Why Hong Kong Value Stocks Are Ready for a Comeback
The recent turmoil in US and Japanese stocks has diverted attention away from the slump in Chinese and Hong Kong stocks. Amidst this chaos, a potential silver lining has emerged for Hong Kong: the looming US rate cut.
US Rate Cut is Good for Hong Kong
Hong Kong's unique economic situation places it in a delicate balance. The city's economy is closely tied to Mainland China, while its monetary policy is linked to the US due to the HKD being pegged to the USD. This peg means that Hong Kong inherits the interest rates set by the US Federal Reserve.
China's economy is currently struggling, prompting the People's Bank of China (PBOC) to cut interest rates to stimulate growth. Conversely, the US has been hiking rates to combat inflation. These divergent economic policies create a challenging environment for Hong Kong, which is caught between a slow-growing economy and high-interest rates inherited from the US. This situation has persisted for the past two years.
High-interest rates have placed downward pressure on the HKD, forcing the Hong Kong Monetary Authority (HKMA) to intervene by buying HKD to maintain the currency peg. Although the HKMA has substantial reserves to support this, depleting these reserves is not ideal, and it does little to improve the economy.
A potential rate cut by the US, expected to start in September, could bring much-needed relief. Lower interest rates in the US would translate to lower rates in Hong Kong, aligning its monetary policy more closely with both China and the US. This alignment could help stimulate Hong Kong's economy by reducing borrowing costs and improving liquidity, providing a more conducive environment for economic recovery.
But Hong Kong Stocks May Slump More Before They Improve
While the prospect of US rate cuts is welcome news, investors should temper their expectations for immediate gains in Hong Kong stocks. Hong Kong is considered a risk-on investment due to its close ties with Mainland China, whereas the US is seen as a haven for risk-off investments. During periods of heightened volatility and fear, investors typically seek safety by moving their investments back to the US. This flight to safety often results in outflows from other markets, including Hong Kong.
Despite the fact that Hong Kong stocks are currently undervalued, they still depend on foreign fund inflows to drive up stock prices. Fearful money tends to retreat rather than invest, meaning a crash in US stocks would not bode well for Hong Kong.
However, given the significant declines already seen in Hong Kong stocks, there might be less downside left compared to US stocks. For instance, the Tracker Fund of Hong Kong (SEHK:2800) and iShares Core MSCI China ETF (SEHK:2800) dipped by less than 3% over the past five days, whereas the S&P 500 ETF and Invesco QQQ Trust dropped more than 4.9% in the same period.
Nevertheless, Hong Kong stocks have still moved in tandem with US stocks, falling rather than rising. If US stocks continue to crash, there could be further selling of Hong Kong stocks as money flees back to the US. For Hong Kong stocks to see significant gains, a return to a risk-on mentality is necessary, which seems unlikely in the near term.
Near-Term: Bonds and REITs, Not Banks
While rate hikes can negatively impact bond and REIT prices, the opposite holds true; bonds and REITs are expected to benefit from impending rate cuts.
The ABF Hong Kong Bond Fund (SEHK:2819) managed to gain 1% even as the Hang Seng Index slumped. This fund could see additional, albeit modest, upside if interest rates continue to decline due to its shorter duration.
Hong Kong REITs have also performed well recently. Link REIT (SEHK:823) and Fortune REIT (SEHK:778) have risen by 5% and 3%, respectively, over the past five days.
Conversely, Hong Kong's major banks have suffered significant drops amid concerns that rate cuts will reduce their profit margins. BOC Hong Kong (SEHK:2388) and Hang Seng Bank (SEHK:11), which primarily operate in Hong Kong, saw declines of about 3%, while HSBC and Standard Chartered, with substantial global operations, fell by more than 10% over the same period.
We anticipate that bank stocks will continue to decline if rate cuts are more frequent or larger in magnitude. Additionally, fears of an economic slowdown or potential recession could dampen loan demand and increase delinquent loans. Banks are cyclical investments, and they are now entering a down cycle. However, we do not expect interest rates to return to near-zero levels. Consequently, banks will remain solid investments in the long term, though it is advisable to wait for their prices to correct to more attractive levels before investing.
Long-Term Outlook: The Comeback of Hong Kong Value Stocks
We anticipate that US interest rates will remain above 3% for the next five years and possibly beyond. This expectation is based on the premise that inflation risks have not been fully eradicated and geopolitical tensions have increased production costs, which are likely to persist.
This scenario bodes well for value stocks, of which Hong Kong has an abundance. According to a study by JPMorgan, growth stocks tend to outperform value stocks when interest rates are below 3%. This is because growth stocks are less affected by the discounting of future cash flows to their present value. However, when interest rates are higher, future cash flows are worth significantly less today, making value stocks, which generate ready cash flows, more attractive.
Additionally, historical data indicates that growth and value stocks take turns outperforming each other, with each period of outperformance lasting for several years. Given the more favorable environment for value stocks, we believe the next five years could be a prime period for Hong Kong value stocks to shine.
The potential US rate cut might be the turning point for Hong Kong stocks. As global investors increasingly turn their attention to value stocks, Hong Kong stocks could become particularly attractive due to their status as some of the cheapest in developed markets. This could position Hong Kong value stocks for a significant comeback in the long term.