Under the expectation of interest rate cuts, the resilience of Hong Kong stocks is still greater than that of A-shares

Abstract

Despite the increased market volatility this week following external fluctuations, and the first weekly net outflow of southbound funds since February, the market still closed higher and continued to outperform A-shares. The independent upward trend of the Hong Kong stock market further confirms our previous view that the Hong Kong stock market can demonstrate greater resilience than A-shares.

Structurally, dividend-paying sectors represented by banks benefited from domestic fund preferences leading the gains again. Recently, the Hong Kong stock market welcomed the "interim report season," with some leading companies receiving widespread market attention. We have previously pointed out that the structural trend is still the main theme of the Hong Kong stock market, corresponding to high dividend factors with long-term returns, as well as technology growth supported by industry prosperity (internet, gaming, education) or policies (technology hardware and semiconductors), and this recent performance has been largely confirmed. In addition, it is worth mentioning that on August 23, Alibaba Group announced that it will dual-list on the Hong Kong Stock Exchange on August 28. If it can be included in the Hong Kong Stock Connect during this round of adjustment on September 9, referring to the proportion of shares held by comparable companies three months after inclusion in the Connect, it is expected to bring in approximately HKD 6 billion incremental funds in the three months after inclusion, with a long-term potential of about HKD 150 billion in incremental funds.

Overseas, the interest rate reduction cycle is about to begin, and solely on this point, the Hong Kong stock market has greater resilience, especially in the long-term growth sectors. However, we still emphasize that for both the Chinese A-share and Hong Kong stock markets, the significance of the Fed rate cut lies in providing room for internal policy operations, which is the core determinant of the trends in the A-share and Hong Kong stock markets, rather than the Fed rate cut itself. In the future, the Fed rate cut provides a window for further easing of domestic policies, if the easing intensity can be stronger than the Fed (the difference between China's actual interest rate and natural interest rate is higher than that of the United States) at that time, it can provide greater stimulus to the market, especially the Hong Kong stock market; conversely, if the easing is the same but the intensity remains flat or even weak, it will not change the overall volatile market structure.

Main Content

"Independent Trend" of Hong Kong Stocks and Structural Opportunities

Market Trend Review

The Hong Kong stock market closed higher again this week and continued to outperform A-shares. The Hang Seng Index rose by 1.0%, the Hang Seng China Enterprises Index and the Hang Seng Tech Index rose by 0.9% and 0.3% respectively, while the MSCI China Index edged up by 0.1%. In terms of sectors, insurance (+2.5%), banks (+2.0%), and information technology (+1.6%) led the gains, while healthcare (-4.6%), consumer staples (-3.2%), and real estate (-2.6%) sectors lagged behind.

Chart: Dividend-paying sectors represented by banks continued to lead the performance this week

Source: FactSet, CICC Research Department

Market Outlook

Despite the increased market volatility this week following external fluctuations, and the first weekly net outflow of southbound funds since February, the market still closed higher and continued to outperform A-shares. The independent upward trend of the Hong Kong stock market further confirms our previous view. Although the Hong Kong stock market is difficult to completely "stand alone" under external turmoil, the decline under low valuation and low positions is relatively controllable. And can quickly rebound and repair, showing greater elasticity than A shares.**

We believe that compared to A shares, the advantages of Hong Kong stocks are: 1) The profit and income structure is more advantageous, with the well-performing Internet sector coincidentally being a sector with a larger weight in Hong Kong stocks, while the midstream manufacturing industry, which has a large proportion in A shares, is generally under pressure due to current oversupply and price pressure. We predict from top to bottom that the full-year profit growth of Hong Kong stocks is expected to achieve 3-4%, better than the 1-2% of A shares, although the overall magnitude is limited, the structural advantages are more prominent. 2) Valuation clearance is relatively sufficient. The Internet, as a "core asset" of Hong Kong stocks, has been sufficiently adjusted over the past three years. Taking Alibaba and Tencent as examples, the current PEs of the two are 22% and 2% respectively, falling below the historical 25th percentile; 3) Foreign positions and chip callbacks are relatively sufficient. According to EPFR data, the proportion of overseas funds holding Chinese stocks has dropped from a high of 15% at the beginning of 2021 to around 5% currently (CICC | Hong Kong stocks: Hong Kong stocks have greater elasticity, CICC | Hong Kong stocks: "scarce" assets in the current environment)

Chart: The well-performing new economy sector has a large proportion in Hong Kong stocks, while the relatively pressured midstream surplus sector has a large proportion in A shares

Source: Bloomberg, CICC Research Department

Chart: The upstream sector has good profit performance, while the midstream is generally under pressure

Source: Bloomberg, CICC Research Department

Chart: Under the benchmark scenario, we expect Hong Kong stock profit growth to be around 3% in 2024

Source: Bloomberg, CICC Research Department

Chart: Tencent and Alibaba's forward PEs are at historical 2% and 22% respectively

Source: Bloomberg, CICC Research Department

Chart: The proportion of active funds globally allocated to Chinese stocks has dropped from a high of 14.6% at the end of 2020 to the current 5.7%, and underweight by 1.1ppt

Source: Bloomberg, CICC Research Department

Structurally, dividend sectors represented by banks benefit from domestic fund preferences leading the rise again. This week, amidst the overall outflow of southbound funds, the banking sector still received an inflow of HKD 1.69 billion in southbound funds, ranking first in southbound fund holdings. Recently, Hong Kong stocks have ushered in the "interim report season", with some leading companies such as Bubble Mart achieving a net profit increase of 90% in the first half of the year due to strong overseas business expansion, resulting in a weekly increase of over 20%; Alibaba and Tencent both exceeded expectations in profits, attracting widespread market attention. Tencent, in particular, received continuous Southbound funds for four weeks in a row, with a cumulative inflow of HKD 35.1 billion. As we previously indicated, the structural market trend remains the main theme for Hong Kong stocks, corresponding to factors such as high dividends with long-term downside protection, as well as technology growth supported by industry prosperity (internet, gaming, education) or policy support (technology hardware and semiconductors). This recent performance has been largely confirmed (CICC 2024 Outlook | Hong Kong Market: Slow and Steady (Full Version)).

Additionally, it is worth mentioning that on August 23, Alibaba Group announced that it will conduct a dual listing on the Hong Kong Stock Exchange on August 28. If Alibaba Group can catch the Hong Kong Stock Connect inspection day on September 5 and be included in the Stock Connect during the adjustment on September 9, based on our joint calculation with CICC's Internet team, referring to the proportion of shares held by comparable companies after inclusion in the Stock Connect for three months, we believe that this adjustment may bring in approximately HKD 6 billion in incremental funds over the following three months; based on Tencent's current Stock Connect holding ratio, it is expected to bring in approximately HKD 150 billion in incremental funds in the long term.

Chart: Banks rank first in Southbound fund inflows

Source: Bloomberg, CICC Research Department

Internationally, the interest rate reduction cycle is about to begin, and in this regard, Hong Kong stocks have greater resilience, especially in the long-term growth sectors. On the evening of August 23, at the Jackson Hole Symposium, Powell stated that it is time for policy adjustments, almost equivalent to an early announcement of a rate cut in September. The probability of a rate cut in September is 100% according to CME interest rate futures, with a 76% probability of a 25bp rate cut and a 24% probability of a 50bp rate cut. Based on past rate cuts, Hong Kong stocks typically rebound at the beginning of a rate cut cycle, and under liquidity drive, the resilience is greater than A-shares, with relatively higher win rates and returns. Sectors with high resilience and interest rate sensitivity are expected to benefit more, such as semiconductors, automobiles (including new energy), and media and entertainment. We believe that the current 10-year U.S. Treasury yield of 3.8% has already priced in the rate cut expectations sufficiently. If the risk premium returns to the level of mid-last year, the Hang Seng Index would correspond to around 19,000; if earnings grow by 10% on this basis, the Hang Seng Index would reach 21,000 (Chart 7) (CICC | Hong Kong: Hong Kong in the Rate Cut Cycle).

Chart: 10-year U.S. Treasury yield at 3.8%, corresponding to around 19,000 for the Hang Seng Index if the risk premium returns to the level of mid-last year

Source: Wind, CICC Research Department

**However, we still emphasize that for both the Chinese markets, whether in Hong Kong or A-shares, the significance of the Fed rate cut lies in providing room for internal policy operations, which is the core factor determining the trends of A-shares and Hong Kong stocks markets, rather than the Fed rate cut itself **Taking the interest rate cut cycle in 2019 as an example, the significant rebound in A-shares and Hong Kong stocks actually occurred in the 1st to 3rd months when Powell announced the halt of rate hikes at the beginning of 2019, rather than the formal rate cuts in the 7th to 9th months. The reason behind this is that when Powell announced the halt of rate hikes at the beginning of 2019, China also decided to cut the reserve requirement ratio, creating a resonance internally and externally. On the contrary, after April, the policy reiterated the "monetary policy total gate" in opposition to the Fed's easing, so even when the Fed officially cut rates from July to September, A-shares and Hong Kong stocks overall maintained a volatile pattern, reflecting more the weak domestic recovery fundamentals and tight policies rather than the Fed rate cuts, with overseas funds also flowing out during this period. Therefore, it is not difficult to see that the future Fed rate cuts provide a window for domestic policies to further ease.If the easing intensity at that time can be stronger than the Fed's (the difference between China's actual interest rate and natural interest rate is higher than that of the United States), it can provide greater boost to the market, especially to Hong Kong stocks; conversely, if the easing is the same but the intensity is equal or even weaker, it will not change the overall volatile market structure.

Chart: Overseas funds mainly follow the fundamentals during the rate cut period, not solely determined by the Fed

Source: Wind, CICC Research Department

Considering this, based on the judgment of the current environment and practical constraints, for the Chinese market, we believe that the impact of the Fed rate cuts may be smaller than the U.S. presidential election. Under the baseline scenario, we expect that the fiscal policy efforts in the third quarter will be more positive than the marginal contraction in the second quarter, but the expectation of "strong stimulus" is still unrealistic.

In terms of allocation strategy, we still suggest that the flexibility of Hong Kong stocks is greater than that of A-shares, and in short-term rate cut trading, growth sectors benefiting from the logic of the denominator may have higher elasticity, such as semiconductors, automobiles (including new energy), media and entertainment, software, biotechnology, etc. However, overall, until we see greater fiscal support, the structural market with wide range volatility remains the main theme. We continue our allocation logic in the second half of the year, recommending three directions under the structural market: downward overall return (high dividends and high buybacks for stable returns, i.e., "cash cows" with ample cash flow; short-term dividends may see differentiation in local dividends, low volatility dividends, and cyclical dividends), partial leverage (industries with certain prosperity or technological growth benefiting from policy support), partial price increase (natural monopoly sectors, utilities, etc.).

Specifically, the main logic supporting our above views and the changes to focus on this week include:

1) Alibaba announced that it will conduct a dual listing in Hong Kong, with the earliest possibility of inclusion in the Stock Connect in September. On August 23, Alibaba Group announced that it will add Hong Kong as a primary listing venue and will be listed on the main board of the Hong Kong Stock Exchange on August 28, without involving new share issuance and financing. We believe that it may be included in the Stock Connect as early as September, which will further expand the scope of mutual access targets and help attract more southbound funds into the Hong Kong market. According to our calculations, it is expected to bring in approximately HKD 6 billion of incremental funds in the three months after inclusion 2) Federal Reserve Chairman Powell delivered a speech at the Jackson Hole Global Central Bank Annual Meeting, clearly indicating a shift in monetary policy. Powell declared at the meeting that "it is time for a policy shift," essentially confirming an interest rate cut in September, as expected. CME interest rate futures imply a 65.5% probability of a 25bp rate cut in September and a 34.5% probability of a 50bp cut. The Fed's focus has shifted from inflation to employment, essentially declaring victory in combating inflation, assessing the job market as no longer overheated, already balanced, and risks are rising.

3) This week, southbound funds turned into outflows, while overseas active funds continued to flow out. Specifically, data from EPFR shows that last week, overseas active funds continued to flow out of overseas Chinese A-share markets, with outflows of approximately $240 million, roughly in line with the previous week, marking 67 consecutive weeks of outflows. Meanwhile, overseas passive funds continued to flow in with $70 million (compared to outflows of $240 million the previous week). Southbound funds also turned into outflows this week, with a total outflow of $1.46 billion Hong Kong dollars last week, compared to inflows of $15.15 billion Hong Kong dollars the previous week.

Key Events to Watch

August 31st: China Manufacturing PMI, September 9th: China CPI and PPI

Authors: Liu Gang S0080512030003, Wu Wei S0080524070001, Zhang Weihan S0080524010002, Source: Kevin Strategy Research, Original Title: "Hong Kong Stocks: The 'Independent Trend' and Structural Opportunities of Hong Kong Stocks"