On July 1st, President Xi Jinping paid his first visit to Hong Kong to celebrate 20 years since Britain handed over the territory to China in 1997, and to inaugurate a new Chief Executive, Carrie Lam (the first woman CE and a welcome change from her predecessor C Y Leung).
I would like to reflect on Hong Kong as a corporate base for Lloyd George Management, as an investment market, and for its larger meaning for China. We have been based in Hong Kong since 1992 (and in our newer incarnation since 2014) and I have been personally resident and domiciled here since March 1982. In 35 years, Hong Kong has gone through some remarkable changes, but it remains a dynamic business centre with low taxes, an excellent legal system and infrastructure, and minimal government interference in business. Nobody who has lived in Hong Kong can fail to love the place for its energy, dynamism, quirky Cantonese-speaking “can-do” spirit of efficiency, and the beauty of its mountains, islands and parks. But in the past few years, the mood has changed among Hong Kong people (especially the younger generation) to one of frustration, and anger, at the gradual erosion of freedom, and the high-priced rents and living costs of the city (akin to London, New York and other financial centres, but more extreme).
The older generation, especially grandparents who were refugees from China in 1949/50 might well say “Look how lucky you are to live in a free city where you can make money, travel freely, and enjoy international education, books, ideas and lifestyle”. But the issues of democracy, human rights and freedom will not go away as the death of Nobel Prize winner Liu Xiaobo reminds us. Hence Hong Kong – whose economic importance as a percentage of China’s output has diminished since 1997 from 20% to 3% – continues to have an outsized political meaning and importance for China. (And behind all this, looms the question of Taiwan)
Since Xi Jinping came to power in 2010, there has been a steady regression to rigid Communist Party controls, including even Hong Kong’s educational system which is now supposed to teach China’s history according to the Party’s handbook. When Hong Kong publishers of books on China’s leadership were whisked away in the night by China’s State Security Police, there was a frisson of fear among the population – so much for “One Country, Two Systems” continuing until 2047. And the 2014 “Umbrella Movement” was ostensibly not only a protest by students against the erosion of democracy, but equally the erosion of their economic dreams and property aspirations.
Yet it is true to say that Hong Kong has in the financial sector at least progressed to being an important centre for listing Chinese shares, and being a conduit for Chinese capital via the “HK-Shanghai” and “HK Shenzhen” Connect. In this respect it is important for overseas investors to focus on the continuing discount of “H” shares (Hong Kong listing) compared to “A” shares in Shanghai and Shenzhen. The mainland China market (market cap US$7.9 trillion, number of listed companies 3,300) continues to be driven to the tune of 80% by retail investors, with high PE ratios and inadequate research – compared to the Hong Kong market (market cap US$3.8 trillion, number of listed companies 2,060) which has low PEs, high dividend yields, low price/book (or price/NAV for property shares), and an intensively researched institutional market. Over the past 20 years, the leadership of the market has shifted dramatically from banks, properties and trading houses, to Chinese SOEs.
Despite the temporary strength of the Chinese Renminbi against the US dollar/HK dollar, it seems clear that the desire of PRC investors to expatriate their capital (very often for their families) will not diminish in the next few years. Hong Kong is the first destination for this capital, being in a good legal jurisdiction with Trust Law and a sound internationally convertible currency. The strength of the Hong Kong share market in 2017 bears witness to this growing influx of mainland money, as do the sky-high rents and property prices. The proportion of mainland buyers in the Hong Kong property market has grown from 12% to 14% of the total transacted value over the last one and a half years, pushing property prices to increase by 25% over the same period. Mainland investors have also targeted the share market through H-shares, registering CNY160bn (US$24bn) in net southbound inflows – double the amount that went north. The Hang Seng Index in 2017 (24% year to date) has outperformed the Shanghai Composite by 18% and the Shenzhen Composite by 28%. The movement of the A-share/H-share premium over the past three years demonstrates this change in sentiment, from the northbound inflow of newly permitted foreign institutional investors buying A-Shares that caused the premium to expand to 150% in the peak of 2015, (i.e. A-shares traded at a 50% premium to its dual listed H-share equivalent), to a subsequent contraction of the premium to as low as 115% when Chinese investors sought dollar denominated equities. Our conclusion is Hong Kong blue chips remain attractive for Chinese investors as a hedge against the depreciating Chinese Renminbi.
In May 2018, we will see MSCI include China A-shares in their global index for the first time. With a capitalisation of US$7.5 trillion, China will initially comprise about 25% of the Global Emerging Market index, and with full inclusion about 40%. This is an unprecedented change, given the size of the market, compared to Pakistan added this year or UAE, Qatar and Saudi Arabia two or three years ago. Currently, there is US$2 trillion in index funds or ETFs benchmarked to the MSCI Emerging Market index and we will expect significant inflows of international money to enter the China market for the first time in many years.
We are now working on the launch of a China Hedged Investment vehicle which will comprise A-shares as well as H-shares and international listed companies. While we retain our long term optimism about China, we have concerns about the short term direction. On the one hand President Xi Jinping appears to have made rapid progress in cleaning up corruption and excluding all his rivals (especially the recent change of leadership in Chongqing). On the other hand, there is an expectation, as we go to press in early August, that the USA may be on the point of taking its first trade measure against China, probably to do with steel dumping, or intellectual property concerns. This would be a shock to the market, after 6 months of relative calm, as the Dow Jones Index has just recently passed 22,000 and the Hang Seng Index has also followed up strongly. We are therefore in a cautious tactical position over the summer, looking for great buying opportunities in Hong Kong and China by the last quarter of the year.
Robert Lloyd George
3 August 2017