The small and open nature of the Hong Kong economy makes it highly sensitive to swings in global growth and investment flows. With the same true of its equity markets, we expect the rising risk of a global recession to prevent this asset class from moving sustainably higher in the near term. However, Hong Kong equities over the long run should continue to benefit from strong growth in China.

Even before the financial-market turmoil of August, the Hong Kong economy was already showing signs of strain from a weakening global economy. Second-quarter gross domestic product had fallen short of expectations, contracting by 0.5 per cent over the previous three months, with softening trade the main drag. And with recent economic data from the US, Europe and the UK now pointing to a rising risk of recession, we see further downside risks to Hong Kong’s economic activity. This view is given weight by the fact that private consumption in the city state makes up some 60 per cent of GDP and is historically sensitive to financial market performance.

As a result, we believe the current consensus estimates for 4.8 per cent GDP growth in 2012 appear overly optimistic, despite Hong Kong benefiting extensively from China’s resilient domestic demand. Should the US economy enter an average recession, whereby GDP contracts by 2 per cent, we believe GDP growth in Hong Kong would be below 1 per cent.

Equities tend to overshoot on the way down

For the purposes of this Daily Theme, we focus on the more selective MSCI Hong Kong Index, rather than the widely-tracked Hang Seng Index, which is composed of both Hong Kong stocks and mainland Chinese companies that are listed in the city state. The first chart, plotting the index against GDP growth, shows that equity markets can decline by more than 30 per cent within 12 months of when GDP growth starts to decelerate. A full-blown recession is not necessary for stocks to drop.

This high degree of cyclicality is partly a function of the heavy weighting of economically-sensitive sectors in the index. Such cyclical sectors, including consumer discretionary, industrials and technology, make up around a quarter of the index, with a third of the remainder comprising of real estate. The Hong Kong Exchange makes up an additional 7 per cent.

Valuations already discount a mild recession

Since the recent August peak, the MSCI Hong Kong Index has slumped nearly 30 per cent, appearing to have largely discounted a mild recession. Among the various measures of valuation, the ratio of price-to-book value (assets minus liabilities), or PB, is a useful guide for identifying market bottoms. Investors commonly use PB to gauge the attractiveness of banks and property companies, which together account for nearly half of the index.

The current PB of about 1 for MSCI Hong Kong is consistent with the trough experienced in 2001 and 2003 when Hong Kong had mild recessions, where GDP contracted by less than 2 per cent. For comparison, the current level of the Hang Seng Index, at around 17,000, is similarly discounting a mild recession. However, despite these attractive valuations, equities are likely to remain volatile in the near term, given a lack of positive catalysts. Specifically, we believe investors will continue to worry about:

1. A potential US recession

2. The lack of game-changing policy action to solve the European debt problem

3. Still-tight monetary policy in China

4. Earnings downgrades. Current consensus is for 2012 earnings growth of 11 per cent in the MSCI Hong Kong, compared with the 10 per cent decline we would expect in the event of a US recession.

Liquidity flows amplify asset price volatility

Historically large swings in investment flows have also contributed to the tendency toward boom and bust in Hong Kong asset prices. Near-zero interest rates in developed economies and stronger growth prospects in China led the city state to experience unprecedented inflows in recent years. This was amplified by Hong Kong’s Linked Exchange Rate System, which pegs the Hong Kong dollar to the US dollar and imports US monetary policy.

Strong investment flows into Hong Kong in recent years have been driven by foreign investors looking for exposure to China and from mainland Chinese investors looking to diversify away from their domestic holdings. Between last November and this June, some $32 billion flowed out of Hong Kong as growth expectations for China moderated. This nearly reverses the short-lived inflows triggered by anticipation of the US Federal Reserve’s second round of quantitative easing, which started in late 2010. Global risk aversion and continued monetary tightening in China may well lead to further outflows.

Hong Kong will keep its dollar peg for now

Strong capital flows to Hong Kong and the increasing influence of China’s economic cycle have fuelled speculation in recent years that the city state may abandon its currency peg to the US dollar. Several alternatives have been mooted by various market participants:

1. Revalue the Hong Kong dollar at a higher rate

2. Link to the Chinese renminbi

3. Link to a basket of international currencies

4. Allow a free-floating exchange rate

We expect Hong Kong will eventually adopt a peg to the renminbi, but only in the very long term when the Chinese currency becomes fully convertible and capital liberalization reaches a mature stage. In the interim, we believe the most likely outcome is for the current peg to stay, as its benefits still outweigh the potential costs and risks associated with the other alternatives. Moreover, the other options may not necessarily solve the problem of large fluctuations in capital flows, and could in fact lead to increased instability.

A long-term beneficiary of China’s growth

While we expect Hong Kong equities to struggle in the short term, the longer-term outlook is brighter. Hong Kong companies should eventually benefit from two structural trends in Chinese growth – the internationalisation of the renminbi and the rise of wealthy Chinese consumers. Once global risks abate, we would look for attractive entry points to gain exposure to these trends through luxury retailers, Macau gaming and certain Hong Kong banks.