#1 Investment Weekly – No Du bye-bye

Not very many people know this, but, Dubai is a sister/twin city of Hong Kong. I think that is a little cheeky, since we are supposed to be competitors. However, leaving that aside, as a sister we in Hong Kong, naturally, feel the pain currently being endured by our younger sibling (Dubai’s history is even shorter than Hong Kong). However, even in these trying times, we can offer a few words of comfort, as our experiences of brash over building and the subsequent, inevitable, collapse are still fresh in our minds here. Fortunately, if our experience is anything to go by, it won’t be Du bye-bye – but more like Du who? for a while.

Dubai’s problems were symptomatic of the leverage excesses of the mid-naughties. It does look a little odd that the debt (US$100 billion) of a single company (Dubai World) is equal three times more than the GDP of the entire country (US$37 billion) in which it resides in. But Dubai World is an odd animal – it’s a sovereign wealth fund (SWF). We in Asia know all about these. Hong Kong has one – it’s called the Exchange Fund. It’s called this because it’s only brief is to defend the Hong Kong dollar’s peg to the US$. Dubai World’s brief is as wide as its investment scope of “promoting Dubai as a hub for commerce and trading”. Being a very large beach, Dubai had to think of something to do with its little bit of oil reserves. After all how was it going to keep the 230,000 Emirati in the lifestyle that they had come accustomed to as the oil wells dried up? If Hong Kong’s experience is anything to go by, Dubai should narrow the brief of its SWF to something more tangible.

The impact of Dubai’s debt restructuring should be limited because its debt is secured by performing assets that are worth something. This is something that commentators have failed to stress with any degree of force. The press has turned 180 degrees since the news was announced. It’s all doom and gloom, with little in the way of informed discussion. Unfortunately the press has also forgotten to mention that Dubai’s biggest creditors are commercial banks. If the debt was held by Goldmans, I would be very worried, because US investment bankers are not interested in long-term relationships and they would have shorted Dubai’s debt a long time ago. I’m sure HSBC and StandChart have protection, but this would be in the form of recoverable assets. Commercial banks are more likely to come to the negotiating table to ensure the long term survival of its customers, and I’m sure this will be the case for Dubai. In fact, this process has been in place for months already, so, for bankers, the only surprise about the reaction to the Dubai restructuring is the fact that apparently nobody knew about Dubai’s problems. Anyone that has watched the BBC’s Middle East Business Report will know that Dubai’s excesses were crumbling and banks had already started providing for possible trouble earlier this year.

Abu Dhabi will undoubtedly come to the rescue, and there are already signs of this. And, just like China’s helping hand for Hong Kong over the years, there will be a cost for Dubai (particularly in terms of control). This will be a major long-term positive for Dubai once the dust has settled, as a wealthy, neighbourly, benefactor will keep the lid on bubbles and can provide assistance in case of outside factors that are beyond Dubai’s scope. However, the cost will come in the form of a major scaling back of ambitions, which will allow the small band of locals the opportunity to see out their days in relative comfort, rather than the extravagances that they so greedily envisioned. As for the successors of FILTH (Failed in London tried Dubai – instead of Hong Kong) they will have to return home or look for the next expat opportunity. They too will have to scale down, but their return to London and beyond will be beneficial in aiding the economic recovery as their expertise will expand the talent pool in the West.

The sell-off of equities in Hong Kong last Friday had all the characteristics of panic. From a long term investors perspective, the selling was a clear indication that the end of the bull market is still a long ways off. For traders, it was a great opportunity to buy for the technical bounce as investor start to realize that the press hype was way off target, and that it is in no one’s interest to see Dubai go under. For the record, the amount of short selling in Hong Kong of HK$9 billion on Friday was the highest since September last year, while the number of decliners at 4,071 was a record for the Hong Kong stock market (even during the worst days of last year, decliners never topped 3,600).
Hong Kong stock market short sales and decliners

Dubai is not Lehman, and so traders should step back in to reestablish positions, while longer term investors will be trying to make sure that prices on December 31 are as preferable as possible as their positions are marked to market. I suspect that window dressing will be particularly active this year as everyone appears to agree that the global economy is showing signs of recovery and that this should be reflected in year-end asset prices.

There were no changes to the Model Portfolio for the week, which held up relatively well despite the Dubai disruption.

#1 Investment Weekly – Evolution of a market

This Tuesday is the 150th anniversary of the publication of Darwin’s Origin of Species and the 40th anniversary of the Hang Seng Index. This confluence of anniversaries is an appropriate time to assess how the Hong Kong stock market has evolved and what lies ahead.

Evolution is a process shaped by the underlying theme that the fittest survive. This is most patently obvious by looking at two sets of statistics of the Hang Seng Index since its launch 40 years ago: constituents and market value. For the overall market, the number of companies listed in Hong Kong in the mid-1970s was ~300 compared with the current number of 1,123 (a 4% CAGR). However, market capitalization in the same period has risen at a 19.5% CAGR from HK$60 billion to the current HK$16,803 billion.
Total market capitalization and # of companies listed in Hong Kong

Data for the Hang Seng Index in 1969 shows but of the 34 original constituents, only 13 are still listed. Not surprisingly, utilities have been the most consistent survivors with all four original companies still with us. Group restructurings (mostly by Wharf and Jardine’s de-listing to Singapore) had the greatest impact on survivability accounting for 11 of the 21 departures (the rest were privatized). Six of the 13 survivors are no longer large enough to be considered a constituent stock.
The original Hang Seng Index constituents

Not surprisingly, as the open door policy was still 10 years away, there are no China companies in the original list of constituents – unlike today, where there are 21 Mainland owned companies in the current list of 42. Between them the 21 Mainland companies make up HK$6,604 billion of the total market value of the current Index of HK$11,050 billion.

The dominance of China companies in the Hang Seng Index is likely to continue as several large cap stocks qualify for entry but are not included because the Index compilers want to gradually increase the number of stocks in the index. The are not very keen to upset their Hong Kong pals who are still in the index (like Cathay Pacific and New World, which are currently keeping Alibaba and CITIC Bank out). The inevitable arrival of Agricultural Bank (thus completing the quadrangle of state-owned policy banks), will tip the balance even further in China’s favour – to such an extent that the market weighting of China companies could top 75% next year. All of this domination has happened in the twinkle of an old man’s eye (in evolutionary time at least).

It is difficult to say whether the evolution of the Hang Seng Index’s value will be quite as dramatic as it has been over the past forty years, with a CAGR of 13%. I suspect that the growth will not be as spectacular as the 13%, because of the size of the market now compared with what it was 40 years ago. In 1969, Hong Kong was very much a backwater, with a closed China generating total trade for the whole year of just HK$64 million (which was also about the same as the average daily total turnover on the local stock exchanges of Hong Kong at that time). Trade between Hong Kong and China is more like HK$5,000 billion a year with total turnover on the stock market last year reaching HK$8,332 billion.

If Darwin were around to observe how Hong Kong’s stock market has been reshaped by the dominance of China he would have noted several key points: 1) the Hong Kong species will be extinct within a very short period of time 2) the sheer brute presence of the China species has been sufficient to wipe out the Hong Kong species, there was no subtlety or stealth involved 3) it would appear that the Hong Kong species was a willing partner in this take-over and 4) unless there is a sudden change in tactics by the China species, the process of domination will continue to a final conclusion in a very short period of time.

For the future of the Index, I can see several things happening over the long term. First, the old colonial names (HSBC, Wharf, Swire, even Hutchison) will de-list or be taken-over (HSBC will have a secondary listing here just like Standard Chartered, which would exclude it from the index). The second-generation of the old property developers don’t seem to be too interested in running these businesses, so the developers will go the same way as the textile companies (probably bought out at high prices by mainland property companies). This will leave the utilities on their own. Second, the denomination of stocks will change to renminbi. And finally, almost all of the value of the index will be in the hands of the mainland – which is part of the overall plan to fully integrate Hong Kong into the mainland. This all sounds quite brutal, but the process of evolution is.

In the meantime, investors in Hong Kong equities can look forward to the rest of the current bull market, and reap as much rewards as they possibly can, as the local population (which will benefit the most) prepares to enjoy the sunset of our prosperity. As a benchmark for how much we still have to look forward to, the chart below shows the Index since its inception. The path of the index has been almost parabolic, and I don’t see this changing as China continues to add to the market’s value. The index has still to reach another all time high, and then some after that. So the model portfolio of this newsletter can still look forward to a Hang Seng Index level well above the previous high of 32,000, probably adding another 10-20,000 points. Evolution generally produces a better outcome than what went before it, so Darwin would be vindicated, and so will the authorities in Beijing that are watching developments here in Hong Kong.

#1 Investment Weekly – Banking back to basics

Hong Kong based banks have been in the thick of the news recently, with out-of-character optimism, a take-over rumour, threats of tax investigations of its customers and the end of a failed experiment all suggesting that Hong Kong’s future riches are under threat.

I’ve been interpreting statements from HongkongBank’s management since 1985 and last week’s interim statement was the most bullish and least ambiguous I’ve ever seen in years. It appears that HongkongBank has been making some major changes of tack recently (moving management, selling assets etc) and the trading statement was a real eye-opener. Comments such as the following are the norm for HSBC’s corporate script writers: “in common with the previous two years prospects are hard to predict” (2003), “potential risk of structural imbalances might lead to economic weakness” (2004), “a sudden correction in the savings imbalance is a major risk” (2005), “near term the outlook is encouraging, but long term is more uncertain” (2006), “the risk are macro events which are outside our control” (2007), “the outlook is uncertain” (2008), “coming 12 months will be difficult” (2009). In other words, management’s outlook has always been as vague as possible, with uncertainties and risks at every corner. The decline in provisions at Household and the UK, and an assurance that the bank is holding on to its deposit base in Asia were interpreted as a blue-skies statement which propelled the stocks price 6% in a single day in 82 million shares (the heaviest day’s trade since August 4 when it revealed its half year profits). Since that jump in August, the stock has plodded along with the overall market, and this will continue because HSBC’s stock price always underperforms in bull markets.

Bank of East Asia has also been an investment basket case for a long time (the underlying downtrend in the relative price chart below has been in place for many years). So rumours of take-over bid last week came did not come as much of a surprise. The bank needs new capital, new blood and a new emphasis, so a take-over and subsequent management shuffle should breathe new life back into the tired old horse. Guoco’s 0.02% increase in shareholding to 9.01%, which was disclosed on November 5, is being used as the reason for a 15% jump in the price of BEA on November 10. The delayed reaction is puzzling, but not surprising: the Li family has a succession issue, the younger Li’s are not attracted by the hard work/low yield world of retail banking, the Li’s weak shareholding position and it’s loss of guangxi have been major impediments for the stock.
Bank of East Asia’s relative price performance to HS Index

The Li’s could point to an underlying long-term threat as another reason to bail from the sector. The key to the success of HSBC, BEA and the like in Hong Kong has been their privileged positions as holders of huge amounts of customer deposits. Although Hong Kong has excellent money laundering rules and enforcement, in many ways there are plenty of opportunities for bank managers/regulators to turn a blind eye to the huge inflows of cash into Hong Kong’s banking system. Flows from China are on obvious source of “dodgy” funds as Chinese citizens seek ways to escape the tax bureau or local mainland officials. However, there is a new threat to inflows from other domiciles that has recently emerged. The US is getting serious about the tax of evasion of its citizens (with a huge budget deficit wouldn’t you?), and the powers-that-be have decided to target Hong Kong in this never-ending battle of wits. Hong Kong’s foreign and local based banks are right in the thick of the cloak and dagger world of tax evasion – most notably acting as the legitimate end of a long channel. The problem for the US authorities is that if they lift the rock too high in Hong Kong, there is no knowing what is going to come out and bite you. The threat to Hong Kong bank’s deposit base is real, although there is no way of knowing the full extent or when the funds will start getting itchy and decide that the tax man is too close for comfort, but the threat is real, and could be very damaging.

Hong Kong’s smallest listed bank has just announced the appointment of a new CEO. He has an English first name and background as a big force in retail banking in Taiwan (so why he would give this up to run a tiny share of Hong Kong’s deposit market is baffling and suggests he was pushed to do it). He will be replacing the former CEO, who didn’t have an English first name and was previously one of those wheeler-dealer investment bankers that nearly brought the world to an end last year. Naturally, the investment banker molded the bank in his image (a blown up investment portfolio and a swanky, expensive, trading floor), only to see the bank’s profits crushed by the collapse of the CDO-SIV markets last year. As far as I am aware, he is only the second CEO of a Hong Kong–listed bank to resign his position before his retirement age (the first was Son Yihan of Ka Wah Bank – he was replaced because of Ka Wah’s losses in 1998).

So, in a week, there has been a series of events which suggest significant changes in how banking will be conducted in Hong Kong: 1) HSBC’s turned bullish and continues to emphasize its Asian retail/corporate banking roots 2) Hong Kong’s oldest Chinese bank is about to change over a hundred years of ownership as the younger Li’s don’t have the stomach or patience for wholesale and retail banking (after all what was the point of getting an Ivy league MBA!), 3) while Hong Kong’s hot money flows (the very underpinning of customer-style banking in Hong Kong) are under threat from a voracious operator – the US tax man, and 4) a tiny bank in Hong Kong is leading the way by jettisoning their deal-maker CEO and replacing him with a (probably) failed retail banker. It seems like Hong Kong banking is returning back to basics.

The Hang Seng Index is also illustrated a basic investment premise – never under estimate a bull market. Although turnover is no where near where it should be, all the ingredients of a bull market are still in place (low interest rates, expanding earnings multiples as trading statements improve, M&A and IPO activity as investors look for size while company owners grab the chance to recapitalize their businesses), capping all of this is the potential for a full economic recovery in the future. However, this assumes that the future is something similar to what it was in the past (in Hong Kong’s case that would include: a benevolent Mainland and the free-flow of cash in a low tax regime with a pegged currency to the US$). Judging from last week’s activities, it seems there are no guarantees for many of Hong Kong’s riches.

Speaking of riches, I will be posting this newsletter’s model investment portfolio each week, so we can count our riches together. No changes in the portfolio this week.

#1 Investment Weekly – Equities over property

I’ve just spent the last two weeks moving home (from owned to rented). The sale of my flat in Kowloon Tong seems to contradict my view that Hong Kong equities are currently in a new bull market phase. I don’t see this.

The correlation between the performance of the Hong Kong economy/property market and its stock market has gradually broken down since the listing in 1998 of China Mobile. The highest concentration of pure Hong Kong equity plays has always been in companies exposed to the local property market. The property sector in the Hang Seng Index has fallen as a percentage of market capitalization from 31% at its peak in 1996, to just 6% today. A weak local property market would have little of no effect on the health of the total equity market. While a weak property market would produce a weakening of local demand for Hong Kong equities, Hong Kong individual investors make up only 26% of total cash transactions (add futures and the percentage halves).

This newsletter warned in its last edition that Hong Kong property prices were showing signs of frothiness, and the HKMA has taken note by clamping down on funding channels. It has issued guidelines to banks about the extension of mortgages over HK$20 million. This was aimed specifically at the top end of the market. However, there was also warning regarding mortgage loans in general, particularly warning bankers that, at some point in the future, interest rates are going to rise, and this eventuality should be taken into consideration when assessing future repaymentability of all borrowers. The government chipped in with a promise to increase the supply of low end flats to counteract the tightness of supply caused by the cut in land supply since 2003. It is inevitable that further measures will be introduced to ensure that flat prices stay in check. However, the killer blow for local property prices must come from the Mainland, where the leakage of funds into Hong Kong has become destabilizing and embarrassing.

The fact that the HKMA has had to continuously intervene to weaken its own currency (which is pegged to a weakening US$) because of hot inflows from China is an unnecessary double embarrassment (almost embarrassing for the government as the announcement of the opening of a Disneyland in Shanghai). The weakening currency (both self-inflicted because of the peg, and because of the weaker US$) is starting to show up in price inflation. The rise in property prices and rents and the expiration of electricity bill concessions means that Hong Kong’s CPI will begin rising sharply in the coming months. Non-mainland tourists are certainly noticing it, while locals on the ground are beginning to feel the effect. Although it is gladdening to see the first decline in the local unemployment rate his cycle (although I’m hearing of lots of cases of people getting their old jobs back six months after being laid off), falling unemployment will eventually feed into consumer price increases. The HKMA will have to act further than it has done already to ensure price inflation doesn’t get completely out of control.
% of monthly returns of HS Index (12 months)

The small rise in the Index in October allowed its Coppock Indicator to rise to a positive number for the first time since August 2008. This reliable long term indicator of Hong Kong equities suggests that stock prices are set to continue to rise, outpacing the performance of local property prices as well as bond prices. The percentage of positive monthly returns is also on a typical bull market trajectory. The past has shown that both these long term indicators are very difficult to reverse and gives confidence that, although property prices could cool in the long term, equity valuations will continue to move higher.

#1 Investment Weekly – Better than alternative

Hong Kong should follow Australia’s example and start raising local interest rates, but it can’t. Instead, the HKMA can only stand idly by and watch massive inflows of hot cash from China pour over the border. Although we are not in bubble territory just yet, if things continue as they have, then Hong Kong will experience another asset bubble and the subsequent, inevitable, bust that follows. This sounds like a bad scenario, but the alternative (a free-floating Hong Kong dollar) is worse.

Asset prices in Hong Kong are starting to rise at an alarming rate as demand is far outstripping supply. The first asset class to begin moving was the (very-transparent) price of local equities, the new phase has been high-end property prices. Both these asset classes have been buoyed by low inflation, low interest rates and high liquidity.
Hong Kong property price, HS Index and Hibor (rebased to 100) 1993-2009

Investors should take the hint that China is not happy with the concentration of inflows of liquidity into Hong Kong assets when the visa restrictions on travel to Macau were lifted in mid September, along with the approval of the Wynn IPO. The move can be taken to mean that China is concerned that excess liquidity is driving asset prices too high too fast. However, as the chart shows, prices are not excessively high relative to historic levels in either local or in foreign currency terms.

Overseas investors have experienced some pretty poor returns in recent years, with the HS Index showing a 21% return in Euro terms (2.1% CAGR) and 37% return in yen terms (3.4% CAGR) since the turn of the century. Yet these investors have had to contend with the same risks as US$/HK$ investors (which have tacked a 7.1% CAGR in the same period).
HS Index in HK$, yen and Euro terms (rebased to 100)

Although there is no way to confirm and quantify what would have happened if Hong Kong had a free-floating currency during the 1998 Asian Financial Crisis or in the 2008 financial crisis. However, if Iceland and Latvia are any indication, then the returns for overseas investors would have been even worse. Although weak fundamentals have impacted the value of the Krona and the Lat, currency speculators have played some part in depressing the values of these small, independent currencies. The impact of a severely devalued currency in Hong Kong would have been compounded by the fact that a weaker currency should help export competitiveness. Unfortunately, Hong Kong’s manufacturing base has been completely relocated to Guangdong, thus mitigating this benefit. Instead, import price hikes would have ramped up consumer prices, devaluing the currency further. In times of crises, the peg has served Hong Kong well, while this benefit is counterbalanced by the lack of control during times of recovery and expansion.

Last week’s sudden strength in equity prices coincided with the end of Golden Week, the hike in Australian interest rates and further US$ weakness. IPOs turned positive, adding to the impression that turnover rose. The illusion will diminish this week as investors take stock of China’s intentions regarding inflows into Hong Kong as the HKMA continues to sell HK$ to keep the peg in its designated range. Falling turnover in equities may not dampen prices significantly, as the 20-day moving average should provide technical support. However, the market will also have to contend with discussions among bankers about the frothiness of the local property market, with a potential increase in mortgage rates on the cards if things don’t cool down.