Exclusive from Zhitong | U.S. stock market crash! Is the domino effect here? Can Hong Kong stocks seize the opportunity for wealth? What to buy?

Last Friday, the three major US stock indexes all experienced a significant decline. Intel (INTC.US) plummeted by 26%, marking its largest drop since at least 1982, while Amazon (AMZN.US) fell by 8.78%, leading the Dow Jones.

Since mid-July, the Nasdaq has been plummeting for three consecutive weeks. From its peak, the retracement has exceeded 10%.

As discussed in the previous article, the recent decline in the US stock market is mainly due to multiple factors such as the continuous decline in US economic data, AI monetization falling short of expectations, high overall US stock valuations, and lackluster performance of leading companies during the earnings season. The weak employment data released on Friday further exacerbated market concerns about an economic recession.

I. Will Recession Expectations Cause a US Stock Market Crash?

On August 2nd (Friday), the US Department of Labor released the employment report, showing that the growth in US employment in July slowed more than expected, with the unemployment rate rising to its highest level in nearly three years, reaching 4.3% (estimated 4.1%). This "surprising and disappointing" data triggered the most severe sell-off on Wall Street this year, leading to a sharp drop in the US stock market, the US dollar index, and bond yields.

According to the Sam Rule, if the unemployment rate (based on a three-month moving average) rises by 0.5 percentage points from its low point last year, then an economic recession has begun. Since 1970, this indicator has had an accuracy rate of 100%. Bloomberg analysts stated, "The Sam Rule has been triggered, and the US is not moving in a positive direction." Although the Sam Rule is a "statistical rule and does not necessarily mean that something will happen," the turning point in market sentiment has already preceded the recession.

Warren Buffett was the first to send out a pessimistic signal to the market. The Buffett Indicator (the ratio of total stock market value to GDP) has now surged above 180%, indicating that the market is severely overvalued.

The latest quarterly report shows that by the end of the second quarter, Berkshire Hathaway's holdings of Apple had decreased from 789 million shares in the first quarter to about 400 million shares, a decrease of nearly 50%; since July, Berkshire Hathaway has also sold approximately 90 million shares of Bank of America, cashing out a total of about $3.8 billion.

Jim Shanahan, an analyst at Edward Jones, pointed out that Buffett's "selling activity is much higher than we expected." Some opinions suggest that considering the extent of Buffett's selling and the fact that Berkshire Hathaway only repurchased $345 million of its own stock this quarter, this billionaire believes that the entire market is too expensive.

"Bond King" Bill Gross has also turned bearish. Early Friday morning, Gross stated on X platform, "Today, there are very few bull stocks in MLPs (Master Limited Partnerships), bank stocks, and financial stocks." "Investors should no longer talk about buying the dip, but should focus on selling."

Mohamed El-Erian, Dean of Queen's College, University of Cambridge, said: "The market now fully understands that it may be too late for the Fed to start cutting interest rates."

II. What's next for the US stock market?

After the release of employment data, Fed Watch data shows that the probability of a 25bp and 50bp rate cut by the Fed in September is 26% and 74% respectively, compared to the previous values of 78% and 22%.

In terms of major asset reactions, the yield on the 10-year US Treasury bond has dropped significantly to below 4%, hitting a new low since February; the US dollar index has fallen to 103.223. Gold rose, then fell, and rose again; against the backdrop of a weaker US dollar index, the RMB exchange rate against the US dollar has risen significantly. The three major US stock indexes have all fallen significantly, showing clear signs of recession trading.

Huachuang Securities has selected the rate cut cycles of 1995, 2001, 2007, and 2019 for review. These four rate cut cycles each include 2 rounds of recessionary rate cuts and 2 rounds of preventive rate cuts. The former is accompanied by a rapid economic cooling or recession, with a fast pace and large magnitude of rate cuts; the latter is when the economy transitions from overheating to normalization, with a slow pace or small magnitude of rate cuts.

Huachuang Securities has made a simple definition: it refers to the trading of various assets in the market based on expectations of the timing and magnitude of central bank rate cuts. Specifically for US rate cut trading, it includes two elements: first, the initial rate cut. Second, it is divided into two stages: trading rate cut expectations (defined as the 3 months before the rate cut, during which the probability of a rate cut quickly rises from below 50% to near 100%); trading rate cut implementation (defined as the 6 months after the rate cut, during which the market has a rough idea of the pace and magnitude of the Fed's rate cuts). Rate cut trading tends to be more event-driven short-term trading. If a longer time frame is defined, it will inevitably be confused with fundamental trading and be more influenced by other factors.

Huachuang Securities found that for the overall US stock market, in preventive rate cuts, the US stock market can drive index gains in both the rate cut expectation and implementation stages by "pulling valuations"; or valuations remain stable, supported by earnings resilience on the numerator side. In recessionary rate cuts, the US stock market declines in both stages, resulting in "killing valuations".

For large and small cap US stocks, there may not necessarily be a phenomenon of high and low cuts during rate cut trading. During the rate cut trading period of preventive rate cuts, both large and small cap stocks generally rise, but it is uncertain which will have a larger increase, and it is also unrelated to the relative trends before the rate cut trading. During the rate cut trading period of recessionary rate cuts, both large and small cap stocks generally decline, but it is uncertain which will have a larger decrease, and it is also unrelated to the relative trends before the rate cut trading.

Looking at US stocks by industry, interest rate-sensitive industries have greater elasticity in rate cut trading, but it is difficult to distinguish between high and low. During the rate cut trading period of preventive rate cuts, interest rate-sensitive industries show greater upward elasticity, with core consumer goods and utilities industries having smaller increases, but there is no clear advantage or disadvantage within interest rate-sensitive industries. During the rate cut trading period of recessionary rate cuts, the decline in interest rate-sensitive industries is also greater, with core consumer goods and utilities industries having smaller declines or even counter-trend increases, but there is no clear advantage or disadvantage within interest rate-sensitive industriesUS Treasury Bonds: Whether it is a preemptive or recessionary rate cut, the long-term US Treasury bond rates show a significant decline in two stages of rate cuts trading. In a recessionary rate cut, due to the faster decline in short-term rates, the US Treasury curve is more likely to steepen after the rate cut lands; in a preemptive rate cut, there is little change in the term spread of US Treasury bonds.

US Dollar Index: In a preemptive rate cut, the US dollar fluctuates weakly during the trading phase of rate cut expectations, and strengthens after the rate cut lands. In a recessionary rate cut, the US dollar is weaker during the trading phase of rate cut expectations; after the rate cut lands, the strength of the US dollar is uncertain. The closer the timing of the rate cut is to the beginning of a recession, driven by safe-haven demand, the US dollar may strengthen.

Gold: Whether in a preemptive rate cut or a recessionary rate cut, gold tends to show a strong and fluctuating trend in the two stages of rate cut trading.

Copper: Whether in a preemptive rate cut or a recessionary rate cut, the price of copper shows no regular pattern in the two stages of rate cut trading.

III. Is Capital Flowing Back to the Chinese Stock Market?

According to Goldman Sachs' prime brokerage data as of last Friday, August 2nd, hedge funds have been selling global stocks for the third consecutive week. Among them, the selling volume of these funds for North American stocks exceeded the buying volume for stocks in other regions.

By region, Goldman Sachs data shows that hedge funds have been net buyers of stocks in the Asia-Pacific emerging markets. As of last Friday, hedge funds have achieved net buying of Chinese stocks for the first time in three weeks, marking the largest net buying volume in two months.

Some industry insiders also stated, "International funds will flow back to the Hong Kong stock market in the short term, showing improvement compared to before, but mainly short-term funds. With the backdrop of RMB appreciation, the FTSE China 3x Bull ETF followed the decline of the US stock market on Friday, tracking the 50 largest stocks in Hong Kong. Although foreign funds also recognize that the Hong Kong capital market is historically cheap, they still tend to believe that the Japanese market offers higher certainty than the Chinese market at present."

The attitude of domestic funds can be glimpsed from the performance of government bonds. Recently, the ten-year government bond has hit new highs, indicating to some extent that the market's existing funds still do not have confidence in the future performance of the stock market and have not attracted money to bottom fish.

Recent views from some foreign investment banks indicate that international long-term funds mainly consider several factors. Firstly, concerns about deflation brought about by real estate have not been effectively alleviated; secondly, the expectations of future great power games are still unclear until the end of the US election.

IV. How Does the Hong Kong Stock Market Perform During the Fed Rate Cut Cycle?

According to statistics from Industrial and Commercial Bank of China International, in all rate cut phases in the Hong Kong stock market since 1983, the Hang Seng Index has had an average increase of 22.0% and a cumulative increase of 264.2%. Whether looking at the average increase or cumulative increase, they are higher than during rate hike cycles.

However, looking at the recent rate cut cycles, the growth of the Hong Kong stock market has shown a significant decline, indicating a diminishing stimulative effect of loose liquidity on the Hong Kong stock market.

By decomposing the stock price changes, it can be seen that during the rate cut phase, the main driving force for the rise in Hong Kong stocks shifted from profit growth to valuation expansion.

Looking at the rate cut phases since 1993, the average P/E ratio expansion of the Hang Seng Index was 20.9%, with a cumulative expansion of 125.3%. During these rate cut phases, the average profit growth of the Hang Seng Index was 12.8%, with a cumulative growth of 77.0%.

It can be observed that during the rate cut phase, the profit of Hong Kong stocks can still maintain growth, but the increase is not as significant as the expansion in valuation, nor as much as the profit growth during the rate hike phase.

Overall, during the rate cut phase, both the valuation and profit of Hong Kong stocks can continue to rise, with valuation expansion becoming the main driving force for the rise in Hong Kong stocks.

Industrial and Commercial Bank of China International (ICBC International) stated that the reason why the performance of the Hong Kong stock index in response to rate cuts is relatively high is mainly because Hong Kong stocks are in the offshore US dollar market, making valuations more sensitive to changes in US dollar liquidity. Additionally, the emphasis of Hong Kong stocks on the financial industry also leads to a greater response of Hong Kong stock profits to changes in interest rates compared to US stocks.

Of course, the triggering factors and timing of rate cuts may have a significant impact on investment returns. Therefore, scenario analysis before rate cuts is also crucial. In the case of a soft landing, the stock market gains in Hong Kong may not be high.

ICBC International emphasized that the three-year adjustment in the Hong Kong stock market this round seems to be different from previous rate cuts, as it appears to be more related to the domestic economic fundamentals in China rather than global liquidity. This indicates that the impact from the domestic economy in China is greater. If only global rate cuts occur, the positive feedback in the Hong Kong stock market may not be very obvious. However, apart from a series of medium- to long-term structural transformation challenges, a large part of the challenges in the Chinese economy also come from cyclical factors. Therefore, China and the global economy are often interconnected. Once the global enters a rate cut cycle, the short-term pressure on the Chinese economy will also significantly decrease.

V. Which industries in Hong Kong will benefit more during a rate cut cycle?

ICBC International also examined the performance of various industries in the Hong Kong stock market from the end of the Federal Reserve's rate hike cycle in 2000 to the first rate cut period. It was found that the daily consumption, healthcare, energy, finance, and real estate industries, which are high dividend industries, have almost always shown leading returns in each market cycle.

During the period from December 2018 to July 2019, amidst a weak domestic economic recovery, the top three performing industries were daily consumption, healthcare, and finance, with gains of 24.5%, 12.0%, and 3.5% respectively.

Unless there are extreme events, this week will be a turning point for the Hong Kong stock market: whether it will continue to follow the weakening trend in the external environment or stabilize and start a rebound.

Of course, to go against the trend and strengthen, support from policies, funds, and various data is needed. So, which directions should we focus on in the current Hong Kong stock market?

(1) PharmaceuticalsFrom a historical perspective, combined with the current market situation, it is recommended to focus on pharmaceutical varieties.

There are two directions in the pharmaceutical sector: large pharmaceutical companies and CXOs.

In terms of large pharmaceutical companies, such as Shiyao, Zhongsheng Pharmaceutical, and Johnson & Johnson, the current valuations are relatively cheap. With the anti-corruption campaign in the pharmaceutical industry entering the circulation field, the risks for pharmaceutical companies have been largely exhausted, and a rebound is expected.

For CXOs, the main logic also points towards a rebound. Last Friday, they performed against the market trend. Companies like WuXi AppTec, Zhaoyan New Drug, and Kanglong Chemical showed good performance, but the rebound may encounter some obstacles.

Comparing the year-on-year data for global investment and financing in 2024H1, there has been a significant improvement. Several CXO companies mentioned in discussions that "customer inquiries and orders are showing signs of recovery." Additionally, the "Full Chain Innovation Drug Support Policy" released by Shanghai yesterday will continue to drive the demand recovery in the innovative drug industry chain, and the performance of related companies is expected to improve quarter by quarter.

China Merchants Pharmaceutical has summarized the semi-annual report and forecast for the CXO sector as follows:

WuXi AppTec: Shows strength and resilience on the order side; in terms of performance, excluding revenue from commercialized COVID-19 projects, year-on-year growth in 2024H1 was -0.7%; Q2 quarterly revenue year-on-year -6.5%, adjusted Non-IFRS net profit year-on-year -10.6%. On the order side, excluding specific commercialized projects, the year-on-year growth in hand orders in the first half of the year was +33.2%.

Kanglong Chemical: Q2 2024 revenue increased month-on-month and slightly year-on-year. In terms of performance, based on the median calculation in the forecast, Q2 2024 revenue increased by 8.0% month-on-month, net profit attributable to shareholders increased by 277% month-on-month, non-recurring net profit increased by 48% month-on-month, adjusted Non-IFRS net profit increased by 4.8% month-on-month; on the order side, customer inquiries and visits in 2024H1 showed signs of recovery compared to the same period in 2023, with new orders increasing by more than 15% year-on-year.

CStone Pharmaceuticals: In 2024H1, revenue and profit both decreased year-on-year; but it is worth noting that the net profit in Q2 increased by 190%-240% year-on-year, and the non-recurring net profit increased by 156%-209% year-on-year.

(II) State-Owned Enterprise Reform

State-owned enterprise reform and pharmaceutical varieties share a common attribute: defense + a certain degree of offense.

The logic behind state-owned enterprise reform is very clear, which is to revitalize assets and increase profitability. There are two specific directions:

One is restructuring. When the three major brokerages surged last Wednesday, part of the reason why they led the gains was due to rumors of integration, which attracted short-term capital attention.

The other is to revitalize assets. A typical direction is the "Unified Big Market," especially the recently high-profile railway operations.

As the world's factory, China's railway freight turnover accounts for only 9.2% of the total social freight volume, far below the 36% in the United States. Insufficient infrastructure is just one reason; weak operational capabilities are the main reason. The reform direction confirmed at the Third Plenum is to reform freight railways, operate in a market-oriented manner, reduce the overall railway freight costs for society while increasing the profits of the railway sector. Railway infrastructure, railway transport service companies, and logistics companies for bulk and large goods are all expected to benefitThere may be performance opportunities for CRRC, CRRC Times Electric, and CRRC Corporation in the Hong Kong stock market