Hong Kong stocks' mainland-driven rally faces longevity test

HONG KONG -- The Hong Kong stock market, Asia's worst performer until mid-April, has rebounded largely thanks to mainland investors hedging against a weak yuan and hoping to take advantage of policy support from China.

Yet the rally is also drawing attention to a conspicuous lack of Western investors, raising questions over whether it is really a new dawn for Hong Kong after the market's three-year losing streak.

The benchmark Hang Seng Index climbed for 10 straight sessions through this past Monday, reaching 18,578.30, a level not seen since last September. Hong Kong shares lost some steam during the week but by Friday morning the Hang Seng was even higher, at around 18,800.

The mood in the market has clearly shifted. Turnover has picked up, too, with the single-day trading value on April 29 reaching 163.4 billion Hong Kong dollars ($20.9 billion), the highest since July 31.

Compared with Asian peers in U.S. dollar terms, Hong Kong is quickly rising from the bottom, although as of Thursday it was still the third-worst performer out of 13 MSCI markets this year, down 3.7%, according to data from Goldman Sachs.

Market watchers say much of the renewed momentum comes from mainland investors shifting into U.S. dollar-pegged assets, amid downward pressure on the yuan, or renminbi.

"We believe southbound investors could be using Hong Kong-listed equities to diversify their currency exposure" in light of yuan depreciation, BNP Paribas said in a note on May 3. But the bank struck a cautious note, saying the same group of investors could become more selective.

Indeed, after two consecutive months of net inflows into Hong Kong stocks via the Connect links with the Shenzhen and Shanghai exchanges, mainland investors appear to have eased up.

They bought the equivalent of HK$32.1 billion of Hong Kong shares in the week starting April 19. But this week, the first trading week after the Labor Day holiday on the mainland, they had bought just HK$4.8 billion worth of the shares as of Thursday.

It remains to be seen how much investors from elsewhere will jump in. Nigel Foo, head of Asian fixed income at First Sentier Investors, pointed to a lack of Western players in Hong Kong's recent stock market rally.

"In general, over in Asia, we are suffering from very negative sentiments not just on the interest rate front, but very negative sentiments towards China," Foo said.

An apparent focus on policy support, rather than fundamentals like corporate earnings, is also making some observers uneasy.

John Woods, chief investment officer for Asia at Swiss private bank Lombard Odier, described the recent improvement in Chinese markets, including Hong Kong, as "bear market rallies."

"Bear market rallies in China are not uncommon," Woods told a group of reporters on Thursday. "What you get is this huge amount of anticipation, [whenever] some measures are announced, and then the whole market starts to rally."

Such government-led rallies are problematic for investment advisers and asset allocators, as they "are very hard to guess, very hard to anticipate, very hard to understand what it might include," Woods said. The trends "tend not to be based on earnings, they tend not to be based on fundamentals [but] then tend to be based on hope."

Woods added that a hope-based investment approach "is probably the worst type of investment thesis you can possibly imagine."

Homin Lee, senior macro strategist who sat alongside Woods, said the Swiss private bank believes the recent rally is "not a convincing signal." He said they see it "as a trading opportunity and not necessary something that you pounce on as strategic opportunity."

High-rise apartments under construction in Zhengzhou, in China's Henan. Expectations of policy support for mainland developers have buoyed some of their Hong Kong-listed stocks.   © Reuters

The Hang Seng China Enterprise Index (HSCEI), which tracks the biggest Chinese tech companies and banks such as Tencent and China Construction Bank, has also rallied -- by 14.3% between April 19 and Monday to hit 6,572.45, the highest level since Aug. 11. The HSCEI could rise further as investors expect potential structural economic reforms at the Chinese Communist Party leadership's long-awaited third plenum in July, BNP analysts said in a recent note. But "this sharp rerating came without any material improvements in earnings estimates and is reminiscent of the COVID-19 reopening recovery in late 2022 and early 2023," the bank said.

The Chinese Communist Party Politburo, in a meeting on April 30, said it is studying ways to systemically reduce unsold properties, according to state media reports. Amid China's prolonged real estate slump, some have interpreted this as a potential lift for property developers that could sell their projects to the government.

Investors could look at certain property developers such as CR Land, COLI and Greentown as they wait for more clarity on potential big government purchases of projects, Morgan Stanley analysts led by Stephen Cheung wrote in a report published on Tuesday. Hong Kong shares of CR Land, COLI and Greentown climbed 5.3%, 1% and 5.2%, respectively, between April 30 and Thursday.

But Hong Kong this month saw a string of disappointing initial public offerings by mainland companies, another sign that the markets may not be in full recovery mode.

Martin Lau, who heads Hong Kong and China equity investments at FSSA Investment Managers, said investors are still asking, "Why invest in China and Hong Kong," even though there are heavily discounted names with a decent dividend that could match the U.S. rates.

"In the past, people bought China stocks for the future prospects," he said. That mindset has changed completely, Lau said. "In a steady economic environment, investors are looking for cheap stocks and hoping the valuations have been discounted."

Geopolitical tensions are likely to make many global investors even more cautious about returning to Chinese assets this year, narrowing the investment universe for Western players, Lau said.

Many sanctioned stocks have risen in the past several years after delisting from the U.S. and relisting in Hong Kong or China, but they are off the table for American investors in particular.

Additional reporting by Kenji Kawase.