chinese risk assets for 2023, given low valuations and an economic upswing led by a controlled reopening next year,” said David Chao, a global market strategist of Asia Pacific ex-Japan at Invesco Hong Kong Ltd.

--With assistance from Wenjin Lv and Lorretta Chen.

©2022 Bloomberg L.P.