Hong Kong stocks' discount to book values ensnare Chinese funds betting on turnaround

Stock Connect, Hang Seng Index, Omicron variant, Alibaba Group Holding, to expel Chinese companies, US-China relation

Hong Kong stocks have become a valuation trap for mainland Chinese money managers.

The Hang Seng Index’s bouts of dipping below book value this year have failed to fetch bottom-fishing opportunities for fund managers that invest in Asia’s third-largest market through the cross-border Stock Connect programme.

Among the 39 mainland China-domiciled mutual funds that focus on Hong Kong stocks, only nine have delivered returns so far in 2021 and the rest have posted losses ranging from 0.6 to 21 per cent, according to Bloomberg data. The worst performer was the US$138 million fund run by Shanghai-based China Universal Asset Management, whose losses were almost double those of the Hang Seng Index.

The Hong Kong benchmark has been trading below its net-asset value over the past six days, its longest such stretch this year, as the emergence of the Omicron variant of Covid-19 and the arrest of Macau’s biggest junket operator have unsettled trading. While the broader market’s dip below or close to book value typically foreshadows a massive turnaround in China’s onshore stocks, that may not be the case for the Hong Kong market.

“With lots of big-weight internet companies, the headwinds on Hong Kong stocks haven’t entirely receded and the market may still be finding a bottom now,” said Huang Senwei, a Shanghai-based strategist at Allianz Bernstein with US$686 billion in assets under management. “We prefer [mainland China’s] A shares to Hong Kong stocks, because of less regulatory uncertainty and more listings of companies with strong industry sentiment that are linked to green energy and carbon neutrality.”

The Hang Seng Index has been battered by China’s regulatory crackdown, earnings misses by technology juggernauts such as Alibaba Group Holding, increased scrutiny of Macau’s gambling industry and lingering tensions between Beijing and Washington.

The price-to-book multiple of the 60-member benchmark stayed at 0.98 times on Friday, the fifth period of time this year in which it has traded at a discount, Bloomberg data shows. The gauge has dropped 13 per cent this year, making it the worst-performing major benchmark globally. The Hang Seng Tech Index approached its record low on Friday, with a 1.5 per cent drop sparked by Didi Global’s decision to withdraw its US listing and a further step by the American securities regulator to expel Chinese companies trading in the US that do not comply with its financial disclosure requirements.

With the overhang remaining, the risk of capital outflows from the city is also building up for local stocks that may be cheapened further. The Hong Kong dollar weakened to as low as 7.80 against the US dollar last week, nearing the level of 7.85 that will prompt an intervention by the city’s monetary authority to defend the local currency’s peg against the US dollar. The depreciation came after hawkish comments by the US Federal Reserve on the quicker withdrawal of stimulus drove the dollar index to a 16-month high.

China’s offshore stocks presented no immediate opportunity for piling in, as the MSCI China Index still commands a roughly 2 per cent premium to other emerging markets in valuation, according to Morgan Stanley.

“Given the gloomy outlook on earnings revisions, uncertainty around the property market, delta variant, the power shortage and last, but not least, the US-China relationship, the current equity risk premium level has further room to go higher in the near term before improving,’’ analysts Laura Wang and Fran Chen at the US investment bank wrote in a report in November. “The internet sector’s fast growth will likely be curbed.”

Morgan Stanley forecasts that in a base-case scenario, the Hang Seng Index will end at 25,000 by the end of 2022, implying about a 5 per cent gain from its last close.

To be sure, historical trading data may at least offer some solace to technical traders. The Hang Seng Index rose almost 6 per cent in the following six months after it stayed below book value for 15 consecutive days in April last year.

For UBS Wealth Management, the time to rebuild positions in China’s new-economy stocks may come in the next six to 12 months, after investors digest the earnings forecast cuts for the sector, which will reflect an outlook of slowing growth.

“We think opportunities will emerge after we gain more clarity from regulatory and related events,” analysts led by Eva Xia at the Swiss money manager wrote in a report last month. “Specifically, we expect the market to gradually position into the projected high earnings rebound in the second half of 2022 and, upon greater clarity on the regulatory reset.”

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