HONG KONG STOCKS are in a good position to achieve a third consecutive year of gains in 2005, despite a weak start, with the return of inflation and record low interest rates expected to provide enough of a boost to domestic sectors to outweigh a global economic slowdown, analysts say. The liquidity-driven upward momentum, which pushed the Hang Seng Index to a 45-month high by the end of last year, should continue in the early part of the year, although a growing belief that a yuan revaluation is off the table in the near term may temporarily halt the inflow. However, widespread projections that the US dollar will remain on a declining trend - which would make Hong Kong assets cheaper relative to other Asian markets - and numerous high-profile China-related initial public offerings in the pipeline should continue to underpin the local market this year. Hong Kong should also get a boost as Beijing continues to relax travel restrictions for mainland individuals and capital restrictions for institutional investors wishing to invest part of their funds outside China. Of the more than 21.3 million tourists expected to have visited Hong Kong last year - an increase from 2003 of at least 32 per cent - a large portion were mainlanders crossing the border with the aim of buying luxury goods or property. The opening of Hong Kong Disneyland in September may also help attract tourists from other parts of the region. 'We are pretty optimistic on the Hong Kong market for 2005 and the driver for that is mainly the domestic consumption story,' said Lorraine Tan, director of Asia-Pacific equity research at Standard & Poor's. This view is echoed by other observers, and their preferred Hong Kong stock picks for the year tend to be companies that should benefit from stronger spending by locals and tourists, including properties, banks, retailers, hotels, airlines and manufacturers of consumer goods. As local interest rates remain low, investors may also look to shift money out of their savings accounts to try to capture better returns elsewhere. Alex Wong, a research manager with Rexcapital Asset Management, said: 'When there is no inflation people have the luxury to sit on cash, but as prices go up it will help drive out idle funds from bank deposits and divert them into higher-yielding assets like stocks and property.' As in 2004, analysts said, the performance of the Hong Kong equity market should be closely tied to the Chinese economy. The general belief that the government will be able to engineer a soft landing, resulting in economic growth slowing only slightly to about 8 per cent to 8.5 per cent this year, should be supportive. Adding to this, continuing speculation on a revaluation of the yuan should continue to attract foreign investors to Hong Kong-listed Chinese companies. However, the macroeconomic measures that were introduced in spring last year to prevent over-investment and the possibility of further interest rate rises may continue to cap earnings growth and market performance for H-share companies. Alex Fan, an analyst with the Daiwa Institute of Research, projected earnings per share growth of H-share index stocks would slow dramatically to 7 per cent this year from an estimated 48 per cent last year. He remained positive on the energy sector - oil and coal - given strong underlying demand in China and strong international prices. Another favourite was the export-related transport sector, including port operators and shipping companies, as a forecast 19.5 per cent rise in exports should be 'strong enough to maintain earnings growth for these sectors', he said. Other analysts recommend mainland insurance companies, which should benefit from rising interest rates. The H-share index came under heavy selling pressure after the administrative measures were put in place towards the end of the first quarter of last year, and was unable to regain the momentum that had lifted it to a more than six-year high of 5,441 in January 2004, even as overheating fears eased in early summer. The index finished the year 5.5 per cent lower, compared with a 13.5 per cent gain for the Hang Seng Index. According to the average projection of 10 analysts, strategists and fund managers polled by the South China Morning Post, the Hang Seng Index will rise at least 10.5 per cent this year to 15,729 points. While lower than last year's 13.2 per cent and the 34.9 per cent gain in 2003, the local index has been unable to achieve three consecutive years of gains since the six-year winning streak that ended in 1993. None of the respondents to the poll expect the Hang Seng Index to fall this year. Their projections range from 15,000 to 16,500. They are even more optimistic about the H-share index. The consensus estimate is for gains of 15.5 per cent to 5,477 points, with forecasts ranging from 5,310 to 5,600 points. Looking at Hong Kong from a valuation point of view, however, several international investment banks said while Hong Kong was 'undoubtedly a great reflation story', the local market was one of the best performers last year and was no longer cheap. Investors could capture better relative returns in some other regional market that did not do so well, they said. Analysts at Merrill Lynch, in a report issued just before Christmas, lowered Hong Kong to market weight from overweight. 'Our sense is that, while alive and well, the domestic reflation theme is well priced into equities,' the report said. Credit Suisse First Boston made the same downward adjustment to its recommendation on the first trading day this year. The bank warned that the favourable liquidity conditions at the end of 2004 were poised to reverse, with negative consequences for the stock market.