Hong Kong stocks: How much room is there after the big surge?

After experiencing a continuous pullback in the first two weeks of the year, Hong Kong stocks began a rebound in mid-January, significantly outperforming A-shares. This aligns with our indication that the Hang Seng Index's 19,000 points is a key support level, where more aggressive entry can be considered during downturns. However, the strength of the rebound after the holiday exceeded most investors' expectations. So, after the rapid rise, what position is the current market in? How much room is there for further growth?

What are the driving factors behind this round of market movement? The enthusiasm for AI has driven technology stocks to lead the way, with sentiment being the main driver. Since mid-January, the rise in Hong Kong stocks has been primarily driven by risk premium, which reflects sentiment. In terms of sectors, information technology related to artificial intelligence has significantly outperformed. In contrast, traditional sectors with high dividends, such as energy, have lagged behind.

What funds are the main players? Active foreign capital has not yet returned, and southbound funds have weakened, likely still dominated by trading and passive funds. Active foreign capital continues to flow out, so it may still be primarily passive and trading funds. However, active funds still dominate in scale, so it is recommended to focus on the movements of active funds going forward. What position is the market in? How much room is there? There are signs of short-term overextension, with some technical indicators nearing overbought levels, but there are still internal divergences among investors. If the risk premium falls back to the 6.7% level seen in May last year, it would correspond to about 21,600 points for the Hang Seng Index; if the risk premium further drops to 6% seen in early October last year, it would correspond to around 23,000 points for the Hang Seng Index, but this is quite challenging. What potential variables lie ahead? The progress of tariffs and policy expectations are mutually influential, with the trend in AI technology being even more critical. On the overseas front, the gradual tariff measures under Trump have relatively controllable short-term impacts. However, the easing of tariff pressures and the excitement brought by DeepSeek in the industry may reduce the likelihood of short-term policy tightening domestically. In contrast, the development prospects of the AI industry are more crucial, but it is currently difficult to make a definitive judgment. For the United States, this will also affect capital flows, tariff policies, and even dollar policies.

How much room is there after the big rise?

1. What are the driving factors behind this round of market movement? The enthusiasm for AI has driven technology stocks to lead the way, with sentiment being the main driver.

1. Firstly, regarding catalysts: The start of this round of rebound in the Hong Kong stock market can be traced back to mid-January, when we indicated that the Hang Seng Index's 19,000 points is a key support level on daily, weekly, and monthly charts. The market rebounded immediately after briefly falling below this level in the first two weeks of the year. In terms of specific event catalysts, the joint announcement by six ministries before the holiday to promote long-term capital entering the market, the tariffs under Trump being more "moderate" than expected, the decline in U.S. Treasury yields, and especially the release of the DeepSeek-R1 model by domestic AI companies boosted overall market sentiment after the holiday.

2. Secondly, the decline in risk premium driven by sentiment is the main driving force. Since mid-January, the MSCI China Index has risen over 10%, with profit contributions only accounting for 1.7%, while valuation expansion contributed 8.8%, making up the vast majority. Further breakdown reveals that the decline in risk premium contributed 8.3%, while the risk-free rate only contributed a slight 0.5%, indicating that sentiment is the main driving forceChart: The risk premium contributes the majority of the driving force in this round of market trend

Source: Bloomberg, CICC Research Department

1. Third, the technology sector leads the way, while old economy and high dividend stocks lag behind. From the industry performance perspective, since mid-January, information technology related to artificial intelligence (+23.9%) has significantly outperformed, followed by consumer discretionary (+18.7%) and media and entertainment (+16.3%), all with gains exceeding 15%. In contrast, the old economy and traditional high dividend sectors have clearly lagged, with the energy sector (-0.2%) declining, and utilities (+0.2%) and transportation (+3.5%) also significantly underperforming.

Chart: Since mid-January, sectors related to technology growth, such as information technology, consumer discretionary, and media entertainment, have all seen gains exceeding 15%

Source: FactSet, CICC Research Department

II. Which funds are the main players? Active foreign capital has not yet returned, southbound funds have weakened, and may still be dominated by trading and passive funds

In addition to improved sentiment, the market's rise is also supported by funds, so analyzing which funds are the main players is crucial for assessing sustainability and future potential. In several reports we released during the rapid market rise from late September to early October last year, we emphasized that active foreign capital did not flow in significantly; instead, more investment-oriented trading funds and passive funds dominated by individual investors were likely in control. Currently, this situation may be similar.

► Southbound trading closed during the holiday, with a noticeable outflow after the holiday: During the Spring Festival holiday, southbound trading via the Shanghai-Hong Kong Stock Connect was closed, but the market still performed strongly, providing us with a window to observe overseas funds as a "controlled variable." On the first day after the holiday, southbound funds showed a significant outflow, indicating profit-taking, thus we can conclude that southbound funds are not the main force behind this round of rebound;

► Active foreign capital continues to flow out, so it may still be dominated by passive (ETF, individual-oriented) and trading (hedge funds) type funds: Similar to the early stage of the rebound from late September to mid-October last year, as of this Wednesday (February 5), EPFR shows that overseas passive funds have continued to flow in over the past six weeks, but these may represent more of a short-term exuberance among non-institutional investorsOn the contrary, more active funds from long-term institutions (LO) continue to flow out, which may reflect that foreign capital remains relatively cautious and wait-and-see. In terms of scale, active funds also dominate. According to MSCI statistics, the scale of passive and active funds tracking emerging markets is basically 80-20, with active funds holding an absolute dominant position in scale. Therefore, we recommend closely observing the trends of active funds.

Chart: EPFR data shows that overseas passive funds have continued to flow back in the past six weeks, but active funds are still flowing out.

Source: EPFR, Wind, CICC Research Department

Chart: EPFR statistics on foreign capital inflow into Chinese stocks by investment direction.

Source: EPFR, CICC Research Department

Meanwhile, the latest data released by EPFR shows that as of the end of December 2024, the allocation ratio of overseas active funds to Chinese stocks has decreased from a 0.9ppt underweight in September to a current underweight of 1.1ppt, still at a historical low.

Chart: The allocation ratio of overseas active funds to Chinese stocks has decreased from a 0.9ppt underweight in September to a 1.1ppt underweight, still at a historical low.

Source: EPFR, CICC Research Department

3. What position is the market in? How much space is left? There are signs of short-term exhaustion; if sentiment further recovers to early October highs, it corresponds to around 23,000 points for the Hang Seng Index.

What position is the market in? Sentiment is approaching the early May 2024 highs, and technical indicators are nearing overbought levels, but there are still internal divergences among investors. First, in terms of investor sentiment, the risk premium of the Hang Seng Index has quickly fallen from 7.8% in mid-January to 6.9%, which is very close to the level during the rapid rebound high in May last year (6.7%). However, it is still somewhat distant from the high of 6.0% in early October last yearChart: The Hang Seng Index risk premium has quickly fallen to 6.9%, approaching the level seen at the market peak in early May of the past five years.

Source: Bloomberg, China International Capital Corporation Research Department

At the same time, some technical indicators have shown signs of being overextended, such as the Relative Strength Index (14-day RSI), which has quickly risen from 32.1% in mid-January to the current 69.8%, nearing the overbought range (above 70%, Chart 5). The scale and proportion of short selling in Hong Kong stocks have also increased, indicating that there is still internal disagreement among investors regarding this round of rising market.

Chart: Some technical indicators show signs of being overextended, with the 14-day RSI reaching the overbought range.

Source: Bloomberg, China International Capital Corporation Research Department

Chart: The proportion of short selling has increased, reflecting internal disagreement among investors.

Source: Bloomberg, China International Capital Corporation Research Department

During the market rebound at the end of September and early October last year, we alerted investors that the Hang Seng Index was clearly overextended around 22,500 points by calculating the risk premium, suggesting moderate profit-taking, and indeed the market corrected around this level (《 How Much Space Is Left After the Big Rise?》). Similar to the previous round, the current market rise is also mainly due to the decline in risk premiumTherefore, we assume that the risk-free interest rate and earnings remain at current levels. 1) If the risk premium falls from the current 6.9% to last year's peak of 6.7% in May, it corresponds to the Hang Seng Index at about 21,600 points, which is about 2% away from the current level; 2) If the risk premium further drops to 6% at the beginning of last October, it corresponds to the Hang Seng Index around 23,000 points, which is a 10% upside from the current level, but reaching the exuberant sentiment at that time still poses certain difficulties, both from the perspective of policy strength and expectations.

Chart: Assuming the risk-free interest rate and earnings remain at current levels, if the risk premium falls to last year's low in May, it corresponds to the Hang Seng Index at about 21,600 points. If it falls to the beginning of last October, it is expected to reach 23,000 points, but this is relatively forced.

Source: Bloomberg, CICC Research Department

IV. Possible Subsequent Variables? The Progress of Tariffs and Policy Expectations are Interrelated, and the Trend of AI Technology is More Critical

On the overseas front, Trump's gradual tariffs are basically in line with expectations, and the short-term impact is relatively controllable. The recent postponement of the cancellation of the "small goods exemption" for imports from China also indicates the "real constraints" faced due to inflation. Our previous calculations suggest that a 30% tariff (an additional 10% on top of the 19% base) may elicit a market reaction similar to that after the third round of tariffs in April 2019. This is because it is largely in line with expectations and the actual impact is controllable, with a deficit rate increase of about 0.5% being manageable.

Although there may still be uncertainties ahead, in the short term, Trump also faces his own "real constraints" in implementing tariff policies. If we assume that he aims to achieve political goals over the next four years or even longer, he first needs to ensure control of Congress in the midterm elections two years from now, and the importance of inflation and market conditions for the election is self-evident. Additionally, with Federal Reserve Chairman Jerome Powell's term ending in May 2026, this means that if tariffs and immigration policies become too aggressive and lead to "out of control" inflation, Powell may adopt a more hawkish stance to demonstrate the Fed's independence and achievements in combating inflation, which would also impact the market. These factors may be burdensome for Trump in the 2026 midterm elections. Therefore, under the "real constraints" of inflation and the market, a strategy of "raising high and lowering slowly" may be a better approach for tariff and immigration policies, at least before 2026.

However, precisely because of this, the easing of tariff pressures, the quantitative recovery of data during the Spring Festival, and the excitement brought by DeepSeek in the industry may further reduce the likelihood of short-term policy tightening domesticallyData from the Spring Festival holiday shows that despite strong travel demand, the average ticket price has decreased by about 10% year-on-year, the average hotel price has also dropped by about 6%, and Hainan's duty-free sales have decreased by about 16% year-on-year. The sales of key retail and catering enterprises monitored by the Ministry of Commerce increased by 4.1% year-on-year, but compared to the 4.5% year-on-year growth during the 2024 National Day, 6.8% year-on-year growth during the May Day holiday, and 8.5% year-on-year growth during the Spring Festival, it appears relatively weak, indicating that continued policy support is still necessary.

We estimate that to address the current accumulated output gap and credit contraction issues, a "one-time" (not accumulated over several years) and "new" (not existing expenditures under the same category) general deficit of 7-8 trillion yuan may be required. We estimate that the known scale under the same caliber is about 3 trillion yuan (if the deficit rate is raised to 4%, it corresponds to about 1 trillion yuan, plus 2 trillion yuan for debt repayment that year). Considering the "real constraints" such as limited leverage levels, restricted room for interest rate declines, and currency depreciation, incremental stimulus will occur, but overly high expectations may not be realistic.

In contrast, the development prospects of the AI industry are more critical, and the significant implications for the systematic reassessment of Chinese assets are self-evident, but currently, it is still at a stage where no definitive judgment can be made.

For the United States, this will also affect capital flows, tariff policies, and even dollar policies. 1) If the AI trend in the U.S. continues, the attractiveness of U.S. assets will still exist, and funds will continue to flow into the U.S., pushing up the dollar and forming a positive feedback loop for U.S. financing (similar to the "Reagan cycle," achieving capital repatriation through financial items, a stronger dollar is more beneficial, similar to the views of the new U.S. Treasury Secretary, Janet Yellen); 2) However, if the U.S. AI trend weakens while China's strengthens, the momentum of capital inflows will slow down, and the positive feedback driven by current capital inflows will be difficult to sustain, which will not only have a significant impact on U.S. growth and U.S. stocks but may also prompt the U.S. to seek other benefits through tariffs and competitive depreciation of the dollar (similar to the "Plaza Accord," achieving capital inflows through trade and investment items, a weaker dollar is more beneficial, similar to the views of Robert Lighthizer), which will pose challenges to global trade, inflation, and growth prospects.

Allocation Suggestions

Although short-term market sentiment is very hot after the holiday and may further advance in the short term, we maintain our view in the annual outlook that the overall market has not yet escaped the oscillation pattern. It is advisable to be more actively involved during downturns, but to take moderate profits during exuberant times.

In the short term, if the risk premium falls to last year's low point of 6.7% in May, it corresponds to the Hang Seng Index at about 21,600 points. If the risk premium falls to last year's low point of 6% in early October, it corresponds to an index level of 23,000 points, but this currently seems quite challenging. Compared to A-shares, the advantage of Hong Kong stocks lies in valuation and industry structure, while the disadvantage is liquidity. Therefore, as long as one enters at the right position, it can provide stronger structural resilience.

In terms of allocation structure, we continue to recommend stable returns (dividends + buybacks, especially for growth companies with a high proportion of net cash) combined with structural growth, such as focusing on technology sectors with their own industry trends and policy support directions, such as semiconductors, artificial intelligence, and robotics, as well as sectors with marginal demand improvement under policy support, combined with industries that have undergone more thorough clearing, such as home appliances and automobiles under trade-in programs, parts of consumer services, and home appliancesTextiles and apparel. On the contrary, pay attention to the potential short-term disturbances in some export industries.

Author of this article: Liu Gang et al. from CICC, Source: CICC Strategy, Original title: "CICC | Hong Kong Stocks: How Much Space Is Left After the Big Surge?"

Liu Gang CFA SAC Practitioner Certificate No.: S0080512030003

Zhang Weihuan SAC Practitioner Certificate No.: S0080524010002

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