HK's stock market should withstand the end of QE2
with Tom Holland
With less than three months to go before the US Federal Reserve is due to turn off its printing presses and end the second round of its 'quantitative easing' stimulus policy, fears are growing that without the Fed's liquidity injections share prices in Hong Kong and across Asia could begin to sink once again.
At first glance, these fears appear sensible enough. After all, after the Fed finished its first round of quantitative easing at the end of March 2010, Hong Kong's Hang Seng index continued to defy gravity for another week or so before slumping almost 15 per cent over the next weeks.
Conversely, at the beginning of last October, when the Fed hinted it was preparing to launch a second round of the policy - dubbed QE2 by the markets - the news had a galvanising effect on Hong Kong stocks. Over the next few weeks the market climbed by 12 per cent (see the first chart below).
So it is hardly surprising that with QE2 set to come to a halt at the end of June, investors are getting nervous that Hong Kong's latest run-up may itself soon run out of steam.
The fear is that with the Fed no longer printing money by buying up US government debt, the great flood tide of liquidity that has swept into Asian markets will begin to ebb, and that local asset prices will sink, with the Hang Seng index surrendering the gains which have recently carried it once again above the 24,000 mark.
Happily, however, there are reasons to believe the end of QE2 may not be the market disaster some fear.
For one thing, it is not entirely clear that the mechanism by which QE2 was expected to support Asian stock prices worked as investors had anticipated when they bought into the region last October and November.
Their idea was that the Fed's US$75 billion a month of US government debt purchases would drive down the yields on US Treasury notes. That would make it less attractive to hold US debt, prompting investors to switch to higher growth markets in Asia.
But things didn't quite work out like that. In fact, some investors concluded the policy was indeed stimulating the US economy as intended. That not only pushed up Treasury yields, improving their attractiveness, it also focused attention on the cheap valuations available in the US stock market.
As a result the fund flows have already reversed. As the second chart below shows, according to specialist research house EPFR Global, since the beginning of 2010 international investors have pulled more than US$20 billion out of emerging market equity funds while pumping around US$50 billion into developed market stock funds.
That turnaround has had a marked effect on valuations. At the end of last year Hong Kong stocks were looking expensive on a price to earnings basis compared with US stocks. Since then, however, the US equity market has outperformed Hong Kong, and today the relationship is the other way round. Yesterday the Hang Seng was trading at 12.7 times expected earnings for this year, while the benchmark US S&P500 index was at 13.7 times.
That means the situation now is very different from March 2010, when the Fed ended its first round of quantitative easing. According to analysts at Credit Suisse, then emerging market stocks were 11 per cent over-valued on a range of measures, including price to earnings ratios and dividend yields. Today they are 5 per cent under-valued.
As a result, there is less chance today that the end of QE2 will trigger the sort of slump we saw in Asian markets over April and May of 2010. That sell-off was prompted at least in part by a flight to safety as investors reacted to the European crisis by cutting their exposure to relatively pricey, and relatively high risk, Asian assets.
Over the next few months, barring fresh shocks from Japan, the Middle East or the European periphery, there is a fair chance that investors will decide that the direct effects of quantitative easing on fund flows have been over-estimated, and that on more sober assessment, Asian markets are looking reasonably valued and relatively attractive.
The market could still suffer, of course, especially if expectations of short-term interest increases grow. But hopefully the end of QE2 is unlikely to prompt a sell-off of the magnitude that we saw when the Fed concluded its first round of quantitative easing.