Understanding the Market | Why did Hong Kong stocks underperform in 2023?

Source: CICC

After two consecutive years of decline, why did the Hong Kong stock market underperform again in 2023? Understanding the driving factors and reviewing market trends can help us find the underlying reasons and provide some reference for future trends.

1. What dragged down market performance? Valuation contraction is the main factor; traditional value stocks performed poorly, while dividends and some growth stocks outperformed

Valuation contraction is the main drag. The poor performance of traditional value sectors (such as real estate, insurance, and consumer goods) is the main factor, while dividends and some growth styles have relatively outperformed.

2. What mainly affected valuation contraction? The continuous increase in risk premium

Valuation contraction is mainly caused by the continuous increase in risk premium. The relatively weak domestic growth, especially the weak sentiment of overseas investors, combined with the continued disturbance of US bond rates and geopolitical situations, have collectively led to the increase in risk premium.

3. Which sectors dragged down earnings? Earnings expectations are still on a downward trend, with real estate and raw materials being the major drags

Real estate and materials industries are leading the decline. Although overall overseas Chinese stocks have achieved slight growth this year due to the low base of last year and the recovery of some consumer sectors, it has not been able to offset the impact of valuation contraction.

4. Market trends in 2023: From rebound and recovery, to volatile consolidation, and then to breaking through the downside

The trend of the Hong Kong stock market this year can be roughly divided into four stages. From the perspective of the market context, domestic policies are still the main factor driving market trends.

5. Outlook: Steady progress, fiscal policy remains the main reliance

Timely and substantial support from fiscal policies is still crucial for reversing the current situation in the market. Otherwise, even if the Federal Reserve cuts interest rates, it may still only be a weak rebound. In terms of operations, we still recommend continuing to adopt a "dumbbell" structure that combines offense and defense.

1. What dragged down market performance? Valuation contraction is the main factor; traditional value stocks performed poorly, while dividends and some growth stocks outperformed

Valuation contraction is the main drag.

From the perspective of valuation and earnings contribution breakdown, the Hang Seng State-owned Enterprises Index has fallen by 14.0% year-to-date, with valuation contraction dragging it down by -14.9% and earnings contributing a slight 1.2%. Other indices are similar, for example, the Hang Seng Index has fallen by 13.8%, with valuation contraction dragging it down by -16.3% and earnings contributing a slight 2.9%; the Hang Seng Tech Index has a relatively smaller decline of 8.8%, but valuation contraction accounts for 32.8% of the decline. Therefore, it is not difficult to see that valuation drag is the main factor leading to this year's market decline.

The poor performance of traditional value sectors (such as real estate, insurance, and consumer goods) is the main drag, while dividends and some growth styles have relatively outperformed.

At the sector level, most sectors of the Hong Kong stock market in 2023 have experienced declines, with real estate (-31.6%), consumer staples (-22.4%), insurance (-21.4%), and transportation (-20.8%) experiencing the largest declines. On the other hand, energy (+16%) is the only sector that has achieved positive returns, while telecom, IT, and media and entertainment have relatively smaller declines, which is consistent with our recommended "dumbbell" allocation strategy since the beginning of the year. In the underperforming industries mentioned above, valuation was a major drag, with the consumer staples sector contracting by 19.3% and healthcare valuations shrinking by 18.6%.

II. What are the main factors affecting valuation contraction? Rising risk premium

Weak domestic growth, particularly weak sentiment among overseas investors, coupled with the continued disturbance of US bond yields and geopolitical tensions, have collectively led to an increase in risk premium.

For example, the continuous outflow of overseas funds this year has to some extent pushed up the risk premium. According to EPFR statistics, overseas Chinese stocks have seen a cumulative outflow of USD 20.51 billion since March 2021.

We estimate that there is a strong negative correlation between risk premium and active foreign capital inflows, with a correlation coefficient of -0.49, which explains part of the increase in risk premium.

III. Which sectors have dragged down profits? Profit expectations are still on a downward trend, with real estate and raw materials being the major drags

Real estate and materials industries are leading the decline. Although overseas Chinese stocks have achieved a slight increase in overall profits this year (MSCI China Index profit growth rate is 2%), thanks to the low base of last year and the recovery of some consumer sectors (such as hotels and entertainment), they have made a small contribution to the performance of the index, but it was not enough to offset the impact of valuation contraction.

More importantly, overall profit expectations are still on a downward trend, with real estate and raw materials being the most obvious, while communication services and energy have shown some recovery. At the same time, revenue expectations have declined by 5.8%, with information technology (-13.2%) and consumer staples (-10.4%) experiencing the largest declines. However, education services (+20.8%) and aviation (+12.2%) have shown significant recovery.

In terms of growth rate, MSCI China's revenue in 2023 decreased by 11.2% YoY, with the financial industry (-35.7%) experiencing the largest decline, while discretionary consumer (+11.4%) showed the strongest recovery.

IV. Market trends in 2023: From rebound and recovery, to volatile consolidation, and then to breaking through support levels

The trend of the Hong Kong stock market last year can be roughly divided into four stages:

1. From the end of October 2022 to the end of January this year, with improved domestic growth expectations and improved US denominator expectations (core inflation peaked and fell back), the Hong Kong stock market rebounded strongly, especially in the real estate chain sector and growth stocks.

2. From early February to mid-May, the overly high expectations on both the numerator and denominator sides were corrected, and the Hong Kong stock market remained volatile, with high dividends leading the way.

3. From mid-May to the end of July: domestic policy expectations improved, short-term growth recovered, and high dividends surged and then fell back.

4. From August to the present, domestic policy and growth expectations weakened, US bond rates rose again, the Hong Kong stock market broke through support levels and hit new lows for the year. Although there were some rebounds in between, as well as a rapid decline in US bond rates, they were unable to effectively reverse the market trend.

From the market context of this year, domestic policy remains the main factor influencing market trends.

After March, the fiscal deficit impulse continued to shrink, and the market performance weakened thereafter; after the July Politburo meeting, various real estate policies continued to be optimized, but adjustments in first-tier cities were relatively delayed, and relaxation only became evident recently, leading to a short-term rebound; the issuance of one trillion RMB in government bonds at the end of October, representing "central deleveraging," was a targeted policy, and the market temporarily warmed up. However, due to concerns that the subsequent measures would fall short of expectations, the market remained weak even as US bond rates declined rapidly.

We estimate that in order to reverse the fiscal impulse, a net increase of approximately 3 trillion RMB in the deficit scale is needed.

V. Outlook: Steady progress, with fiscal policy still the main reliance

Since November, US bond rates have declined faster than expected, but the Hong Kong stock market still shows signs of weakness, fully demonstrating that domestic growth and policy are the main drivers of the market.

Looking ahead to next year, we believe that fiscal expansion is the key and targeted lever to reverse the credit cycle and weak growth. The Central Economic Work Conference in December pointed out that "active fiscal policy should be moderately strengthened and improved in quality and efficiency." Based on this, there is a consensus in the market that there may be expectations for an increase in fiscal expenditure next year.

However, we reiterate our previous view that timely and more forceful fiscal policy support is still crucial for the market to reverse the current situation, considering the effectiveness of the policy and its "shelf life." We estimate that expanding the fiscal deficit by 5-6 trillion RMB is expected to bring the fiscal impulse to a historical high of 4% in the first half of 2024; if the fiscal deficit expands by about 3 trillion RMB, the corresponding fiscal impulse will return to positive territory in the middle of next year.

In summary, we reiterate our previous view that timely and more forceful fiscal policy support is still crucial for the market to reverse the current situation. Otherwise, even if the Federal Reserve cuts interest rates, it may still only result in a weak rebound.

At the operational level, we still recommend adopting a "buying on dips" strategy to deal with possible consolidation, continuing to focus on stable cash flow sectors (high-dividend industries still have attractiveness in the current macro environment, such as telecommunications, energy, and utilities), high-end technology upgrades (technology hardware, semiconductors), and mid-range advantageous industries going global (construction machinery, automobiles and parts, new energy and photovoltaics, certain consumer products and brands), these three main themes.