HK/China Equity Perspectives [October 2019]: A Black Swan or a Buying Opportunity

INTEREST RATE NO LONGER A DRIVER

We argued early this year that the three key elements which could drive the market performance in 2019 would be

• Trade tension between China and the US
• Macroeconomics
• Interest rate direction

At the current juncture, we believe interest rate is no longer one of the key elements as we have witnessed how expectation had turned a 180 degree since early this year, with more central banks joining the US Federal Reserves (FED) to ease further.

TRADE TENSION TO TECH WAR TO CAPITAL MARKET WAR?

ADRs experienced significant selling pressure due to speculations in late September that the US administration may restrict Chinese corporates’ access to the US capital market (see diagram 1).

Although the US Treasury Department has already clarified that there has been no plan to prohibit Chinese companies from listing in the US markets, it certainly has already affected investor sentiment and weighted down valuations of Chinese ADRs.

Since the trade war which began last year, it had morphed into a technology war with sanctions against prominent Chinese enterprises such as ZTE and Huawei, and now potentially escalating into a capital market war, which restricts Chinese corporates’ access to the US capital market.

In our view, if it happens, the impact on the Chinese economy would be far bigger than the additional trade tariff or technology embargo.

Nevertheless, as these measures would also have huge impact on the US financial industry, we do not expect the US government to launch them especially before the US presidential election in November 2020.

MACRO – SURPRISE PMI RECOVERY

China industrial production dropped to two-decade low of 4.4% year-on-year in August, suggesting heightened growth pressure. However, September PMI (Purchasing Managers Index) came in better than expected.

China’s official PMI edged up to 49.8 in September from 49.5 in August, thanks to recoveries in production and total new order. The Caixin China manufacturing PMI – which tracks 500 small, private manufacturers, also rose to 51.4 in September from 50.4 in August, the second consecutive month the index stayed above 50, signifying expansion in activity.

The surprise PMI recovery perhaps justified PBoC’s decision of cutting LBR (Loan Prime Rate) only by 5bps, which is below market expectation. The PBoC also indicated there is no urgency for further monetary easing. While we do not expect China economic growth to accelerate from there, the PMI figures do suggest the macro conditions are better than feared.

LOCAL POLITICAL UNREST IS A NEW CONCERN

Hong Kong politics has become the new key swing factor, at least for the Hong Kong equity market.

Since early June, Hong Kong retail related equities have experienced significant downward pressure on the back of the on-going protests, which has resulted in sharp reduction in mainland tourist arrivals (see diagram 2).

The political unrest also impacted investor sentiment and resulted in reduced transaction volume in Hong Kong equity market (see diagram 3).

OCTOBER – A MONTH OF HIGH RISK HIGH RETURN

We estimated that less than 25% of the index-weighted earnings for HSI are directly generated in Hong Kong. It is interesting to note that statistics shows over the last 30 years, October, on average, recorded the best monthly return for HSI (see diagram 4).

However, we believe most investors would not have forgotten about the two worst monthly performances, which also happened in the month of October (1997, 2008). We believe investors should not be overly pessimistic, especially for Hong Kong listed H-shares given their cheap-valuations.

While we remain cautious about the downside risk from local politics, we see any significant correction as a good buying opportunity.

CONSUMER SECTOR – FOCUS ON CHINA, AVOID HONG KONG

We continue to favour the consumer sectors, pivoting our focus on China domestic consumption while avoiding the Hong Kong retail names (see diagram 5).

We believe that the latest PMI figures point to a recovery in domestic demand, and China domestic consumption remains relatively more insulated from the trade tension between China and the US.

On the other hand, share prices of Hong Kong retailors and retail landlords have experienced significant pullback over the

last three months. In the near-term, it is difficult to determine when and how the protests in Hong Kong are going to end.

In the longer-term, with the government now encouraging Chinese companies, particularly state-own enterprises, to increase investment in Hong Kong, investors may also have concerns about local companies’ competitive positioning in the future. We therefore expect domestic Hong Kong consumer companies to experience prolonged valuation de-rating against their mainland peers.