HK dollar and HK equities likely to repeat 2010

It is obvious that the movement of capital, either inflow or outflow, can move asset prices. This phenomenon is particularly true for the Hong Kong equity market given its liquidity and absence of capital control. On Oct 19, 2012, the Hong Kong dollar hit the strong front of the peg at 7.75 per US dollar due to inflow of "hot money". To keep the peg intact, the Hong Kong Monetary Authority intervened to weaken the HK dollar by purchasing US dollar in the market several times since then. I fully agree that the money inflow could somewhat propel the equity market, but it is ill-advised to make a bullish case for equities purely based on the HK dollar testing the strong front against the US dollar.

One of the counterexamples was actually not too long ago in November 2010. Back then, the equity market was buoyed by the expectation of quantitative easing 2 when Ben Bernanke, the Fed's chair hinted it in August and officially announced the measure in November 2010. With the inflow of capital into Hong Kong, the HK dollar started to strengthen against the US dollar in August from close to 7.78 to 7.75 per US dollar in late October 2010. Hang Seng Index did rise along the way with the HK dollar and posted a sharp spike up in early November reaching 24,988, the post-2008 high on Nov 8, 2010 (the 7th trading day after the HK dollar first hit the strong front in October 2010).

However, the "hot money" in November 2010 was proven to be "dumb money" as the Hang Seng Index recorded a correction of more than 10 percent in the following month alongside the weakening HK dollar. In fact, November 2010 also marked the post-2008 peak for the Hang Seng Index until now. This counterexample doesn't necessarily repeat every time, but it clearly shows the HK dollar testing the strong front may only hint of "dumb money" joining the rally's last phase.

Indeed, when comparing 2012 with 2010, there are a lot of similarities. First, 2010 was the year the debt crisis in Europe broke out, and which has still been lingering throughout 2012. Furthermore, the trigger in the investment world in both 2010 and 2012 was the expectation on accommodative polices from central banks (QE2 from the Fed in 2010, OMT from the ECB and QE3 from the Fed in 2012).

The repeat theme of 2010 in 2012 has played out nicely, particularly for the Hang Seng Index. However, if 2012 is really going to repeat 2010, headwinds to the market are expected to emerge in November. Furthermore, I am particularly concerned about the political events in November, namely the US presidential election on the 6th, the National Congress in China on the 8th, the Eurozone finance ministers meeting on the 12th and the Catalonian parliamentary election in Spain on the 25th.

While each of these political events is equally important and could possibly derail the rally, my real concern is still in Europe. The Greek Prime Minister Antonis Samaras said that his government would run out of cash on the 16th of this month if the Eurozone finance ministers couldn't make the decision to release another tranche of aid during their meeting. The case for Greece has always been a game of brinkmanship and it may actually turn out to be fine. However, the market will need to deal with another European country further down the road. Catalonia, the autonomous community of Spain which has been trying to gain independence, will have the regional parliamentary election. The victory of any anti-Spain party would cast doubt on the fourth largest economy of the eurozone.

Whether the rally in Hong Kong equities could extend into the second half of this quarter seems doubtful. I would keep a close eye on these political events and turn bearish once the market starts reacting adversely.

Sources: Thomson Reuters, Harris Fraser

The author is a senior investment analyst at the Harris Fraser Group. The views expressed here are entirely his own and do not constitute any advice.