Rates rise may hit equity values

WITH the transition to the Year of the Dog completed, a return to normality means a return to the hard economics that will define conditions in the world economy, and by extension, Hong Kong.

Friday's announcement of a 0.2 per cent rise in the United States Producer Price Index was enough to knock back Hong Kong share prices in London, but more importantly the figures confirm the trend of inflation on a rising track in the US.

The corollary of US prices on the up is that interest rates will surely follow and therein lies the biggest threat to Hong Kong's fragile asset values, aside from uncertainty across the border.

The rises come at a time when international funds are taking a second look at the value on offer in the emerging markets of the region and will undoubtedly have an impact in drawing them back to other destinations.

Predicting the Hang Seng Index has long been abandoned by this column but the warning signals should be noted as the new year gets underway.

The run-up, which saw the Hang Seng rise more than 100 per cent during the Year of the Rooster, received its impetus from the enthusiasm of foreign investors for Hong Kong and the region.

Huge flows of portfolio funds were thrown at the territory as part of a thematic enthusiasm for the East Asian growth story.

While Hong Kong may still represent good value for those on the ground who daily crunch the balance sheets of its big companies, that is not the way those funds came into the market and most likely will not be the considerations used when they leave.

Hong Kong share values face a twin threat. The first is the possibility of a global sell-down of equity markets, which would inevitably pull the Hang Seng with them.

That may seem unlikely, but it is important to remember that the financial establishment is the last source you will hear it from. The industry leaves little scope for entertaining market crashes and history usually has them still talking the market up when it happens.

There are many good reasons for market optimism in Hong Kong, most notably the continued dynamism in China's economy, but the far-off warning signals from the US cannot be ignored.

Equity values ultimately reflect company profits and with corporate profit growth in the industrialised world still shaky, investors might easily lose faith in the prices they have placed on those expectations.

Rising interest rates only add to the cocktail since investors progressively have the choice of investing in debt instruments which offer competitive yields with equities.

Closer to home, rising interest rates will undoubtedly have a healthy effect on Hong Kong's inflationary economy, which loses competitiveness daily as prices rise.

Rising interest rates are the surest way to take speculators out of a ''bubble market'' and could yet be the factor that halts this cycle of property inflation.

It is not to be forgotten that more than 40 per cent of the Hang Seng Index's value is supported by the price of property.