Asia

Has Hong Kong peaked? (Part III of III)

Construction workers on bamboo scaffolding

On the face of it, Hong Kong stocks look pretty cheap by global standards. But I believe the bubble in Hong Kong real estate (property) could be about to burst, dragging the stock market down with it.

According to the Financial Times the local benchmark Hang Seng stock index has a P/E ratio of 11 and a dividend yield of 3.4%. At first glance this looks like good value – at least for a developed market index in a money printing world. Especially when compared with indices such as the S&P 500 from the USA (P/E 17, yield 2.4%) or the Nikkei from Japan (P/E 18.3, yield 1.6%).

But there are good reasons for this. Overall the financial services sector makes up 45% of the Hang Seng index, including global banking giants such as HSBC Holdings and some of the largest mainland Chinese banks and insurance companies, such as China Construction Bank (CCB) and Ping An Insurance.

This goes a long way to explain the market’s overall low P/E ratio, given how the global banking industry is depressed and that a cloud of uncertainty overhangs the Chinese banks.

Specifically the Chinese banks have been growing their balance sheets and profits at amazing rates in recent years. For example, over the past three years, CCB’s profits after tax have grown an average 21% a year. Book value (also known as “net assets” or “shareholders’ equity”) has grown 19% a year. Book value can be thought of a everything a company owns less everything it owes – assets less liabilities.

 …investors are concerned about the lack of transparency in Chinese bank balance sheets…

Despite these growth rates, Chinese banks trade at low P/E multiples. This is because investors are concerned about the lack of transparency in Chinese bank balance sheets, the huge Chinese credit boom of recent years, and the risk that a large amount of the loan book will never be paid back, leading to big losses. In the case of CCB this is reflected in the P/E ratio of just 6.3 on the Hong Kong market.

So the apparently currently low P/E is for good reasons. But prices could still fall further if there is a loss of confidence in Hong Kong. One of the things most likely to lead to such a problem would be a steep fall in the property market.

If there’s one thing we’ve been reminded of in recent years it’s that when real estate markets crash, bank stocks get dragged down with them, as do stock markets in general. This has been true in many countries, including the USA, Britain, Spain, Ireland…the list goes on.

There are various reasons for this:

  • Activities connected with real estate, such as construction, estate agency, furniture sales and so on make up an important part of the economy. This is especially true in Hong Kong, a place obsessed with real estate.
  • For most people their biggest asset is their home, so falling prices hit consumer confidence, which in turn hits borrowing, spending and the economy overall. In Hong Kong this asset class is enjoying a spectacular bubble (see part II).
  • A weak economy leads to higher unemployment and increased debt defaults (including mortgages)
  • Falling real estate prices mean that even if banks seize defaulted properties they may not be able to sell them for enough to recover the defaulted mortgage loans
  • As a result of all of this, bank profits collapse due to asset write offs (bad loans) and lower levels of transaction activity in a weak economy

The risk for Hong Kong stocks

Hong Kong stocks have done pretty well in the past decade. The MSCI Hong Kong index was up 11.2% a year over 10 years, against 5.9% a year for the MSCI USA (both measured in US dollars). That means the MSCI Hong Kong was up 189% in total, with compounding (profits on profits), whereas the MSCI USA was up only 77%.

…falling real estate prices would be just the thing to get the ball rolling. Everything could get dragged down at once…

However, if the investor crowd gets seriously negative about the territory then there could be wholesale dumping of Hong Kong stocks. Big, loud headlines about falling real estate prices would be just the thing to get the ball rolling. Everything could get dragged down at once, irrespective of the fundamentals of individual companies.

For example, global investors in country funds could start pulling out. Let’s take a look at just one exchange traded fund (ETF), the iShares MSCI Hong Kong ETF (NYSE:EWH). This is a US$3.7 billion fund invested in large companies in Hong Kong. It has 62% of assets in the financial services sector (including real estate), and a P/E of 15.8 (higher than the Hang Seng).

If the Hong Kong stock market starts heading down significantly, large numbers of investors could pull their money out of EWH. The fund managers would have to sell some of all their stocks so they could pay cash back to the investors that were on the run. Other country funds would be doing the same. The selling pressure would drag the whole market down even further.

(This is a general problem with stock markets. Once the selling starts it can become indiscriminate and unlinked to individual company performances. The good news is that these situations provide great buying opportunities for value investors.)

Right now Hong Kong stocks look attractively price on the face of it, given the relatively low P/E ratio and high dividend yield. But once you dig deeper, and given the massive bubble in Hong Kong real estate, there are reasons to think Hong Kong stocks could fall significantly from here.

Only time will tell, but at OfWealth we recommend caution when it comes to Hong Kong stocks.

Stay tuned OfWealthers…

Rob Marstrand,

robmarstrand@ofwealth.com

Until next time,

Do you live in Hong Kong or have experience of living there? Let us know your thoughts on the current situation? Leave your comments below.

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.