ING Investment Management is cautiously optimistic about the outlook for Hong Kong stocks. Senior investment manager Oscar Leung Kin-fai says there is the possibility of resistance, or even a correction, as we enter the historically volatile month of October. In the all-important property sector, Mr Leung favours developers over investors, and he points to recent rosy signs of a turnaround in property market activity. 'We see transaction volumes and prices of property have been picking up a bit in the past month. For developers, the government is bringing in more measures to support the market, so we think the developers will continue to outperform the market in expectation of a recovery in the market,' Mr Leung says. 'For property investors, the recent rally in investor stocks may need to take a rest. In terms of earnings, investors will remain flat. The current value is just a narrowing of the market discount to net asset value. We don't really see a dramatic pickup in their revenue.' But for developers, Mr Leung says he expects more of a pickup in earnings as they continue strategically to sell properties and book profits. He says a rebound in property prices will, if sustained, tip the balance of the local economy well toward recovery. 'Once we see a slight pickup in property prices, or people's confidence in the property market is restored, then we can see more consumption created. That will bring a wealth effect and a feel-good effect. That will help domestic consumption, which has been holding back the economy.' According to Mr Leung, the negative wealth effect of low property prices, including the more than 100,000 homes in negative equity, has been acting as a dampener on consumption. 'Property owners whose property values have dropped don't feel good. They tend to be cautious, they don't spend, they just keep their money in the bank and don't buy much. So a slight improvement in property prices will definitely create some wealth effect.' He says the property market is running ahead of the economy, showing some signs of life but not enough to convince people it is in an uptrend. 'People feel more optimistic about 2004 and, we hope, the next round will be the rebound in the real economy as well as a pickup in activity and property prices.' With that will come the benign impact of positive wealth effect: growth in the stock market leading to more consumption and a further pickup in property prices, in turn leading to an even greater wealth and feel-good effect. The result: greater consumption and an economy back in growth mode. Apart from the property sector, Mr Leung favours transport companies and conglomerates, particularly those with diversified businesses in Hong Kong, and especially shopping arcades. 'We also like some transportation-related, container terminal stocks. We believe trade will continue to grow between Hong Kong, China and the rest of the world, so the transport sector will perform.' Selected China-related banks will also outperform because of their perceived advantages in future cross-border business, he says. Mr Leung says the recent decision by the mainland to allow more visitors into Hong Kong will boost the retail sector, lifting employment. This, together with the Hong Kong government's favourable policies towards the property market, will help boost confidence and consumption. Mr Leung says yield gap comparisons indicate that the stock market, at around the 11,000 level, is a long way from overvalued. ING compared the so-called risk-free rate of 10-year Exchange Fund notes with the average dividend yield on Hang Seng Index stocks. Common sense suggests people will tolerate lower yields from stocks in the expectation of capital gains. The Exchange Fund note now yields about 4.7 per cent and the HSI dividend yield is about 3.6 per cent. This 1.1 per cent gap compares with the 5 per cent gap in 2000 when the Hang Seng was at about 18,000 points. Mr Leung says there is room for further growth. 'We don't think the market is too pricey at this stage. But people now are not very optimistic. We have just recovered from the bottom. Mr Leung says near-term risks include the sustainability of the US recovery, which appeared largely funded by debt, and the potential fallout from the mainland's domestic investment binge in the first half of the year. 'The strong economic growth in the first half was mainly driven by investment. The government has already noticed the overheated investment environment and lifted the banks' deposit reserve ratio one percentage point.' Mr Leung says the next 12 months will continue to be themed as a recovery story. 'We have just recovered from Sars and now we will probably see some consolidation in the market. The stock market can reflect a lot of things in a short time, but we need to wait for the economy to pick up. We need to monitor things like retail sales volume and property sales but definitely, if things go smoothly, the estimated 10 million mainlanders coming to Hong Kong will help the domestic economy rebound.'