Conclusion: The combination of slowing growth, accelerating inflation, and a property bubble that will either pop or continue to be addressed from a policy perspective has us bearish on Hong Kong equities over the intermediate-term TREND.
Position: Bearish on Hong Kong Equities for the intermediate-term TREND.
Of the limited push-back we have received on our Year of the Chinese Bull thesis, the off-limits nature of the Shanghai Composite Index to many foreign institutional investors appears to be among the most concerning. While it’s certainly true that capital controls prevent many funds from taking direct ownership of mainland Chinese equities, we don’t necessarily agree that the Hang Seng is always a safe substitute for your investment allocation to Chinese stocks.
While history shows us both indices tend to move in tandem, registering a positive correlation of r² = 0.77 over the last 20 years, further analysis shows that Hong Kong can indeed sucker punch investors looking for surrogate exposure to China. Pulling back a historical chart of the Shanghai Composite vs. the Hang Seng, we do find two periods where Hong Kong equities experienced major bear markets while Chinese equities either remained flat or appreciated slightly:
- During the period from August 6, 1997 to August 11, 1998, the Hang Seng Index lost (-59%) of its value while the Shanghai Composite gained +3%. Admittedly, the events of the Asian Financial Crisis, in which the Hong Kong Monetary Authority (HKMA) was forced to aggressively defend the Hong Kong dollar from speculators, contributed to this large negative divergence.
- During the period from March 27, 2000 to September 18, 2001 the Hang Seng Index lost (-49.1%) of its value while the Shanghai Composite gained +1.3%. As in the example above, special circumstances contributed to the Hang Seng’s drastic underperformance; a confluence of selling pressure from the HKMA unwinding the positions it took to support the market during the height of the Asian Financial Crisis, the SARS epidemic, and the Dot.com bubble bursting all played a role in the aforementioned bifurcation.
Net-net, while we certainly agree that exogenous events have played a role in historical bifurcations of Hong Kong’s equity market performance from mainland China’s equity market performance, we think the simple point we are trying to make is clear enough – Hong Kong is not mainland China. On occasion, macro fundamentals have the ability to create incredible divergences in equity market performance over sustained periods of time. As such, we have been and will continue to analyze each market on its individual merit, rather than accepting them as a package deal.
On an individual basis, the fundamentals of Hong Kong’s economy do not warrant being long its equity market. From a growth perspective, Hong Kong’s GDP growth is slowing; the monster +7.2% YoY number in put up in 1Q (+170bps above consensus) only augments our call for a measured decline in the YoY growth rate of Hong Kong’s economy over the intermediate-term TREND. From an expectations perspective, a slowdown is already built into the models of both Hong Kong policy makers (+5-6% YoY in 2011) and sell-side economists (+5.4% YoY in 2011 according to Bloomberg consensus estimates).
We do, however, question whether the magnitude of the slowdown is accurately reflected in current estimates. If the slope of Hong Kong’s yield curve is telling us anything, it’s that perhaps growth is slowing more than what is already baked in from an expectations perspective.
Additionally, having declined (-6.8%) from an intermediate-term lower-high on April 8th, the Hang Seng itself might be its own best leading indicator. Our quantitative models have it broken from an immediate-term TRADE perspective and demonstrably bearish from an intermediate-term TREND perspective, which tends to suggest risks to economic growth are mounting.
Over the intermediate term, we flag inflation as the main risk to growth in Hong Kong. Early in the year, we made the research call that CPI in Hong Kong would accelerate and surprise investors to the upside, as the combination of easy credit (+31% YoY in March) and cash handouts totaling HK$6,000 to each permanent resident (in response to at least four major demonstrations protesting inflation) fuels demand-side price pressures, while the confluence of exorbitant property prices (+22.2% YoY in March) and higher commodity prices (CRB Index +34.6% YoY) fuels supply-side cost pressures.
As of April, CPI in Hong Kong hit a 32-month high of +4.6% YoY and our models have further upside over the intermediate term. The HKMA agrees, as evidenced by the recent upward revision of their full-year inflation forecast to +5.4% YoY from a prior estimate of +4.5% YoY. The sell-side has been slow to react, maintaining their +4.5% YoY forecast for Hong Kong’s 2011 CPI since late March (Bloomberg consensus estimates). All told, we expect higher rates of inflation to detract from Hong Kong’s economic growth over the intermediate term by slowing Household Consumption (~62% of GDP) and ratcheting up the GDP Deflator by which real growth is calculated.
Higher inflation, particularly in the property market, brings us to our third key reason for being bearish on Hong Kong equities over the intermediate-term TREND – macroeconomic policy. As mentioned before, property prices are indeed a major problem for Hong Kong consumers, as well as a major risk for Hong Kong’s banking system and economy at large.
According to proprietary data published by Centaline Property Agency, Hong Kong’s largest private real-estate broker, home values have surged +70% since the start of 2009 and are now at an all-time high. Their data has Hong Kong home prices +3% greater than the prior peak reached just prior to the Asian Financial Crisis. While our data has Hong Kong housing prices per square foot at “only” (-7.7%) below the prior peak on a nominal basis, the pace and magnitude of the recent run-up is similar across data-sets.
As a result of this liquidity-fueled surge in property prices, in large part due to purchases by mainland Chinese buyers, Hong Kong now ranks dead last in the world (325 out of 325 major urban markets) on the metric of housing affordability, with the territory’s Median House Price at 11.4x Gross Annual Median Income. Government efforts introduced in November which included, among other things, a levy designed to discourage speculative transactions, have done little to cool the rapid inflation in Hong Kong’s housing market. On a YoY basis, growth in residential real-estate prices has bounced around in a tight range since the measures were implemented last fall.
As recently as April we have, however, seen signs of cracking in this market, with the volume of transactions declining (-37.6%) YoY (a 25-month low) and the prices of those transactions falling (-26.8%) YoY (a 10-month low). While we need more data to accurately determine whether this is the start of a startling trend in Hong Kong, on an absolute level, the data is what it is – the first indication of property market weakness in quite some time.
Despite this one-off sign of cooling, the HKMA remains vigilant in dealing with this issue – at least from a rhetorical perspective (the HK$’s peg to the USD prevents the de facto central bank from raising rates). As such, Hong Kong authorities remain limited in their policy options to deal with this issue, currently opting to run the “central banking 101” play of notifying the market that it is “watching price developments closely”.
One of the more tangible things they can do in the near term to curb credit growth and mitigate the financial impact of a potential wave of defaults is by forcing Hong Kong’s banks to build reserves. While we believe that it is perhaps too early to call for a major property market bust in Hong Kong, we do not think it’s too early to start calling out the downside risk to Hang Seng earnings based on the likelihood of future reserve ratio hikes. Currently, the index is overwhelmingly weighted to the Financials (banks, real-estate developers, and insurance companies combine to equal 56.2% of the Hang Seng’s market cap.), so weakness in this sector has the ability to drag down the rest of the market on beta alone.
All told, the combination of slowing growth, accelerating inflation, and a property bubble that will either pop or continue to be addressed from a policy perspective have us bearish on Hong Kong equities over the intermediate-term TREND. As the title aptly points out, Hong Kong is not mainland China.