Last week a report from Morgan Stanley sent shivers down the spines of many investors as the market took it as a major bear comment on Hong Kong stocks. Here is an edited version of the report. HONG KONG'S Hang Seng Index seems stuck in a trading range of 9,500 to 11,500. The Index should ping-pong between the upper and lower limits with every tremor of global optimism and pessimism about interest rates and China. Yet, when one looks out the window, the same throngs of craft furrow the harbour's dirty waters in a creative confusion of wakes and waves, and nothing seems to have changed or slowed the real economy. Buyers should look at the Hang Seng below 10,000 and sellers above 11,000 until something happens to make the index bounce out of this rut. For the moment, it would be best leave one's weighting at five per cent, midway between a statement of pessimism, which would take it down on two to three per cent, and one of optimism, which would take it up to seven per cent or so. The factors which could take the Hang Seng through 7,000 some time this year are simply the reverse of those that would drive it up to 14,000. If China's MFN status is not renewed, $20 billion of China's trade would be at risk, GNP growth in Hong Kong might fall to three per cent from the forecast five per cent and 75,000 jobs could be lost. Furthermore, cutting exports is exactly the wrong way to cool the Chinese economy, which relies on earning foreign exchange to finance the imports of capital equipment and infrastructure goods that boost productivity and raise the inflation-free growth rate. At the very least, MFN is going to add to Hong Kong risk until a decision is reached. If Deng Xiaoping dies this year, the political struggle could lead to a neglect of the Chinese economy, which is plainly overheating. The Deng succession issue cannot be timed, but when it happens the market will sell off sharply. The nightmare scenario would be if Deng's death caused capital to flee China at the same time as the loss of its MFN status cuts exports. If US interest rates rise to eight per cent at the long end, and by another 105 basis points at the short end, this will hit Hong Kong in the bloated paunch of its residential property market. Given the Hong Kong currency's peg to the US dollar, Hong Kong's monetary policy is ultimately set by Alan Greenspan, and rising US rates are Hong Kong's too. Undoubtedly, Hong Kong is a lot cheaper than most other Asian markets. It must be on 14 times this year's earnings. It has also fallen by 20 per cent - a substantial correction compared with most other global markets, and the sort of correction that would warrant repurchasing equities in any market. The sector to stay a mile away from is banks . . . for three reasons: rising interest rates; a dangerous blow-off in residential property prices and, in many cases, of mortgage lending connected to the boom; big and expensive competition for staff and rising rents for Grade A real estate, which hits costs. Far more profits in Hong Kong are made out of real estate (directly and indirectly by 40 to 50 per cent) than in China (five per cent or so). So, a view of Hong Kong has to be a view of real estate markets, too. Here the picture is mixed. Higher interest rates could have their impact, of course, and that would stop bullish sentiment about Grade A office space. It is true that people who need office space and flats are going to continue moving to Hong Kong for the foreseeable future, as long as the China story is intact. In Hong Kong current spare capacity of Grade A office property is less than 40 per cent, and looks likely to stay low for a few years. In top residential property, values are just plain absurd. As a rental market, it is driven by the expatriate community seeking apartments at any price they can't afford, because they don't have to. Any crackdown on money from China flowing into this market could affect prices badly. Undoubtedly, the people who buy residential property to escape negative real interest rates on deposits, and benefit from them on mortgages, also buy shares. Any rise in interest rates or weakness in the Hong Kong dollar will damage lender and owner alike. To imagine that the quality market would be immune to this is cuckoo. And if there is any area in which the Hong Kong bubble looks as vulnerable as the Tokyo bubble, it has to be here.