#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.

#1 Investment Weekly – All the world’s a stage

I spent a good two hours watching the celebrations marking the 60th anniversary of the founding of the People’s Republic of China in Tiananmen Square last week. The marching was impressive as the world watched China’s actors on the big stage. As I come from a military family I think I’m quite qualified to comment on the precision of China’s goose-stepping armed forces. But there was something odd about the precision. It was the fact that China’s military leaders, or maybe the Party organizers, deemed it necessary that all the troops on parade had to be the same height (apparently 1.75m) and weight. There was no deviation from this requirement. Everyone was the same.

Now, for the largest standing armed forces in the world, I’m sure it wasn’t difficult to pick only troops that were the required height and weight, but it struck me as being a bit too precise and lacking diversity. Anyone that has watched the Trooping of the Colour in London will appreciate the precision of the marching but will also understand how odd the absolute uniformity of the Tiananmen parade was. Members of the armed forces of all countries come in all shapes and sizes, why did the organizers insist on this sameness? The simple explanation is: symbolic unity (although cynics might argue that it symbolizes the Party’s Marxist dogma of “the individual is not as important as the whole”). In fact, the uniformity symbolised the fact that China’s armed forces have kept the country unified since 1949 – unlike most militaries around the Asia-Pacific region. It has been the PLA, not the Communist party that has kept China unified, terrified and, therefore, harmonious.

This brings me to the next point: the overwhelming desire of the overseas press to describe the National Day events in a disharmonious fashion. Although it could be almost correct to say that the celebrations were linked in some way to the Communist Party, the national day celebrations were marking the 60th anniversary of the founding of the People’s Republic not the communist party (which was founded in July 1921). However, headlines by the world’s press were completely misleading and forums were ablaze with China’s propagandists trying to overwhelm any negative comments. The Times incorrectly wrote “Millions watch huge military parade to mark 60 years of communism”. The response from China’s netizens was immediate: don’t bash China, leave us alone, you don’t know what you are talking about because you have not visited China etc. The vitriolic Chinese forum contributors generally shoot themselves in the foot by trying to defend their positions. They don’t understand that China’s closed doors produced one economic disaster after another in the first 30 years of the PRC, while China’s poor reputation abroad (of a backward and bitter nation) means that very few people would dare to visit the Mainland (even including your Hong Kong based author). Without the rule of law and an independent police and judiciary, China’s reputation overseas will remain poor.

However, the parade was not aimed at a foreign audience. It is true that millions of Chinese watched the parade on TV – although the Times didn’t mention that CCTV’s live coverage to the Mainland was actually delayed by 30 seconds. However, to say that the parade, which was not completely dedicated to the military, was marking 60 years of communism is clearly wrong – although some party hardliners would have secretly celebrated 88 years of communism in China in July (because of the auspiciousness of the number). At least half of the parade was dedicated to the achievements of the provinces of China as well as the 56 different ethnic populations living within China’s borders. The floats were pretty standard fare, with the exception of the flat screen TV displays. I spotted Hong Kong’s float near the end of the procession, followed by Macau’s and finally Taiwan’s. This was a curious addition because, of course, Taiwan does not recognize being part of the mainland. The mainland obviously believes it is a province of China and hence the inclusion of the float. I haven’t seen or heard any reaction to this unilateral decision to include Taiwan in the party in this way.

The scale of the parade means that it was equivalent to a mini-stimulus package for the Chinese economy (as well as giving something of a fillip to the confidence of China’s ever-growing consumers). There were no official figures about how much the parade cost, but we know there were 100,000 civilians, 3,700 musicians and singers and 8,000 troops involved, all of which needed dressing (with the female troops wearing rather flattering mini-skirts and kinky boots) and equipping. The vehicles all needed painting and servicing beforehand. The world is certainly watching the economic performance of China as a litmus test for the health of the current recovery.

So what has the 60th anniversary got to do with the Hong Kong stockmarket? Quite a lot, because as this newsletter pointed out last week, China holidays will reduce liquidity, and this in turn will result in weaker stock prices (down another 3% last week). Average daily turnover last week was only HK$45 billion, even with a new IPO practically everyday. The index closed the week below its 20-day moving average, and is likely to stay below this week. The only consolation is that there is support for the index at the bottom of the Bollinger Band, which is where it closed last Friday. Fortunately, the bottom of the band is still rising, so any declines in the Hang Seng Index will be gradual and stage managed. After all, the world is watching.

#1 Investment Weekly – Cynics everywhere

Oscar Wilde described a cynic as a person that knows the price of everything and the value of nothing. He probably wasn’t thinking about stock market investors, but his insight seems to have encapsulated the current reality of global equity markets. There seem to be cynics everywhere right now. Basically, these are investors who did not believe the solidity of the March lows and are trying to understand why they should believe equity values now, despite the surge in prices around the world.

It has been a golden week for cynical conduct, started in Hong Kong by investment bankers from Morgan Stanley that dumped their cornerstone investment in Shanshui Cement a year after bringing the stock to market, followed by the G20 photo-op and capped most handsomely by the spin doctors at HSBC who, on announcing that their CEO would be relocating back to Hong Kong so as to oversee the bank’s expansion in the region, cynically forgot to mention that those shareholder terrorists Knight Vinke had been pressuring the bank to cement its Asian credentials by making a move like this for years.

With this sort of cynical behaviour going on locally and around the world, it was little wonder that the Hang Seng Index gave up its previous week’s gains. Global equity markets are starting to look a little jaded, with the amount of new stock coming to market, overwhelming demand. The Morgan Stanley sale struck right at a time of high IPO issuance, leaving IPO investors fearful that so called cornerstone investors will dump stock as soon as no one is looking. This explains why IPOs last week performed poorly. The G20 meeting was as useful as a cut in US dollar interest rates, with officials appearing to talk up the US dollar’s price while at the same time admitting that its value was diminishing as the reserve currency of choice. HSBC’s announcement that its CEO will move to Hong Kong was the most cynical piece of knee-bending you will ever get to see. There are many instances of overseas companies bowing to the wishes of China and its huge potential for profits, but coming from a company that started its life in the colonial years of Shanghai and Hong Kong was a slightly pathetic sight to see.

On a final note of cynicism, I was sad to read that that great bastion of Empire, the Far Eastern Economic Review, is finally set to close in December. The regional weekly magazine had been publishing well-written, hard-hitting articles about topics of great importance for the region for many decades. That is, until 2001, when Dow Jones decided sack its staff and changed the editorial direction. Actually, the start of the slippery slope was in 1987 when HSBC sold to Dow Jones, so the writing has been on the wall for quite a while. My sadness at FEER’s demise stems from my time as the chief editor of a competitor regional banking magazine in the late 1980s. Our advertising sales would ritually put down FEER despite the fact that our publisher was an ex-FEER man and our correspondents contributed to FEER. To be honest, we were mostly in awe of the magazine, and actually FEERed it. Its demise is not surprising, of course, because, we sold out to a giant Australian publisher, only for the magazine to close down a few years later. Editorial direction was changed, the culture of the magazine was cast aside, and the content’s integrity was irreversibly lost. Twenty years later the same mistakes were made by Dow Jones, with the same result. However, all is not lost: if you wish to read articles by noted journalists on topics related to Asian business or politics – simply search the net and read for free.

So, if you want cynical-free advice on the direction of the Hang Seng Index for the shortened week ahead, here it is, from an independently-minded, ex-banking magazine editor: it will move sideways to lower in thin turnover. I believe the first signs of uncertainty about the bull market are starting to appear as valuations (not prices) are now close to pre-Lehman levels. The first phase of the usual three stages of any bull market in equities is coming to a close. The easy money has been made. The next phase will require discovery, investigation and an increase in risk. While the transition phase to the next part of the cycle pans out, money will move to the sidelines. Traders will take their profits and wait for dips down to the bottom of the Bollinger Band at 19,400, while long term investors should not concern themselves with movements within the current upchannel, as long as the long-term support line doesn’t break the neckline at 17,000.

#1 Investment Weekly – A global peg?

Hong Kong’s leaders are constantly harping on about how they want the SAR to be a global financial centre. Unfortunately, this dream can never be fulfilled while its currency remains detached from the rest of the world and limited in scope as it is. A point in case is the overstated impact that mainland IPOs have on the Hong Kong dollar.

Hong Kong’s peg to the US dollar is getting plenty of air time recently (alongside Panama’s much older US$ peg) as the debate about establishing a global reserve currency has grabbed the attention of right-wing economists (Stiglitz, Roubini et al) and politicians (principally the US and China). From the economists’ point of view a global reserve currency has plenty of positives in terms of helping to rebalance trade surpluses and deficits, while providing greater stability to the world’s financial systems – something that was lacking during the meltdown of 2008. Politicians are grabbing the opportunity to play the global reserve currency card in their efforts to appease their voters. On the one side, the US insist that the US dollar did not exaggerate the problems of 2008, while China (who has the most to lose from a weak US$) and a few other neutrals such as Russia are pushing for a debate about the idea of a more stable currency regime. The IMF, the possible arbiter of any such arrangements, is encouraging all sides to discuss this, as this increasingly marginalized organization attempts to secure its future.

Disbelievers of the possibility of a new global currency regime are probably those that believed the Euro could never happen, or that the Euro will not be able to withstand the current slowdown in economic activity in the Eurozone. Fortunately, the sceptics may not be around long enough to see the establishment of a global currency reserve (it took 20 years for the Euro to arrive), so we may never to able to tell them they were wrong. But, just as it is almost certain that one day the Renminbi (or its equivalent) will be the currency of Hong Kong, so, investors should be prepared to admit to the inevitable that a more stable economic future lies in the establishment of a more solid currency regime relative to the current set up.

However, this is a long term inevitability, and one that will require much political will, and further tweaking of the experiences that Hong Kong has had to initiate in the 26 years since the establishment of the HK$’s peg to the US$. For one thing, a method of relieving pressure on a pegged exchange rate system when there are sudden and large movements of demand in a particular country or system.

The chart below is the nominal amount of HK$ money supply. The shape of the chart is not particularly unusual in that there is a general movement higher throughout the time period. Hong Kong’s economy has prospered on the back of China’s success.

HK$ M3 (HK$ billion)

However, what is of real interest here are the large amount of outlier months during the period. If you look at the chart, you can probably make out at least 10 occasions when HK$’s M3 shot up significantly in a particular month, only for the stock of money to revert back again a month or two later. Generally speaking, these spikes coincided with large IPO offerings (or, on one or two occasions that I can remember, when large HK$ loans were drawn down). The data is only for the month end, so, there are a large number of IPOs that did not straddle the month end and therefore are not included in the data. If they were included, the chart would look more like a saw blade, with patches of blunt edges.

During these spikes in demand for HK$, Hibor interest rates would have fallen well below there natural levels, thus giving the impression to outsiders, particularly those quant funds that may not have been aware of the reason for the short term decline in rates, the impression that something is happening that may be worth trading on.

If enough fund managers pile in, the situation could be destabilizing, particularly as interest rate begin to normalize after the IPO is complete. This is what happened during the Asian Financial Crisis in 1997. Although Asian currencies were being devalued around the region, the HK$, which was pegged to the US$ was unchanged. The quants saw this was an opportunity to attack. They used HS Index futures contracts to short stocks and attacked sold the currency. In the meantime, Hong Kong listings of IPOs were continuing to lift the money supply well after the baht devalued. When the IPOs ceased, and the crisis worsened, the M3 fell back, only to surge again after the HKMA’s August stock market intervention. An almost perfect rerun of 1997, occurred again in 2007, as huge IPOs flooded the Hong Kong stock market (encouraged by the “through-train” idea), thus exaggerating the money supply. The pull back in M3 in 2008 was partly due to foreign banks pulling down their liquidity, but also because the IPO proceeds were being repatriated back to China.

One lesson from the Hong Kong experience then is that there can be no outliers in any future global reserve currency regime. Particularly if the currency is small relative to the size of its capital markets (Pound Sterling springs immediately to mind). The Hong Kong dollar could not stand alone under such an environment as China’s currency certainly be included in the reserve currency regime. If China and the US give up the national rights of their currencies, I’m sure Hong Kong (which is ostensibly pegged to both currencies) would be forced to follow.

This is probably a long way off, nearer in time is the likelihood that China may have to start seriously thinking about cooling its asset markets. SHK Properties has just announced record high offers for flats at its Cullinan development. Hong Kong is now officially out of recession, and the streets, restaurants and shops are feeling a little bit too packed for comfort. Equity prices are feeling decidedly toppy, with retail punters rushing at every new tip and IPO. If the world’s leaders are serious about avoiding the errors of the past two years, a short sharp reminder that nothing goes up in a straight line, and that investors are supposed to invest in the stocks of companies, rather than consider the stockmarket as some form of gambling/ATM machine, then a few choice cooling words from either side of the Pacific would be appropriate at this time.

Technically the HS Index continues to bump against the top of its trading range. Although turnover picked up towards the end of last week, part of this was due to the half day of orders lost on Tuesday because of a typhoon, while volume was not unusually heavy. In fact, average turnover and volume fell compared with the prior week. A put:call ratio of over 90% and rising short selling suggest a period of calm, price weakness ahead of the Golden Week holiday in China and holidays in Japan as well as the disruptive impact of IPOs in Hong Kong and the US.

#1 Investment Weekly – Harmony and stability

I’m not sure how seriously the market took the news that China’s main financial regulator (SASAC) had issued a guidance note stating that it would be acceptable for mainland banks/state enterprises to default on certain commodity derivative contracts because they were not transparent enough. It is the type of defiant proclamation that seeps out of China on a regular basis, and so, it seems to have been ignored – as the others generally are. However, this may be one of those rare occasions when ignoring China’s hubris could be dangerous.

“An harmonious and stable crackdown” is how The Economist has described the past 60 years of Communist rule in China – which will be vehemently celebrated (by China’s leaders at least) at the end of the month. I suspect that the cadres in Beijing will also be keen to show the world that while the country has embraced the vagaries of the free-market for more than half the time of the Party’s existence, this has always been done with Chinese-characteristics (which is a moniker for: balancing yin and yang and doing things for the long run). With this is mind, I would not be surprised to find that another Mainland trait, which has often been employed over the past 30 years, and that is the element of surprise (one of Tsun Tsu’s many pieces of useful advice).

Combining centrist control and free-wheeling market forces is a delicate balancing act, and, right now, the free markets are riding rough shod over the controlled expansion of China’s economy. An element of control is required, and the SASAC announcement sounds like something that the Chinese could employ to put a check to the unfettered upsurge in China’s asset prices. For one thing, the market has seemingly ignored the threat that walking away from contracts will have on the world’s financial markets. The last time China turned its back on binding contracts was during the ITIC crisis of 1998-99, when local and international banks were forced to write off billions of dollars of loans that they had assumed were guaranteed or backed by the Chinese government. It turned out the contracts were worthless. In other words, China has history on this sort of threat, while at the same time the authorities are trying to bring about a harmonious and stable crackdown on the country’s booming asset markets.

The negative news from China’s controllers was increased a notch further – very late last Friday- by the threat of a trade war with the US: this time over tyres. I suspect that the market will be hearing more and more of these sorts of superficial stories as the Shanghai index attempts to return back to its previous high of 3,400. The list of possible negative newsflow could include: higher stamp taxes (stock market or on property), a serious clamp-down on loan usage or a tightening of bank reserve requirements. However, these are more like last-resort moves. There may be other types of stories before the big hitting brakes are applied.

With these sorts of threats hanging over the market, a pull back from current levels would be a natural course of action to take. The index is already pushing on the string which represents the top of its Bollinger Band, and, therefore, needs to take a breather. Turnover will drop because of the uncertainty of what sort of threats may come out of China, but also because funds are being raised by a large amount of IPOs coming to the China markets (10 deals raising US$7.14 billion in September alone).

Even if there is a self-induced pull back in the HS Index to the bottom of the Bollinger Band, at 19,400, or maybe even to the bottom of the Ichimoko Cloud at 19,100, the medium term uptrend from the March low will still be intact. So, any weakness from current (slightly over-extended) levels can be viewed as a buying opportunity, rather than a major threat to the current bull market.