Peg offers hook to gain from equity yields gap

PUBLISHED : Friday, 12 June, 1998, 12:00am
UPDATED : Friday, 12 June, 1998, 12:00am

As I see it, there is a two-item check list on the question of whether the Hong Kong stock market offers value at the moment. Mark your choice: 1) Will the peg to the US dollar hold? Yes/No.

2) Will inflation in the US remain restrained? Yes/No.

I have already argued in this column that the defences of the yuan in the mainland are stronger than most people think, and that the influence of the yen on the rest of Asia is weaker than most people think.

Ergo, I do not subscribe to the commonly held theory that a declining yen will take the yuan with it and that Hong Kong's peg will then become untenable.

My answer to the first question on the check list is yes.

Secondly, there is no indication that US inflation will rocket upwards soon. The pessimists have predicted this for years and have been consistently wrong.

Disinflation is now entrenched in the US economic structure through the size of the US dollar capital markets.

It is not the Fed in control here so much as fixed-income investors who do not like inflation and who have the clout to stop it. Mark the answer to that second question as yes too.

Now follow it from step to step. If US inflation remains down, then US interest rates will remain down. I am not saying we won't see the occasional scare and a blip upwards, but the long-term trend will keep bond yields generally where they are.

If US interest rates remain low, then price earnings ratios on the US stock market will remain high. Earnings growth will probably decline, but it is not earnings growth that is the primary determinant of the pricing level of a stock market.

In an efficient market, this is governed more by the pricing of competing financial assets in the same currency.

The HK dollar is effectively the same currency as long as the peg lasts.

Political sovereignty over Hong Kong may have been restored to the mainland last year but economic sovereignty was surrendered to the US when the peg was adopted in 1983. That is what a currency board link does. It makes you a currency colony.

Now look at the difference in pricing between the Hong Kong and US stock markets. Only, instead of taking the price divided by the earnings to get a PE ratio, take the earnings as a percentage of the price to get an earnings yield.

This way, it is more easily compared with interest rates and property returns.

What the chart shows is that pricing in Hong Kong is more volatile and cheaper than in the US (it offers a higher yield) but it has generally followed the US up and down for years. Except now, of course, the yield gap between the two has widened enormously.

What it offers is the investment opportunity of substantially higher returns in Hong Kong than in the US with no currency risk as long as the peg holds.

I think the peg will hold. I think the valuation is compelling.


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