How to view the recent consolidation of Hong Kong stocks?

Summary

This week, the A-shares broke upwards, while the Hong Kong stocks performed weakly. How should we view the recent adjustment of Hong Kong stocks?

1. Since June, the Hong Kong dollar has continuously touched the 7.85 "weak side convertibility guarantee" position, prompting the Monetary Authority to withdraw a total of HKD 59.072 billion in Hong Kong dollar liquidity since June 28, leading to expectations of marginal tightening in liquidity, which has suppressed the short-term performance of Hong Kong stocks.

2. The AH price difference has converged to a historically relatively low level, with the Hang Seng Hong Kong Stock Connect AH premium rate now within the mean -1x standard deviation range, which has marginally weakened the cost-effectiveness of allocating Hong Kong stocks compared to A-shares in the short term, resulting in a slowdown in net inflows of southbound funds and even daily net outflows. However, in the medium term, as the AH price difference repairs to a neutral level, the suppressive effect on Hong Kong stocks may weaken.

3. The internet technology sector, a key weight in Hong Kong stocks, is facing intensified price competition in the e-commerce field, leading to rapid downward revisions in profit expectations, which has pressured and dragged down the performance of Hong Kong stocks.

How will the market unfold in the future?

1. In the short term, the Monetary Authority has withdrawn HKD 59.1 billion in liquidity, but HIBOR has only slightly increased, and the Hong Kong-US interest rate spread remains high. Subsequently, the Monetary Authority may continue to withdraw Hong Kong dollars to raise HIBOR rates, and the expectation of marginal tightening in Hong Kong stock liquidity remains. In the medium term, we believe that under the backdrop of global liquidity abundance, the Monetary Authority's withdrawal of Hong Kong dollars will have limited impact on market liquidity, and Hong Kong and A-shares will still be value traps, maintaining our judgment of a "volatile slow bull" pattern for Hong Kong and A-shares.

2. Actively pay attention to investment opportunities under the "anti-involution" policy background. The implementation and promotion of "anti-involution" related policies are expected to accelerate the exit of backward production capacity, improving the ROE levels of related industries, which will be a significant boon for the stock market. Historical experience shows that the nature of the market is first valuation, then profit. Stock prices catalyzed by policies lead the price increase after capacity clearance, and excess returns in sectors are mainly concentrated in the early stages of the market.

Industry allocation: Rapid rotation continues, maintaining a base allocation in low-volatility dividend assets such as banks while continuing to seek marginal improvement opportunities in low-level clues from a risk-reward perspective.

1. In terms of Hong Kong stocks, focus on sectors such as Hang Seng Technology/Hang Seng Internet/Hang Seng Cloud Computing/Hang Seng Innovative Medicine, where the ERP has been restored to high levels, and pay attention to the steel theme market catalyzed by the "anti-involution" policy.

2. In terms of A-shares, considering the expectations of the "anti-involution" policy that have fermented this week, the industry’s rise and fall since the high-low cycle (since June 12) and adjustments in profit forecasts, pay attention to rotation opportunities in sectors such as semiconductor equipment, batteries, steel, fiberglass, and industrial metals. On the other hand, with the start of the mid-year performance disclosure period, pay attention to sectors such as optical modules/PCBs, storage, gaming, wind power, military industry (month-on-month improvement), shipping, small metals/precious metals, innovative medicine/CXO, etc., which may exceed expectations.

How to view the divergence in AH performance this week?

This week (June 30 - July 4), the divergence in AH performance was significant, with Hong Kong stocks reversing their previous relative strength and declining. The Hang Seng Index, Hang Seng Technology, and Hang Seng Hong Kong Stock Connect saw weekly declines of -1.52%, -2.34%, and -1.03%, respectively, while net inflows from the southbound market slowed, and market turnover slightly decreased The A-share market has shown a relatively independent trend, with the Shanghai Composite Index, ChiNext Index, and CSI 300 weekly gains of 1.40%, 1.50%, and 1.54%, respectively. In terms of specific sectors, high-weight sectors in the Hong Kong stock market (banks, internet, new energy vehicles) performed poorly, dragging down the overall performance. Sectors such as steel, building materials, power equipment, new energy, and coal have all been catalyzed by domestic "anti-involution" and fertility subsidy policies, with AH trends generally aligning.

This week, the performance of the Hong Kong stock market and the A-share market diverged, and the driving factors behind this can be analyzed from three aspects:

First, the low-level repair of AH premiums in the Hong Kong Stock Connect sector and the slowdown of southbound capital inflows led to a net outflow on Thursday. The overall AH premium rate of the Hang Seng Hong Kong Stock Connect sector is now within the mean -1x standard deviation range, and the AH premium level of the banking sector has fallen below the historical mean -1 standard deviation position since mid-June, reaching a historical low since 2015. The cost-effectiveness of the Hong Kong banking sector has marginally weakened, underperforming the A-share banking sector, which has dragged down the overall performance of the Hong Kong stock market.

Second, the internet technology sector is under dual pressure from fundamentals and valuations. The internet technology sector is a uniquely important weighty sector in H-shares and is a major factor dragging down index performance. In terms of valuation, since the beginning of this year, under the DeepSeek narrative, leading internet companies in Hong Kong and the US Mag7 have formed a "seesaw" pattern—when the DeepSeek narrative strengthens, the US AI monopoly narrative weakens; when the US AI monopoly logic solidifies, the valuations of leading internet companies in Hong Kong come under pressure. Since May, the overseas NV chain narrative has continuously strengthened the AI monopoly logic, putting pressure on the valuations of Hong Kong internet companies. On the fundamental side, intensified price competition in the industry has led to rapid downward revisions of profit expectations, especially for leading platform companies such as Meituan, JD.com, and Alibaba, which have seen significant performance pressure, while the profit expectations of US AI giants have been notably revised upward. Under the divergence of fundamentals, Hong Kong internet companies have faced considerable suppression, while A-share listed companies related to the overseas NV chain have been catalyzed by the upward revision of US stock profits, leading to an increase in expectations for fundamental recovery.

Third, the continued depreciation pressure of the Hong Kong dollar and tightening liquidity further suppress market sentiment. The Hong Kong dollar is pegged to the US dollar under a linked exchange rate system. When the exchange rate of the Hong Kong dollar against the US dollar reaches 7.85, triggering the "weak side convertibility guarantee," the Monetary Authority must passively withdraw Hong Kong dollars to maintain the exchange rate <= 7.85. Therefore, since June, the Hong Kong dollar has continuously touched the 7.85 "weak side convertibility guarantee," prompting the Monetary Authority to intervene in the foreign exchange market for three days. From June 28 to July 4, a total of HKD 59.072 billion in liquidity was withdrawn, with the operation scale on July 4 reaching HKD 29.634 billion, the highest since 2017 Market liquidity tightening expectations are putting pressure on the valuation of growth styles. Since 2017, the Hong Kong dollar has repeatedly touched the 7.85 "weak side convertibility guarantee" four times, and the Hang Seng Tech Index has been under pressure within this range.

How will the market evolve?

In the short term, the depreciation pressure on the Hong Kong dollar continues, and liquidity is unlikely to ease marginally, which may continue to suppress the growth valuation of Hong Kong stocks. On June 28, July 2, and July 4, the Hong Kong Monetary Authority (HKMA) withdrew a total of HKD 59.1 billion in three days. From June 24 to July 3, the total deposits of Hong Kong banks decreased from HKD 173.464 billion to HKD 144.175 billion, but the exchange rate of the Hong Kong dollar against the US dollar is still close to 7.85 and has not significantly declined. The HIBOR overnight rate slightly rose from 0.02% to 0.0204%, and the three-month HIBOR rate rose from 1.55% to 1.70%. Looking ahead, as the HIBOR rate has not significantly increased, the Hong Kong-US interest rate spread (overnight) remains at around 4%, which may continue to bring depreciation pressure on the Hong Kong dollar. The HKMA may continue to withdraw Hong Kong dollars to maintain the exchange rate below 7.85, and the expectation of liquidity tightening may persist.

In the medium to long term, the overall downside risk brought by the HKMA's tightening of Hong Kong dollar liquidity is controllable. Since 2017, the Hong Kong dollar has touched the weak side guarantee four times, and the pace of intervention by the HKMA is mainly constrained by the Hong Kong-US interest rate spread, which is primarily influenced by whether the HIBOR is too low or the SOFR continues to rise. For example, in 2022 and 2023, the depreciation pressure on the Hong Kong dollar was due to the continuous rise of the SOFR, leading to a passive widening of the interest rate spread. Hong Kong's policy autonomy is relatively poor, and it can only passively follow the pace of US interest rate hikes, resulting in a continuous rise in HIBOR and an increase in corporate financing costs. Currently, the SOFR rate is stable, and the US is in a rate-cutting cycle. The HKMA's pace and scale of withdrawing Hong Kong dollars are based on the exchange rate of 7.85 and real-time US dollar demand, rather than a fixed level of HIBOR. The low interest rate environment in Hong Kong may continue, and the overall downside risk of liquidity tightening is controllable.

In addition, the current proportion of short-selling transactions in Hong Kong stocks has decreased to a relatively low historical level, and the downward pressure on Hong Kong stocks is small. As the sentiment in Hong Kong stocks warms up and southbound capital resumes net inflows, it may automatically alleviate the depreciation pressure on the Hong Kong dollar

Structurally, we recommend focusing on sectors such as Hang Seng Technology/Internet/Cloud Computing/Innovative Pharmaceuticals, where the ERP has been restored to a high level. The Hang Seng high dividend ERP has reached a relatively low level (mean -1x standard deviation). Although the short-term cost-performance ratio is declining, the allocation value of high dividend sectors remains in the medium to long term, and a pullback may present a good allocation opportunity.

On July 1, the sixth meeting of the Central Financial Committee proposed "governing enterprises' low-price disorderly competition in accordance with the law and regulations, and promoting the orderly exit of backward production capacity," while the China Cement Association released the "Opinions on High-Quality Development Work for 'Anti-Involution' and 'Stabilizing Growth'." The policy directly addresses the "increment without income" dilemma faced by the mid-to-downstream manufacturing industry, breaking the vicious cycle of "low-price competition → profit shrinkage → innovation stagnation" through supply-side constraints (production capacity reduction/technical standard enhancement), and promoting the industry to shift from "quantity expansion" to "quality improvement," especially targeting the issue of overcapacity in the mid-to-downstream manufacturing industry during the capital expansion cycle from 2020 to 2022.

Historical experience shows that policy catalysis leads to price increases ahead of capacity clearance, with excess returns in the sector concentrated in the early stages of the market. On February 5, 2016, the State Council issued the "Opinions on Resolving Overcapacity in the Coal Industry and Achieving Development Relief." After the policy was released, from February to April, the coal sector saw significant excess returns, while coal prices remained at the bottom during the same period; however, in the third quarter of 2016, coal prices began a major upward trend, but excess returns in the coal sector narrowed or even continued to decline.

Recently, the expectations for the "anti-involution" policy have fermented, and we believe it is also an important re-evaluation clue for the "confidence reassessment bull market." In recent years, sectors with a significant oversupply and notable price reduction pressure mainly include photovoltaics, chemicals, steel, coal, building materials, aquaculture, automobiles, lithium batteries, etc. As the market transitions from oversupply to supply-demand balance, the stabilization of profit margins is expected to drive the recovery of pessimistic valuation expectations in the industry, especially in areas with a high proportion of backward production capacity, where the potential for valuation recovery is stronger; coupled with a rebound in demand, this is expected to further translate into EPS.

In terms of industry allocation, rapid rotation continues. While maintaining a bottom position in low-volatility dividend assets such as banks, we continue to look for marginal improvement opportunities in low-level clues. Considering the recently fermented expectations of the "anti-involution" policy, the industry’s rise and fall since the high-low cycle (since June 12), and adjustments in profit forecasts, we focus on rotation opportunities in sectors such as semiconductor equipment, batteries, steel, fiberglass, and industrial metals. On the other hand, with the start of the mid-year performance disclosure period, we pay attention to sectors such as optical modules/PCBs, storage, gaming, wind power, military industry (month-on-month improvement), shipping, small metals/precious metals, and innovative pharmaceuticals/CXO, where performance may exceed expectations.

Author of this article: Chen Guo, Source: Chen Guo Investment Strategy, Original Title: "How to View the Recent Adjustment of Hong Kong Stocks?"

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