July 212 Steven Sun* Equity Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 4298 stevensun@hsbc.com.hk Roger Xie* Equity Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 4297 rogerpxie@hsbc.com.hk *Employed by a non-us affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations 1
July 212 Introduction is one of the most volatile markets in the region, a result of the dominance of interest-rate sensitive stocks. ROEs are below the Asian average, but the market deserves a premium to reflect optimism on longterm growth for as one of China s financial centres, but also the low risk attached to its market. Market structure In the last decade, the market has fluctuated between 1, (during the SARS epidemic in 23) and 3, in 27, when China related stocks traded at high multiples. This volatility is partially explained by the market structure. Although the top-five stocks account for only 35% of the market low compared with the rest of Asia they are all of a similar nature. Financials, including banks, real estate and insurance, account for 61% of the market. It is more concentrated than Malaysia, India, China, Korea or Taiwan. Steven Sun* Equity Strategist The Hongkong and Shanghai Banking Corporation Limited +852 2822 4298 stevensun@hsbc.com.hk *Employed by a non-us affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations Market performance (Index levels) 12 1 8 6 4 2 Jan-95 Feb-96 Mar-97 Apr-98 May-99 Jun- Jul-1 Aug-2 Sep-3 Oct-4 Nov-5 Dec-6 Jan-8 Feb-9 Mar-1 Apr-11 May-12 MSCI 26 24 22 2 18 16 14 12 1 Rel to Asia ex Japan (RHS) Largest stocks in Stock rank Stock name Index weight 1 AIA GROUP 12% 2 SUN HUNG KAI PROPERTY 6% 3 HUTCHISON WHAMPOA 6% 4 CHEUNG KONG 6% 5 CLP HOLDINGS 5% Top-5 35% 6 HK.EXCHANGE & CLEARING 5% 7 HK AND CHINA GAS 4% 8 LI & FUNG 4% 9 BOC HONG KONG 4% 1 HANG SENG BANK 4% Top-1 21% The dominance of financials is partially offset by some large consumer discretionary plays in the market (think Li & Fung) as well as various utilities. These, in theory, should be more stable in nature. is one of the most liquid markets in Asia as well, with a cumulative monthly market turnover which is nearly 5x the daily market cap. Retail participation in this market is also relatively high (about 3% of total turnover), adding retail dynamics to the market. market composition Sector Weights FINANCIALS 61% UTILITIES 14% CONSUMER DISCRETIONARY 13% INDUSTRIALS 1% INFORMATION TECHNOLOGY 1% TELCOM SERVICES 1% ENERGY % MATERIALS % CONSUMER STAPLES % HEALTH CARE % : Stock market liquidity 5 4 3 2 1 HK 1998 1999 2 21 22 23 24 25 26 27 28 29 21 211 212 Note: Chart represents the number of months that the market takes to turn over Source: Bloomberg, HSBC 2
July 212 Correlations On average, tends to trade in line with the rest of the Asian market when it comes to sensitivity and correlations with global or local indicators. This is partly because the market, one of the largest and most liquid markets, sets the tone for the rest of the region. Correlations of MSCI Asia ex Japan Macro correlations Since 21 Since 21 ISM.76.84 Exports.6.6 Money supply.42.44 Fund flows.68 past 1 years past 5 years previous 5 years Indices Past 15 years Past 1 years Asia ex Japan.88.9 Aworld.72.77 Geographic breakdown of corporate revenues (%) Asia Pacific 74 Domestic 33 Rest of the world 26 Source: MSCI, Bloomberg, Thomson Reuters Datastream, HSBC Earnings and valuation Currently, earnings are trading above trend growth. The sharp recovery in recent years has been driven by real estate and s exposure to China, a reflection of Chinese earnings which are also above trend. This is one of the key reasons why is a relatively volatile market in Asia. Banks and real estate are both volatile, interest sensitive sub-sectors. Large declines were seen during the Asian Financial Crisis in 1998 and smaller declines were evident during the 23 recession (including a period when the SARS epidemic swept the city). Actual vs trend earnings MSCI annual EPS growth 9 8 7 6 5 4 3 2 Nov-99 Sep- Jul-1 May-2 Mar-3 Jan-4 Nov-4 Sep-5 Jul-6 May-7 Mar-8 Jan-9 Nov-9 Sep-1 Jul-11 May-12 % y -o-y 4 3 2 1 (1) (2) 52.5 46.5 - -39% Actual Earnings Trend 1991 1993 1995 1997 1999 21 23 25 27 29 211 213 On average, earnings have grown 1% since 25, which is below the Asian average of 15%. 3
July 212 Earnings estimates have actually declined in recent years, with 12-month forward EPS growth now being forecast to be flat to negative, down from EPS estimates of 2% at the peak in 21. Earnings momentum vs MSCI returns 12-month forward EPS growth* vs MSCI Index (%) 3 2 1-1 -2-3 -4 8 6 4 2-2 -4-6 (%) 3 2 1-1 -2-3 8 6 4 2-2 -4-6 24 25 26 Momentum 27 28 29 21 211 212 MSCI HK Index y-o-y (RHS) 24 25 26 27 EPS grow th 28 29 21 211 212 MSCI HK Index y -o-y (RHS) Note: Earnings momentum is defined as the 6 month % change in 12M forward EPS forecast. *Percentage change in trailing 12-month and 12-month forward EPS Note that even at the peak, earnings growth estimates barely exceeded 2% for the market (this was in 24). At its worst, a decline of 2% was projected in 28. This gradual decline in earnings downgrades has led to analysts toning down their recommendations and becoming fairly neutral on the market. Since 23, analysts have been generally optimistic on their ratings (based on recommendation consensus score, or RCS). This is after very bearish views in the Asian Financial Crisis and the 22 recession. Part of this structural shift towards optimism comes from China. When looking at Chinese recommendations, a similar structural shift can be noted. Even in 28, when global financial turmoil hit, analysts were at worst slightly bearish. Upgrades as % of total earnings revisions* vs MSCI returns Recommendation consensus score (%) 1 8 6 4 2 24 25 26 27 28 29 21 211 212 % upgrades MSCI HK Index y-o-y (RHS) 8 6 4 2-2 -4-6 3.2 3. 2.8 2.6 2.4 2.2 2. 1.8 94 95 96 97 98 99 1 2 3 4 5 6 7 8 9 1 11 12 Recommendation consensus score (RCS) Average ±2SD Analyst s f eeling more bearish Analysts feeling more bullish *Number of EPS estimates up as a % of total number of revisions in estimates Note: The recommendation consensus score (RCS) assigns a score of 1 to each buy recommendation, 3 to hold and 5 to sell. On average the market PE hovers around 15x, with peaks of over 2x in 26 and a 1x trough in 28. The average PE in the last decade is 15.8x. 4
July 212 All sectors, except utilities, offer good value compared with their own history. Relative valuations show that tends to trade at a 2-3% premium to the rest of Asia. ROEs have hovered around 8-1% in the last decade with a peak in 27 (12%) and a trough in 28 (6%). With ROEs not substantially higher than the rest of the region, most of this can be explained by positive views on growth (think China) and lower perception of risk (lower cost of capital). : PE band chart Relative valuation 23 21 19 17 15 13 11 9 7 5 3 Price level Dec-2 Feb-4 Apr-5 Jun-6 Aug-7 Oct-8 Dec-9 Feb-11 25x 2x 15x 1x Apr-12 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1..9 1 2 3 4 5 6 7 8 9 1 11 12 PE:HK/Ax J This coincides with a narrowing of the difference between bond and earnings yields, i.e. stocks were expensive in 26 during the height of optimism on Chinese growth and cheapest in 28-9 during times of financial turmoil. : PB vs ROE/COE (12-month forward) : Earnings and bond yields 2.5 2. PBR ROE/COE 12 1 BY EY 1.5 1. 8 6 4.5 2. 1998 1999 2 21 22 23 24 25 26 27 28 29 21 211 212 1 2 3 4 5 6 7 8 9 1 11 12 Source: MSCI, Thomson Reuters Datastream, Bloomberg, HSBC Source: MSCI, Thomson Reuters Datastream, Bloomberg, HSBC 5
July 212 Fund flows While in large parts of Asia foreign investors have been steady accumulators of equities (e.g. Indonesia, India), in this is not the case. Investors have, in general, been overweight equities throughout the cycles. On a cumulative basis since June 23, mutual funds are net sellers of USD1.7bn equities, with a net accumulation of only USD6bn in 27 and a net outflow of USD2bn in 28. Cumulative foreign institutional funds since June 23 USDbn 7. 6. 5. 4. 3. 2. 1.. -1. -2. -3. -4. fund weights vs MSCI benchmark Funds Current -1M -3M -6M -12M Active Weight 1.7 1.7 1.8 1.7 1.7 Z Score.4.6.7.5.7 Source: MSCI, EPFR, HSBC Jun-3 Jul-4 Aug-5 Sep-6 Oct-7 Nov-8 Dec-9 Jan-11 Feb-12 Source: EPFR, HSBC Economic basics After China started to reform its economy in 1978, reinvented itself from a manufacturing base into an international trade and finance centre. As its manufacturing base moved moving over the border into Guangdong province, its service industry has grown rapidly. Donna Kwok Economist The Hongkong and Shanghai Banking Corporation Limited +852 2996 6621 donnahjkwok@hsbc.com.hk This enabled the city to survive three recessions in the decade to 28, during which GDP growth averaged 4.7% annually and income per capita rose by almost a third to USD32,9 (ranked fourth highest in Asia today after Japan, Singapore and Macau). Over time, this process has also turned domestic demand into an increasingly driver of growth. Private spending has contributed more to growth than net merchandise exports since the end of 21. As a result of China easing travel restrictions, the number of mainland tourists to has surged from 4.5m in 21 to 2m in 211, outnumbering visitors from all other countries combined. This has boosted retail sales but also increased commercial rents and property prices. Economic policy primer Trade matters to not because of the actual production of exports, but because of the financing, marketing, distribution, buying and selling of manufactured goods. These entrepôt services not manufacturing itself are what keeps the city s trade machine humming. Manufacturing used to account for over a fifth of the economy in the 198s but less than 3% today; entrepôt services now account for 37% of the economy (21% from imports/exports and 16% from business logistic services), compared with 22% three decades ago. Increasing integration with China, through trade, tourism, and financial links, has helped underpin economic growth. The mainland has long been s largest trading partner, accounting for about half of s exports by value. is also the premier stock market for Chinese firms 6
July 212 seeking to list abroad, and the top source of foreign direct investment and overseas direct investment) funds entering and leaving China. is well placed to accelerate the development of the offshore renminbi market, which for the next 5-1 years should boost its status as a global financial centre. continues to link its currency closely to the US dollar, maintaining an arrangement established in 1983. The fixed exchange rate means the city s monetary policy is largely dictated by the US. Key economic data % Year 28 29 21 211 212f Consumer spending 2.4.7 6.7 8.5 5.1 Government consumption 1.8 2.4 2.8 1.8 1.1 Fixed investment 1-3.9 7.7 7.6 4 Stockbuilding (% GDP).5 1.4 2.2.8 -.2 Domestic demand 1.6.8 7.5 6 3.4 Exports 2.6-1.1 16.7 4.2 3.9 Imports 2.3-9 17.3 4.7 4.1 GDP 2.3-2.6 7.1 5 3.1 Industrial production -6.7-8.3 3.5.7 2.5 Unemployment* (%) 4.1 5 3.9 3.3 3.3 Retail sales 1.6.6 18.3 24.8 15.5 Consumer prices 4.3.6 2.3 5.3 5.3 Budget balance (% GDP).1 1.6 4.3 3.9 3.4 HKD/USD 7.75 7.76 7.77 7.77 7.8 3-month money (%) 2.36.45.25.27.48 Prime rate (%) 5.313 5 5 5 5 *Average Source: CEIC, HSBC estimates Political structure is a Special Administrative Region of China. The head of government in is the Chief Executive, who serves for five years with a two-term limit. The Executive Council, presided over by the Chief Executive, decides on matters of policy and the introduction of bills to the Legislative Council, s legislative branch. Key regulatory bodies The Monetary Authority (HKMA) is responsible for maintaining monetary and banking stability. The Securities and Futures Commission (SFC) regulates the securities and futures markets in Hong Kong. Exchanges and Clearing Limited (HKEx) operates the securities market (the Stock Exchange of ) and a derivatives market and the clearing houses for those markets. The Hang Seng Index is the major stock index. 7