Kevin Smith takes a look at some of the political issues that have contributed to mass protests in Hong Kong and the impact on the risk and return characteristics of the local equity market in the short and long-term.
In our September 2019 article “Reflecting on Policy Errors in the Administration of Hong Kong” we paused to reflect on the build up to three months of mass protests and escalating violence with “no end in sight” and the detrimental impact on both the stock market and economy. Following a quiet period as the population of Hong Kong adjusted to lock-down measures in response to the Covid-19 pandemic we once again witnessed violent protests at the weekend with at least 180 people arrested for illegal assembly and misconduct but not rioting which carries a much high sentencing tariff if found guilty. The rally on Sunday was originally planned in response to plans to criminalise ridicule of the Chinese national anthem, however, Beijing subsequently announced plans to impose a new national security anti-sedition law on Hong Kong. This is a repeat of the plans previously announced in the summer of 2003 to introduce a similar anti-sedition law known as Article 23. Back then 500,000 people took to the streets on 1st July 2003 and the government quickly backed down and withdrew the legislation. The fear with that piece of legislation was that even mild criticism of the regime in China could be interpreted as a breach of Article 23 and subject to harsh penalties. The same fears have been sparked by this new version of the legislation together with the idea that this law could be applied retrospectively to the people arrested in the protests last year.
When Hong Kong ceased to be a British colony in 1997 the transition to full Chinese sovereignty was to be delayed for fifty years under the Basic Law. During this transition period Hong Kong operates as a Special Administrative Region (HKSAR) of China hence the term “One country, two systems” with the HKSAR enjoying autonomy for all issues except foreign policy and defence. To quote Jonathan Robison, “one country, two systems should not be viewed as a framework for liberal democracy, something Hong Kong never had under the British, but as a compromise over what the Communist Party can tolerate.” China is moving to full control of Hong Kong; in 27 years the Basic Law will have expired and a full range of national security measures will be applied. It is very unlikely that protests of the type seen in the past eleven months will be tolerated. The proposed national security law may well be put back on the shelf for the time being, however, we can be sure that it will be enacted in some form by the year 2047.
The built up to the 1997 handover saw hundreds of thousands of local Hong Kong residents taking steps to acquire foreign nationality especially in Canada, Australia and the United Kingdom while many companies registered in overseas jurisdictions especially Singapore, Bermuda and the Cayman Islands to protect their corporate assets. Many HKSAR residents will now be deciding if their long-term future is tied to Hong Kong or should be elsewhere. This time around, alternative destinations for residency are likely to be located within Asia with a focus on Singapore, Japan, and Taiwan. Just like 1997, the vast majority of Hong Kong residents are likely to choose to stay and the deciding factor will be the evidence of how the economies in Shanghai and Shenzhen have been allowed to flourish with the Beijing authorities doing very little to interfere with the operation of those markets and economies.
Equity markets react badly to uncertainty, the combined impact of political unrest and the Covid-19 pandemic has impacted Hong Kong as shown in Chart One, with a decline of 11.31% in the current year which is worse than the 9.08% decline in the United States although a little better than the World average showing a decline of 12.25%. The impact on ten-year numbers is more marked with Hong Kong lagging behind the United States and World averages at 6.83% versus 11.7% and 8.29% respectively. From a longer-term perspective Hong Kong remains one of the strongest markets in the world with annual returns in double figures at 10.67% per annum, ahead of the United States at 10.42% and the World average of 7.55%.
Chart One: Comparison of Market Returns for Hong Kong vs. The United States and the World
Chart Two shows that Hong Kong has a number of very favourable attributes in particular a price to book value of 1.10x which is less a half of the World average of 2.25x and just one third of the extreme levels now being recorded in the United States at 3.27x. The price to earnings ratio in Hong Kong at 14.4x in in line with the long-term average, while the World average and in particular the United States stand well above their long-term numbers of 15-16x.
Chart Two: Comparison of Valuation Attributes for Hong Kong vs. The United States and the World
Chart Three has a comparison of volatility between Hong Kong, the United States, and the World average. At the end of April 2020 Hong Kong and the United States had identical numbers for three-year annualised volatility at 16.98%, both were higher than the World average of 16.04%. The protest movement that started in Hong Kong in June 2019, while reducing market returns in the short-term has not increased volatility beyond normal levels typically experienced in equity markets across the globe. Hong Kong does have significantly higher volatility when measured over the past ten years at 17.85% versus the United States at 13.95% and the global average of 14.22%. Hong Kong has always generated much higher variability of returns than is typical in other equity markets, for example the decline registered in 2008 was 51.2% some ten percentage points more than the global decline, while the recovery in 2009 of more than 60% was twenty-five percentage points better than achieved globally.
Chart Three: Comparison of Volatility Attributes for Hong Kong vs. The United States and the World
In conclusion, the protests in Hong Kong while impacting short-term returns achieved by that market have not altered the longer-term volatility characteristics of the market versus the United States and the rest of the World. Despite weaker returns achieved in the past decade, Hong Kong remains one of the few markets to achieve more than ten percent annual average returns in the past thirty years. Those strong returns were not achieved at the cost of high and rising equity market valuations, in terms of price to book and price to earnings Hong Kong is valued well below the United States and the World average. Hong Kong is well placed to produce a strong recovery in the equity market when calmer politics prevail.
Kevin Smith, also of Delft Partners, is portfolio manager of the TAMIM Asia Small Companies portfolio. Click here to learn more.
Markets & Commentary
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