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Rothschild supposedly said something along the lines of buy when there’s blood on the streets. While this is often a good analogy for contrarian investing, it’s safe to say it doesn’t apply to every troubling situation. With the situation deteriorating in Hong Kong recently, we may start thinking Hong Kong equities could start to look like an interesting opportunity. I disagree. It’s time to sell the iShares MSCI Hong Kong ETF (EWH).
Hong Kong’s “One Country Two Systems” was put in place to provide a 50-year transition period after the 1997 Handover from British rule back to Chinese. While Hong Kong’s sovereignty would be controlled by China (One Country), it would maintain its rule of law and its freedoms, and free market capitalism would be allowed to continue. The hope was, by 2047, Mainland China would be more like Hong Kong in 1997 and that the end of “One Country Two Systems” would be a seamless integration.
Fast forward to 2019 and it is quite obvious that China will not become Hong Kong in 1997 but that China will change Hong Kong’s way of life and that Hong Kong will become “just another Chinese city”.
There are many reasons for today’s protests. They are social and economic. Hong Kong’s currency peg to the US dollar, but the economy’s close ties with China economy means Hong Kong has a messy monetary policy. After 2008, the US had ultra-low interest rates appropriate for the US but China’s economy was still growing fast. This meant Hong Kong’s interest rates were massively too low causing a huge boom in asset prices. In the 10 years to 2015, property prices had gone up 150% while wages had gone up only 50%. In other words, asset owners got rich and everyone else got massively squeezed. Especially, the young.
This and other issues boiled over into the Umbrella protests of 2014. The catalyst was a change to the education syllabus which would include Communist Party propaganda. Another issue was related to the election process for Hong Kong’s local government. Occupy Wall Street was the inspiration behind “Occupy Central” which is the central business district of Hong Kong.
Those protests were relatively peaceful and died down after around three months. The underlying issues were never resolved. It was only a matter of time before a new catalyst would cause another round of protests.
That catalyst was a proposal to change the Hong Kong’s law to allow easier extradition from Hong Kong to China. Given the disparity between Hong Kong and China’s legal systems and how this very much encroaches on “One Country Two Systems”, plus many other minor encouragements in recent years, Hong Kongers decided to protest.
In 2014, the government largely waited out the student protests knowing the public would begin to get annoyed at the inconvenience of blocked roads in a city that always runs at 100% capacity. That strategy basically worked.
This time, however, the protests seem more broad based. With the United Kingdom distracted by Brexit, China knows the UK is unlikely to get involved in Hong Kong’s affairs and so they are testing the limits of “One Country Two Systems” and Hong Kongers know this. They have no choice but to protest and try to win the world’s attention. This is why we see American flags at some protests. America may not be perfect but, at least, it is free. Hong Kongers value their freedom which is being eroded. The protests this summer have been larger and more broad based than back in 2014. This isn’t just students but people from all walks of life worried about their future. Xi Jinping has set himself up as ruler for life with a socialist agenda and an all-powerful state. Hong Kongers are free market people and want something closer to democracy than what they are likely to get in 2047. However, this isn’t really about 2047, it’s about the encroaching Chinese government on Hong Kong’s way of life, fuelled by economic inequality.
Why does this all impact Hong Kong equities though? The Hong Kong market is a proxy for China and Hong Kong’s large markets are international, surely.
While this is true, there are a few big issues to deal with.
The largest sectors of MSCI Hong Kong are Real Estate and Finance. Together, these sectors have a weighting of 62.2% in MSCI Hong Kong. Real Estate is a combination of commercial and residential. Because of the low interest rate environment, Hong Kong property has been expensive, but Hong Kong has still been an attractive Asia Headquarters for international firms. With the protests dragging on and the highlighted issues of Chinese encroachment, Hong Kong is starting to look much less attractive compared to Singapore and, for those companies that need a China presence, Shanghai.
The same kind of thing applies to banks; with political unrest, why keep money in Hong Kong banks? Hong Kong banks are also massively exposed to Hong Kong property. On the residential side, the Hong Kong government is under pressure to ease the tight property market which is squeezing the working and middle classes (the people who are protesting). They have the power to release more land for property construction and impose other policies which would put pressure on property prices. Falling property prices are obviously bad for both Real Estate and Banking stocks.
Finally, with MSCI increasing the weight of A-shares (stocks listed in Shanghai) into their Emerging Market indexes (EEM), Hong Kong listed stocks are becoming less attractive to institutional investors needing China exposure, as they must now buy more Mainland listed stocks for benchmark reasons. This fund flow issue is another headwind for Hong Kong stocks.
Hong Kong under “One Country, Two Systems” is a “Special Administrative Region”. But this is a flawed structure, similar to how the eurozone is flawed. It’s a political structure which doesn’t work in reality. It only works and stays together when times are good. When everything is fine, the cracks can be papered over easily. However, fundamentally, Hong Kong’s Western values and culture are not easily compatible with the Mainland’s state-led and authoritarian way of working. Already, we are seeing record numbers of Hong Kongers applying for visas in other parts of the world. This brain-drain would be very damaging longer term. These plans to leave would indicate deposits would probably be leaving Hong Kong too, another bad outcome for Hong Kong’s financials. Lower US dollar interest rates are also not helpful for banks’ net interest margins. In the shorter term, the disruption of the protests is impacting retail sales. Consumer stocks account for another 22.5% of MSCI Hong Kong. The sentiment towards Hong Kong isn’t great, but the market is still assuming the protests will blow over and things will normalize. However, as mentioned before, the broader aspect of the protests, as the public realizes it’s up to them to save themselves, means these protests will continue for a long time, as Hong Kong’s government (directed by Beijing) stubbornly refuses to give much ground. The fact that Hong Kong’s airport was targeted by protestors shows the protestors know that they must target commercial interests in order to win more influence.
Finally, the technical picture of MSCI Hong Kong isn’t looking great. A double top at around $27 indicates the market does not want to go higher, and while the sharp fall in the last few weeks did find support from the long-term upward trend line of higher lows, once we break that level at around $23, it’s likely the market will capitulate and the next technical support level is around 30% lower at around the $16 level. All in all, it’s very bearish.
Data by YCharts
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in EWH over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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