Contagion is infecting Hong Kong's stock market. This week, the Hang Seng Index fell 580.73 points or 3.76 per cent, enough to wipe out all of last month's gains. To local investors, the losses are particularly galling. Hong Kong's economy is in robust health, with the International Monetary Fund forecasting growth of 6.3 per cent this year. Incomes are rising, consumer confidence is high, and inflation, at 1.4 per cent, is modest. Hong Kong's companies are in good shape, too. Earnings were up over the first half of the year, and dividend yields are better than deposit rates. With China's economy growing strongly, most analysts are predicting better profits next year. Local investors are still bullish. Yesterday, Andes Cheng, an associate director at South China Research, forecast that the Hang Seng Index would reach 16,000 points by the end of the year and continue to do well into the first quarter of next year. But over the past two weeks foreign fund managers have begun to sell, spooked by fears that rising inflation will push American interest rates higher. The same trend has struck other markets around Asia, but in Hong Kong, where foreigners hold about 30 per cent of all stocks, the impact was especially severe. It seems unfair that concerns halfway around the world should cloud the Hong Kong market's outlook. But the international fund managers now selling Hong Kong stocks have good reason to be worried about American inflation. Between June and August, United States consumer prices rose at an annualised rate of 4.2 per cent, up sharply from last year's rate of 3.3 per cent. Much of that increase has been driven by the rise in energy prices. In the aftermath of Hurricane Katrina, petrol prices topped US$3 a gallon, double their level at the beginning of last year. The fear now is that US companies will be forced to pass on those higher energy costs to customers through higher prices, leading to more widespread inflation. It is a danger the US Federal Reserve is looking out for. Since June last year, it has raised interest rates 11 times, raising the benchmark short-term rate to 3.75 per cent from a 40-year low of 1 per cent. But energy prices are not the only thing troubling the Fed's governors. They are also worried that President George W. Bush's enthusiasm for cutting taxes while increasing government spending, which has seen the budget pass from a surplus under president Bill Clinton to a US$400 billion deficit last year, will stoke inflation. With Mr Bush now pledging to spend an extra US$200 billion to rebuild New Orleans, the Fed is on a full-scale inflation alert. Last week, Federal Reserve Bank of Dallas president Richard Fisher warned: 'With the nation's already large fiscal deficits, it would be ill-advised for the Fed to monetise any fiscal profligacy.' In plain English that means the Fed is going to go on raising interest rates. Wall Street expects another increase on November 1, to 4 per cent, and rates could climb as high as 4.5 per cent by the time Fed chairman Alan Greenspan retires at the end of January next year. Higher US rates hurt the local stock market in three key ways. Firstly, because of Hong Kong's currency board exchange rate mechanism, there is a direct link between US and Hong Kong rates. When the Fed raises its short-term rate, so do Hong Kong's banks, which is particularly painful for the property developers. This week, the Hang Seng properties index fell 4.06 per cent. Secondly, there is a fear that as rates rise, heavily indebted US consumers will cut back on their spending. That could dampen demand for Chinese exports, eroding the earnings prospects of H shares. Bit it is the third mechanism that is most damaging. The prospect of higher rates has dented confidence in the US stock market, with the S&P 500 Index sliding about 3 per cent this week. And where the US leads, Hong Kong follows, despite the different business environments (see chart). The reaction is not simply a blind knee-jerk. As concerns about inflation at home have grown, US investment managers have found their appetite for risk waning. For many, that has meant reducing their weighting to overseas markets such as Hong Kong. 'For the first time this year, we are seeing the smart, long-term institutional money leaving the market,' said Steven Chang, a vice-president at State Street Bank, which, with about US$10 trillion of custody assets, is ideally placed to monitor fund flows. Nervous of the risks ahead and anxious to ensure their year-end bonuses, international fund managers are selling up and locking in profits made over the first nine months of the year. Some $25 billion has left the Hong Kong stock market in the past couple of weeks. But higher inflation and interest rates are not the only factors pushing the market lower. Opportunistic investors buying Hong Kong-listed stocks as a proxy for yuan appreciation are also exiting as it has become clear Beijing is determined to limit any further rise in the currency following July's revaluation. The spate of big new listings coming up is also diluting the market's performance. 'Some investors are switching out of other outperforming stocks to shift into the newcomers, including China Construction Bank,' said Peter So, the head of China equity research at Macquarie Securities. But not everyone is cutting and running in the face of these developments. Ayaz Ebrahim, the chief investment officer at HSBC Investments, is standing firm in Hong Kong's markets, despite the risks. 'I firmly believe that growth is pretty decent and that valuations are fair,' Mr Ebrahim said. 'Hong Kong is buzzing.'