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2018 Outlook - Hong Kong Equity Market

December 2017

2017 has been a very strong year for equity markets, and the Hong Kong market has been among the best performers globally, with the Hang Seng Index up more than 30% at the time of writing. This is especially impressive as we entered the year with considerable macro uncertainty in the world following the shock election of President Trump in the US on a platform that was very hostile to free trade, and China in particular. The US dollar was also rallying strongly, which in the past has created headwinds for Asian markets, and the Fed was expected to hike rates several times and commence tapering its balance sheet, all of which had the scope to upset the equilibrium in global asset markets after such a long period of ultra-low rates. North Korea, meanwhile, also presented a more and more visible threat to regional security.

In reality, however, politics globally have largely remained a side-show this year, and it has been the continued benign economic backdrop that has helped underpin markets. Global growth has strengthened moderately while, critically, inflationary pressures have remained very subdued - so bond yields have remained well anchored at close to their historical lows despite the Fed hiking rates three times and starting taper. The US dollar, meanwhile has pulled back from its earlier highs. Despite the hostile rhetoric from the US, there have been only very limited trade sanctions imposed and global trade growth has continued to strengthen after several years in the doldrums. This so-called ‘goldilocks’ environment – not too hot, not too cold – is ideal for equity investors as the improving growth supports corporate earnings, while there is still no pressure on valuation multiples from a rising cost of capital.

In China we have seen a slightly more mixed backdrop this year. Growth has improved in 2017 versus 2015/16 as the lagged impact of strong credit growth and booming property prices have fed through into investment spending, while the stronger external backdrop has supported exports. Consumption has also remained robust, again supported by rapid household loan growth and the positive wealth impact of buoyant property prices. However, unlike most western economies, China has seen market interest rates and bond yields rising sharply at the same time, as the Central Bank has moved to try and squeeze out some of the excess leverage in the ‘shadow banking’ system. Partly reflecting this different liquidity backdrop, on-shore China A-shares have in general underperformed their off-shore H-share or US listed counterparts.

Although overall GDP growth and investment spending have been fairly robust in recent quarters, helping out the profits for the more cyclical parts of China’s ‘old economy’, some of the strongest performance in the China equity markets continues to come from those companies geared into the strong secular trends in the service sector. On-line companies like Tencent, Baidu, Alibaba continue to rapidly gain market share from off-line peers in areas like retailing, advertising and entertainment, while also stimulating the creation of profitable whole new markets in areas like mobile gaming, cloud computing etc. Strong demand from consumers ‘upgrading’ their products in sectors like autos, electrical goods, home furnishings is also enabling outsized revenue growth from companies offering aspirational products to local buyers. More generally, rising urban incomes also continues to support strong demand in areas like travel and education.

Encouragingly, with the opening up of the A-share market through the Stock-Connect in the last two years, we are also presented with a much wider universe of stocks with which to gain exposure to these trends.

Closer to home in Hong Kong, we look at companies that have outgrown the relatively mature Hong Kong economy and are delivering attractive growth from their regional or global footprints – banks, insurance companies, conglomerates, manufacturing businesses etc. The gradual uptrend in US and Hong Kong dollar interest rates is further supporting margins and revenues for some of these financial names. In addition, we also continue to see attractive value in some of the more traditional Hong Kong property names – particularly those concentrated in the commercial rather than residential markets, where a lack of supply is putting upward pressure on rents and rising recurring income can drive strong dividend growth over the longer term. Rising US rates would normally present some headwinds to these names, but equity prices have long since decoupled from the physical property markets in Hong Kong, and with discounts to net asset value approaching 50% in many cases, we think these risks are largely priced in.

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