Investors may have scaled back but they haven't fled

The sell-off in the stock market over the past five weeks has been painful, especially for buyers who arrived late to the party. But while volatility has shot up and investors have scaled back their appetite for risk, the slide in share prices does not reflect a wholesale retreat from Hong Kong's financial markets.

That will stand holders of locally listed stocks in good stead when sentiment turns up.

Since hitting a 51/2-year high of 17,328 points on May 8, the Hang Seng Index has shed more than 2,000 points. The reason - insofar as there is ever a discernible reason for market movements - is that investors trimmed the weighting of risky assets in their portfolios.

With the Hang Seng Index up 16 per cent for the year by early last month, it was a sensible enough step. Against a backdrop of record high oil prices, mounting inflationary pressures thtahreatened to push US interest rates higher than previously expected and a pending crackdown on over-investment in China, shareholders sensibly decided to cash in some gains.

If you're cynical enough, you might also consider the possibility that fund managers decided to lock in some profit to clear the way for staying up late to cheer on their World Cup favourites.

Of course, the steep market decline was not limited to Hong Kong. Stock markets around the world swooned, commodities tumbled and high-yield bond prices dropped. In Asia, regional currencies slipped back against the US dollar as international investors repatriated their money. Overall, the level of volatility in global financial markets shot higher. In the US, the VIX index, which measures equity market volatility, doubled between the beginning of last month and early this month (see chart).

The turmoil is likely to continue for a while yet. Following Wednesday's unexpectedly high inflation data from the US, financial strategists are busy revising their forecasts for US interest rates. Most now believe another 25 basis point rise is a foregone conclusion when the Fed meets in two weeks' time. A growing number think one further rate rise is likely after that, pushing the key US federal funds rate to 5.5 per cent, its highest in more than five years.

Even so, there are grounds for optimism for local investors. Despite 16 successive increases that have seen the benchmark short-term US dollar interest rates rise fivefold over the past two years and the recent emerging markets' sell-off, Hong Kong interest rates remain at a considerable discount to comparable US dollar rates (see chart).

In other words, although investors in Hong Kong may have scaled back their exposure to local equities, they have not fled the territory altogether in search of safer havens for their cash.

In fact, in recent weeks the discount of the three-month Hong Kong interbank offered rate to its London counterpart has held steady at between 0.6 and 0.7 of a percentage point, indicating that financial markets have retained a deep pool of liquidity, despite heightened perceptions of risk. According to HSBC economist George Leung fund outflows have been 'negligible'.

Tai Hui, an economist at Standard Chartered Bank, thinks the discount will narrow somewhat over the coming months. Mr Leung expects it to widen. But both believe it is here to stay. That means there will be plenty of funds poised to re-enter the local stock market when investors' appetite for local equities recovers, whetted by strong economic growth and healthy corporate earnings prospects.

Ultimately, the current sell-off could prove no more lasting than the correction that hit the market two years ago.

Back then, fears of high oil prices, rising interest rates and investment restrictions in China triggered a 3,000-point slump in the Hang Seng between February and May of 2004. Within six months, however, the market had recovered its losses and few now remember the slide.