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.
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This morning U.S. new home sales were reported for the month of April and rose 7.3% month-over-month, climbing to 323K versus 301K in March. Initially, this was treated as a positive data point by the market as the Homebuilding Index, represented by the ticker XHB, was trading up almost a percent in early trading. Unfortunately, despite marginal sequential improvement, the April number is representative of a continuing bleak long-term trend.
As outlined in the chart directly below, while the months of supply dropped to the second-lowest level since 2006, it is still well above the long term range of 4 – 5 months.
Further, our Financials Team has authored a long-term displacement theory as it relates to new home sales. In effect, the theory postulates that because of the massive over-building that occurred, it will take a commensurate period of under-building to bring the market back to equilibrium. According this analysis:
“In May of last year the government reported that new home sales came in at a 300k annualized rate (seasonally adjusted), which was the lowest rate of new home sales ever recorded since the data series began in 1963. Based on our cumulative displacement model, new home sales would need to remain at 300k for approximately the next 10 years in order for this cycle to fully play out and be consistent with the prior three cycles. The green circle shows where we were a year ago on this chart, and the yellow circle shows today.”
The chart below highlights this analysis and the cumulative time until the new homes market will be back in balance.
The new home market is, of course, only a small part of the overall housing market. In fact, based on the most recent annualized monthly numbers, new home sales are roughly 6% of the overall market. Therefore, even if we are seeing marginal sequential improvement in new home sales, it is not necessarily indicative of any real change in the housing market. In fact, the existing home market is likely a much better indicator of where new home sales are going than vice versa. In the existing home market there is definitely no silver lining.
The April numbers for existing home sales was reported last week and were down -0.8% from March to an annualized number of 5.05MM home sales. At the same time, inventory jumped, as reported by the National Association of Realtors, to 3.87 million homes on the market, which is a +9% increase compared to March. On a months-supply basis, inventory rose to 9.2 months from 8.4 months in March.
The impact of this large amount of inventory is, logically, that home prices continue to decline absent a commensurate build-up in demand. The median price of an existing home was $163,700 in April, once again according to the National Association of Realtors, and down -5% versus a year ago. The year-over-year decline moderated slightly in April compared to the -5.9% decline in March. Since the series is not seasonally adjusted, sequential changes are not meaningful in analyzing price.
The other key metric we watch, which will be reported for the most recent week tomorrow, is mortgage applications for new home purchases. This is one of the best measures for future home purchases and it dropped -3.2% week-on-week last week, though did tick up +2% year-over-year. The chart below shows the long term trend in mortgage applications, which suggests what we already outlined above, which is that housing demand remains quite weak, despite mortgage rates at near all-time lows.
As a potential bright spot, our Financials Team also recently noted the following:
“Purchase apps for 2011 YTD are 5% below the full-year average for 2010, but are down 17% YTD vs. the comparable period last year. Given that the next few months will mark easier comps as we lap the post tax-credit doldrums of summer 2010, it's looking possible that overall demand may be close to flat in 2011 relative to 2010. Should demand start to stabilize, this would mark a definite positive inflection from the secular falling demand trend that's been in place since 2005. Recall that our home price model is driven by 12-mo lagged demand.”
If the purchase applications do turn, this would indeed be an inflection point and something to keep front and center as a way to gauge an improving housing market, but so far any turn is minimal at best.
Also on the negative side of the ledger is the current debate and discussion over the Federal Housing Authority in Washington. The Republicans circulated a proposal Monday that proposed to both increase the size of down payments from 3.5% to 5%, and to also decrease the size of the loans. The issue is scheduled to be discussed Wednesday at a House Financial Services subcommittee hearing led by Rep. Judy Biggert (R-Ill.).
Despite the sequential pick-up in new home sales, we still don’t see a silver lining in the U.S. Housing Market. As Housing Headwinds continue to percolate, that also supports our Q2 Macro Theme titled Indefinitely Dovish which postulates that the Federal Reserve will keep rates lower longer than investors expect.
Daryl G. Jones
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