Hang Seng Index

Equities at the ready in Hong Kong

Hongkongers have shunned stocks for property and bonds. But it's timeto return to equities

PUBLISHED : Monday, 22 October, 2012, 12:00am
UPDATED : Monday, 22 October, 2012, 1:54am

Giulia Liu, a retiree in her late 50s, got burned trading stocks last year. She put HK$1.6 million into the local market, trading individual shares with a focus on small-caps, and lost 60 per cent of her money when markets dived on the euro-zone crisis.

"One year ago, I was trading heavily. It was my first experience trading stocks," says Liu. "I was confident, I made a little money, but [in 2011] a lot of it was wiped out."

Liu spent the past year avoiding the stock market, but recently has started trading again, encouraged by the market bounce seen after the US Federal Reserve announced a third round of quantitative easing (QE3).

Liu is on to something. People are talking about equities again. The market is up 17 per cent this year and what may be Hong Kong's biggest listing in 2012 - Shanghai Fosun Pharmaceutical - is going through bookbuilding. (See IPO preview, linked beside).

The time may be now to dive back into that most maligned asset, Hong Kong equities.

Let's put matters into context. Hong Kong is on track for its slowest IPO year since 2003, when the Sars outbreak stopped the city in its tracks. Share trading is down 40 per cent from 2007 levels, in terms of dollar value. (See chart.)

Investors have pulled out of this market on a massive scale and, in their wake, several brokerages have wound up or drastically cut equity trading operations in Hong Kong, including Royal Bank of Scotland, Samsung Securities, Piper Jaffray, Renaissance, MF Global, Daiwa Capital Markets and Mizuho Securities.

People have jettisoned Hong Kong equities for good reason. Investors were burned on a series of poorly performing IPOs late last year. The market generally has underperformed for the past three years, courtesy of the euro-zone crisis, a slowing Chinese economy, and anxious talk of a US "fiscal cliff" that could trigger huge cuts in government spending and, with it, a recession.

The International Monetary Fund chimed in earlier this month with a bearish outlook for the global economy. And finally there's the matter of leadership changes in the United States and China next month.

"Beginning in April, trading volume on the Hong Kong exchange fell off sharply. While we have seen a modest pickup following the announcement of QE3, concerns regarding growth in the mainland, a change in leadership both in China and the US, as well as euro-zone uncertainties, have seemingly kept investors on the sidelines," says Michael Beer of Citi's Hong Kong equity strategy team.

There is still much uncertainty and reason to be negative. All of which begs the question as to why investors should return to such a problematic asset.

There are two reasons, negative and positive.

The bad lies in the fact that Hongkongers, in switching out of equities, invested too heavily in bonds and property. Both assets are at the mercy of rising interest rates which, while not likely today, will happen eventually. When interest rates do rise it will hit bond and property prices simultaneously. Those investors with all their eggs in these baskets will be wishing they had some diversification in, for example, equities.

And while property and bonds have been on a terrific run since 2008, there are reasons to worry the market for both is heading for a correction.

The benchmark Hong Kong Centaline property index reached its highest level in March. Analysts have been talking about an overheated property market for more than a year, and Hong Kong's housing chief Anthony Cheung Bing-leung this month warned the market is in a "strange and worrying" state. When discussing real estate, the word of the moment is "bubble".

Likewise, people may not appreciate the extent to which conservative assets like bonds can get bid up, and subsequently fall in price. Should the day come when interest rates rise, bond prices will fall, and the outcome might easily be losses - even for top-rated, ultra-conservative bond funds.

Meanwhile, there is the simple mathmatical fact that, as bond prices rise, yields drop. As it stands, US-dollar investment-grade bonds yield far less than Hong Kong's rate of inflation. Owning these investments will lose you money in the long run.

"It's hard to find value in bonds," says Mark Konyn, chief executive of Cathay Conning Asset Management.

Coutts private bank recently announced it was cutting its exposure to bonds in favour of equities, partly because bonds are too expensive and yields too low. The bank also anticipates an equities revival, which will take money out of bonds, causing their prices to fall. "We are gradually reducing our exposure to cash and investment-grade corporate bonds to buy global equities," says Gary Dugan, chief investment officer, Asia & Middle East, at Coutts.

So people need equities to diversify, in particular to insulate themselves from the risk of rising interest rates. But there are positive reasons to buy equities in their own right.

The first is that they are cheap. The Hang Seng Index is trading at about a 40 per cent discount to its historical average, as measured by the index's average price-earnings multiple, a benchmark used to compare share prices. (See chart.)

Hong Kong reits and high-dividend stocks, such as power and telephone firms, routinely pay dividends that beat bond yields. Power Assets Holdings (the renamed Hongkong Electric, of which the latter is now a subsidiary) pays a 4 per cent dividend yield, while a two-year bond from the same issuer yields 1.2 per cent, to cite just one example.

Stocks are volatile and prone to cataclysmic declines, as seen in 2008 and 2011. But long term they tend to outperform bonds and are the only asset that can dependably deliver real returns.

"Equities are one of the only asset classes to deliver a positive return after inflation," says Young Chin, chief investment officer, Pyramis Global Advisors.

Meanwhile, the US Fed's September QE3 announcement, which came alongside an aggressive bond-buying programme from the European Central Bank (ECB), has buoyed share prices around the world, including Hong Kong. The HSI is up 7.5 per cent since the Fed made public its money-printing plan.

"Quantitative easing and ECB actions are designed to inflate financial assets. This directly affects US and European equities," says Adrian Mowat, emerging market equity strategist for J.P. Morgan.

Mowat says Hong Kong equities typically follow the US market. The HSI, for example, almost exactly tracks the returns of the S&P 500, a US benchmark, in the year to date. The message being that, while the outlook is bearish on the mainland economy, the US market sets the pace for Hong Kong stocks and the American market looks buoyant: share prices are up, as is the housing market.

In another sign of a turnaround, Damien Brosnan, Asia head of ECM syndicate at UBS, says investors are slowly coming back to the city's beleaguered new-listings market. Brosnan is working on the Fosun Pharmaceutical listing and is getting orders from private bank clients for that offer. This is encouraging since private banks have been largely absent from the city's IPO market this year and anticipates the onset of a revival in demand.

"Over the past four to six weeks we've seen more interest in IPOs from wealth management clients and from brokers. It seems like it's getting better," says Brosnan.

Equities are an optimistic asset. People buy them because they believe economies will grow and profits rise, fuelling share price gains. And the recent uptick in Hong Kong equities suggests the beginnings of a turnaround in sentiment. The best argument for equities may simply be that people are more hopeful.

Liu, who lost so much money last year, is trading again, and says she has made 20 per cent returns in recent months. "There are a lot of positive signs the American market has improved, and maybe the [presidential] election might push it up a little bit. Local people like me are encouraged by this."