Hong Kong Is Going Parabolic

by: Ivan Martchev

Hong Kong's market is one global market that doesn't need currency-hedged ETFs as it has been de facto denominated in U.S. dollars via the hard peg of the local currency. Since 1983 the Hong Kong dollar has moved very little relative to the U.S. dollar, save for a few adjustments of the tight trading band fixing it at its present level of 7.75HKD.

It is interesting to note that as the mainland Chinese are now actively managing the parabolic rise of the Shanghai Composite (as shown in green in the chart below), they are trying to do the same with the former British colony as they opened the floodgates towards Hong Kong shares on March 27, 2015. This has resulted in the regular hitting of quotas for purchases of Hong Kong shares by mainland investors. Last Wednesday and Thursday, Chinese investors bought the maximum daily allowance of 10.5 billion yuan, making the Hong Kong Hang Seng Index the best performing global market last week, up 10%.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

A rise of 10% in a week for a major benchmark index is not normal and it typically happens only after a major stock market bottom such as the bottom hit in March 2009. There is no recent "bottom" in Hong Kong - just the careful management of the flow of funds towards Hong Kong.

I don't know how high the Hang Seng index will rise but suffice to say that if central planners like the mainland Chinese want to get an asset price up, they can do a lot to move the market via relaxation of trading restrictions. It is peculiar to note, though, that they have been unsuccessful in arresting the decline of the mainland real estate market over the past year. It seems like the encouragement of the parabolic rise of the Shanghai Composite from 2K to 4K in the last year is an attempt to dampen the negative wealth effect that is evident from the downturn in the mainland real estate market.

I am not sure the substitution of a stock market bubble for a real estate bubble is a real solution for the mainland Chinese. I think it could compound the problem in 2016. Before then we may experience one of the legendary Chinese momentum markets similar to the way the Shanghai Composite moved from a low of around 1000 in 2005 to over 6000 in 2007.

The all-time high in the Hong Kong Hang Seng index is 32K while the benchmark closed at 27.3K last week. Given the relaxation of trading restrictions, it seems a foregone conclusion that we will retest that all-time high soon in 2015. The Shanghai Composite closed over 4K last week and it too is being prepped by the Chinese authorities for an assault on its all-time high at 6124.

I think that an index "managed" by regulators is a terrible policy as it can create massive misallocation of capital. The Chinese clearly believe that such a practice is beneficial to their economy as they have good experience with misallocation of capital in their central planning policies. I think we are rapidly approaching the moment when the interventionist policies of the mainland Chinese will be proven wrong.

Still, one lesson we learn having experience dealing with the stock market is that one should never stand in front of a momentum market. It is comparable to jumping in front of a moving train. The legendary George Soros, who generated $40 billion in profits after 40 years of trading in his Quantum fund, astutely noted in 2009, "When I see a bubble forming, I rush in to buy, adding fuel to the fire. That is not irrational."

The rational trade here would be for one to be long with the expectation that the bubble will pop in the next 6-12 months based on the expectation that the real estate market in China is likely to drag the economy into a precarious situation at a time of record leverage in the mainland financial system.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Typically, the way bubbles progress, the index keeps delivering accelerating gains based on the "greater fool" theory. After the last buyer is in, the index has a sharp correction and a weak rebound that fails to make a fresh all-time high. After a lower high is established, the index rolls over and unravels the vast majority of the gains. The last such trip for the Shanghai Composite was its move from 998 (in 2005) to 6124 (in October 2007) and back to 1665 in 2008. I think we will see something similar here with the caveat that there is absolutely no sign that the index is ready to roll over. The train full of greater fools is still gathering momentum at the moment.

Hong Kong Rally Beneficiaries

Right now mainland Chinese investors are officially using 2X more leverage to buy Chinese stocks than investors in the U.S. relative to the size of their market. Bloomberg reported that

the outstanding balance of the margin debt on China's smaller exchange in Shenzhen was 502.5 billion yuan on April 1. That puts the combined figure for China's two main bourses at the equivalent of about $242 billion. In the U.S., which has a stock market almost four times the size of China's, margin debt on the New York Stock Exchange was about $465 billion at the end of February.

If one looks closer, beyond the official statistics, one finds that the notorious local unregulated shadow banking system is likely involved in the parabolic rise of Chinese equities. We have no clear data on how much that adds to the leverage ratios.

This leverage is spilling over in Hong Kong. This makes Hong Kong iShares (NYSEARCA:EWH) a diversified way to possibly capitalize on moves in the local stock market. EWH is actually weighted differently than the Hang Seng Index as it follows the MSCI Hong Kong index, the benchmark for foreign investors interested in the former British colony's stock market. EWH already made an all-time high last week.

EWH holdings are not expensive. They trade at an average P/E ratio of 12.6 and a price to book of 1.3. About two-thirds of the ETF holdings are in real estate and financial companies, which have long dominated the trading hub. Still, the point I would like to make is that the rise in the Hong Kong market is engineered via the mainland floodgates, and mainland investors are not always responsible users of leverage.

The obvious beneficiary of surging Hong Kong stock market volumes is the stock exchange itself, which is publicly traded as Hong Kong Exchanges and Clearing (OTCPK:HKXCY). The reasons why the stock trades at an unusually high P/E multiple of 56 is because the company has a massive operating margin of 63%. Surging volumes for a profitable exchange should mean surging profits as long as the floodgates keep letting mainland Chinese investors do with Hong Kong what they were already doing with the mainland market.

One stock that has not yet been caught in the frenzy is Hang Seng Bank (OTCPK:HSNGY), which still trades at a forward PE of 15. Major Chinese banks have been somewhat lagging due to their exposure in the mainland real estate mess, but in this case the bank is domiciled in Hong Kong and as such can be considered as "the lesser evil' when compared to mainland banks.

Implications for U.S. Interest Rates

I think that the weakness in commodity prices - which is related to a slowdown in mainland China, as well as the strength in the dollar - is giving FOMC members reasons to delay any interest rate hikes. I believe the FOMC is reluctant to initiate a series of rate hikes that could disrupt the markets during a time of a global deflationary shock.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Such considerations are the reasons why December 2016 fed fund futures have been rallying and in effect are showing a reduced probability of rate hikes, as estimated by fed funds futures traders. At 98.92 at the close last week, that contract estimated four quarter-point rate hikes to push the fed funds rate to 1.08% by December 2016. A month ago the same fed funds futures contract indicated six quarter-point hikes.

A deteriorating economy in China also suggests lower long-term U.S. interest rates via the weakness in global aggregate demand and safe haven status of Treasuries. While Treasuries were surprisingly down last week after a weak employment report, I think we will see a new all-time low of 10-year Treasury yields in 2015; the 30-year T-bond already did that in January of this year.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

This suggests that long high-quality duration is a trade that has not run its course despite any disruptions that may come to the bond market on the news of a single Fed rate hike. The U.S. has the highest long-term interest rates of any developed global economy and that will keep attracting capital to the U.S. Treasury market in 2015.

Disclosure: Navellier may hold mentioned securities in one or more investment strategies offered to its clients.

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