Hong Kong Stocks: Reasons and Outlook for the Year-End Correction

The pullback at the beginning of 2025 caught most investors off guard, but in a sense, we are not surprised by this trend. Looking back over the past three months, we indicated on October 3rd that the Hang Seng Index was clearly overextended around 22,500, then assessed that the market could fluctuate around 19,000-20,000, and in our outlook for 2025, we judged that the market had not yet escaped the oscillating pattern. The overall thinking has remained consistent and has been largely validated.

Recently, the widening interest rate differential between China and the U.S. has increased market pressure, especially as the downward trend in Chinese bond rates often puts pressure on the market, accompanied by a weakening exchange rate and capital outflows. This reflects more of the results of macroeconomic and policy factors. On one hand, there is strong growth in the U.S. and expectations of a slowdown in the Federal Reserve's interest rate cuts. On the other hand, and more importantly, the domestic interest rate decline and the underlying concerns it implies still need to be alleviated. Further policy efforts, especially fiscal policy, remain necessary, but whether through indirect debt relief or direct demand stimulation, a considerable scale is essential.

A potential variable affecting the intensity and speed of policy decisions comes from external challenges. The different scenarios of tariffs after Trump's inauguration may determine market paths and domestic policy responses. 1) If tariffs are implemented gradually (initial tariffs of 30-40%), the expected impact on the market will be limited; 2) If the maximum tariff of 60% is imposed, the market may face significant disturbances. However, we believe this could provide better allocation opportunities. Meanwhile, earlier this week, the U.S. unexpectedly listed two leading Chinese companies on the military enterprise list. Although this list does not directly involve investment restrictions, the disturbance to investor sentiment is still worth noting. However, from a holding perspective, a relatively "positive" factor is that compared to the peak in 2021, the proportion of foreign capital holdings has significantly decreased, and further downward space is also limited.

We believe that overall, the market has not yet escaped the oscillating pattern, and caution is the main approach in the short term. Under the assumption that policy support is in place but overly strong expectations are unrealistic, one can be more actively involved during downturns, but should take profits moderately during exuberance. Structurally, we continue to recommend stable returns (dividends + buybacks, especially for growth companies with a high proportion of net cash). Focus on marginal demand improvement supported by policy, combined with sectors that have undergone more thorough industry clearing.

Main Text

Market Trend Review

Affected by a new round of overseas uncertainties and the rise of the U.S. dollar against Treasury bonds, Hong Kong stocks have weakened for two consecutive weeks since the beginning of 2025, with the Hang Seng Index approaching the 19,000-point mark again. On the index level, the Hang Seng and Hang Seng Tech indices fell by 3.5% and 3.2% this week, respectively, while the Hang Seng China Enterprises Index and MSCI China saw declines of 3.7% and 4.3%. On the sector level, only the materials sector rose against the trend by 1.5%, while media and entertainment (-8.4%) faced significant sell-offs. Additionally, sectors such as transportation (-5.7%), real estate (-5.3%), and insurance (-5.1%) also saw declines exceeding 5% Chart: Last week, the MSCI China Index fell by 4.3%, with sectors such as media and entertainment, transportation, real estate, and insurance under the most pressure.

Source: FactSet, CICC Research Department

Market Outlook

The pullback at the beginning of 2025 caught most investors off guard. Not only did Chinese bonds quickly hit new lows, but U.S. bonds and the dollar also reached new highs, and the Chinese market, including Hong Kong stocks, suddenly retreated sharply. However, in a sense, we are not surprised by this market trend. Looking back over the past three months, we indicated on October 3rd that the Hang Seng Index was clearly overextended around 22,500, suggesting moderate profit-taking (《How Much Space Is Left After the Big Rise?》). Subsequently, we assessed that the market was stuck between 19,000-20,000, which could go either way, and caution should prevail in the short term (《Why Is the Market Not Responding Well?》、《What Kind of Policies Is the Market Expecting?》). In our 2025 outlook, we judged that the market has not yet escaped the oscillating pattern, and this overall thinking has been consistently validated (《2025 Outlook: Overcast but No Rain》).

Recently, the widening of the China-U.S. interest rate differential to a historical high of 310bp has also invisibly increased market pressure. As we analyzed in《New Highs in U.S. Bonds and New Lows in Chinese Bonds》and《What Is the Market Falling at the Beginning of the Year?》, the widening of the China-U.S. interest rate differential, especially driven by the decline in Chinese bond yields (which had been narrowing before April 2022) often puts pressure on the market, accompanied by a weakening currency and capital outflows. Compared to A-shares, Hong Kong stocks not only bear the same numerator pressure reflected by the decline in Chinese bond yields but also face more denominator pressure caused by rising U.S. bond yields. However, recently, Hong Kong stocks have performed relatively better than A-shares, which reflects that the recent pullback in Hong Kong stocks was more pronounced and that the widening of the China-U.S. interest rate differential is more driven by the decline in Chinese bond yields. The widening of the interest rate differential is merely a surface phenomenon; it more fundamentally reflects macroeconomic and policy factors, which have recently intensified:

Chart: The recent widening of the China-U.S. interest rate differential to a historical high of 310bp brings pressure to the Chinese market, especially Hong Kong stocks.

Source: Bloomberg, Wind, China International Capital Corporation Research Department

1. On one hand, the unexpectedly strong December non-farm payrolls reinforced expectations of robust U.S. growth and a slowdown in Federal Reserve interest rate cuts, pushing U.S. Treasury yields above 4.7%. However, unlike the market, we are not overly concerned about this. The reflexivity brought by high interest rates leading to tighter financial conditions will prevent rates from rising further, and this "reflexivity" has been repeatedly demonstrated over the past year.

2. On the other hand, and more importantly, the domestic interest rate decline and the underlying concerns still need to be addressed. The recent rapid decline in China’s bond yields indicates that investors are still hedging against potential further declines in interest rates by locking in stable rates for longer terms, which inherently reflects concerns about growth and inflation prospects. To hedge against the risk of rates declining too quickly, the central bank announced on Friday that it would suspend open market operations for government bonds starting in January. From the market reaction on Friday, although the 10-year China bond yield jumped at the opening, it gradually fell during the day and closed even lower. In contrast, the stock market's decline even widened. We believe this trend following the policy announcement on Friday is because it is still necessary to further lower financing costs, especially compared to the returns on financing. At the same time, the central bank's purchase of government bonds in the open market can also achieve a coordinated effect between fiscal and monetary policy, promoting liquidity to flow to the segments that need it more, effectively lowering the still relatively high financing costs for certain private sectors (such as small and micro enterprises).

Chart: The central bank announced on Friday that it would suspend open market operations for government bonds starting in January, with the central bank currently holding nearly 3 trillion yuan in government bonds.

Source: Wind, China International Capital Corporation Research Department

Chart: The current financing costs faced by domestic households are still higher than the investment return rates.

Source: Wind, China International Capital Corporation Research Department

Looking ahead, further policy efforts, especially fiscal policy, remain necessary, but whether through indirect debt relief or direct demand stimulation, a considerable scale is essential. Vice Minister of Finance Liao Min stated at a press conference on Friday that a more proactive fiscal policy can be expected in the future [1] Our calculations indicate that to address the current accumulated output gap and credit contraction issues, a "one-time" (not accumulated over many years) and "incremental" (not from existing expenditures under the same category) general deficit of 7-8 trillion yuan may be required. Currently, the known scale under the same caliber is about 3 trillion yuan (if the deficit rate is raised to 4%, it corresponds to about 1 trillion yuan, plus 2 trillion yuan for debt repayment that year). We believe that under the constraints of leverage levels, whether financing costs can quickly decline in a short period, and exchange rates, incremental stimulus will occur, but overly high expectations may not be realistic.

Chart: Currently, the financing costs for small and micro enterprises in China are significantly higher than the benchmark financing costs.

Source: Wind, CICC Research Department

Chart: To solve the current accumulated output gap and credit contraction issues, a "one-time" and "incremental" general deficit of 7-8 trillion yuan may be required.

Source: Wind, CICC Research Department

Of course, one possible variable that determines the magnitude and speed of policy strength comes from external challenges. As Trump's inauguration approaches, the pace and intensity of tariffs will be closely related to subsequent policy expectations. In our report "Possible Paths and Impacts of Tariff Policy," we estimate that 1) if tariffs are implemented gradually, such as an initial tariff of 30-40%, which means an additional 10-20% on the current 19% level, this is also the general consensus in the market. The impact on actual growth and the market is relatively controllable, so the strength of the policy needed to hedge is also relatively small (we estimate that a deficit rate increase of about 0.5-0.7% would be sufficient to cope). 2) If an unexpected maximum tariff of 60% is imposed, its direct and indirect effects may be non-linearly amplified, and the fiscal strength needed to hedge (to compensate for the GDP drag from exports would require a deficit rate increase of 1.5-2% to hedge) will also be greater. In this scenario, it is inevitable to impact the market, but precisely because of the need for strong policy hedging, it can provide better allocation opportunities.

Chart: EPFR shows that the allocation ratio of foreign capital to Chinese stocks has decreased from an overweight of nearly 1 percentage point in mid-2021 to an underweight of 1.2 percentage points currently

Source: EPFR, CICC Research Department

In addition to domestic policy expectations, recent overseas disturbances have also been increasing. Earlier this week, the U.S. unexpectedly included two leading Chinese companies on the Chinese Military Companies List (CMC), raising market concerns and directly leading to a significant pullback in related stocks [2]. According to the details disclosed on the U.S. Congress website, the CMC does not directly restrict secondary market investments; its impact mainly focuses on signing, renewing, or extending contracts for goods, services, or technology with the U.S. Department of Defense [3]. However, from a holding perspective, one relatively "positive" factor is that compared to the peak in 2021, the proportion of foreign capital holdings has significantly decreased. The allocation ratio of overseas active funds tracked by EPFR has dropped from over 14% at its 2020 peak to 5.6% (November 2024), and it is underweight by nearly 1.2 percentage points, with limited further downside potential. The situation summarized from other metrics is generally similar; whether it is the A-share holdings compiled by the People's Bank of China (USD 429 billion as of the end of September 2024 vs. approximately USD 618 billion at the end of December 2021), the holdings of Chinese stocks by U.S. Treasury (USD 620 billion at the end of 2023 vs. USD 1.08 trillion at the end of 2020), or the holdings summary from leading global asset management institutions (USD 776 billion in Q3 2024 vs. USD 1.38 trillion in Q1 2021, Chart 10), all indicate that foreign holdings have clearly retreated.

Chart: Under the People's Bank of China metrics, foreign A-share holdings decreased from the end of 2021 peak of USD 618 billion to USD 429 billion at the end of September 2024

Source: Wind, CICC Research Department

Chart: Under the U.S. Treasury metrics, as of the end of 2023, U.S. investors' holdings of Chinese stocks were approximately USD 622 billion, significantly down from USD 1.08 trillion at the end of 2020

Source: U.S. Department of the Treasury, CICC Research Department

Chart: A bottom-up analysis of the holdings of overseas institutions in Chinese stocks, as of Q3 2024, approximately USD 776.1 billion, significantly down from the peak in early 2021.

Source: FactSet, CICC Research Department

In terms of recommendations, we reiterate our previous view: The overall market has not yet escaped the oscillation pattern, and caution is the main focus in the short term. Under the assumption of policy support but unrealistic overly strong expectations, one can be more proactive during downturns, but should take profits moderately during exuberance. The Hang Seng Index has key support levels at 19,000 points on daily, weekly, and monthly charts. Compared to A-shares, Hong Kong stocks have advantages in valuation and industry structure, but liquidity is a drawback; therefore, as long as one enters at the right position, it can provide stronger structural resilience. Structurally, we continue to recommend stable returns (dividends + buybacks, especially for growth companies with a high proportion of net cash). At the same time, pay attention to sectors with improved marginal demand supported by policies, combined with industries that have undergone more thorough clearing, such as home appliances and automobiles under trade-in programs, as well as certain consumer services, home appliances, textile and apparel, and electronics.

Specifically, the main logic supporting our views and the changes to watch this week include:

1) In December 2024, China's CPI year-on-year fell, and the decline in PPI slightly narrowed. In December, China's CPI year-on-year fell from 0.2% in November to 0.1%. This was due to improved weather conditions facilitating agricultural product transportation, coupled with sufficient pork supply, which led food prices to drop from 1.0% to -0.5%. The CPI for consumer goods fell from 0% in November to -0.2%, possibly indicating the impact of "trade-in for new" on prices. In December, the PPI year-on-year narrowed from -2.5% to -2.3%, but still below market expectations, while month-on-month it dropped from 0.1% in November to -0.1%. At the industry level, differentiation continues, with seasonal demand for gas and electricity rising, but prices for black metals and building materials have declined due to the impact of real estate and infrastructure projects being halted 2) December U.S. Non-Farm Data Exceeds Expectations. The U.S. non-farm payroll data released this Friday showed that 256,000 jobs were added in December, significantly higher than the expected 165,000. The unemployment rate of 4.09% was also lower than the expected 4.2%. The labor participation rate and hourly wage growth were basically in line with expectations. A highlight of this report is the renewed recovery in the service sector, which added 231,000 jobs, becoming the main driver. The retail sector saw a significant rebound in December with an increase of 43,000 jobs, contrasting sharply with a decrease of 29,000 in November, indicating that the consumer market may have warmed up during the year-end holiday season. Market reactions showed that the better-than-expected non-farm data pushed U.S. Treasury yields higher, nearing 4.8%, reaching a new high since 2024, while the U.S. dollar index also approached the 110 mark.

3) The People's Bank of China Announces Suspension of Open Market Treasury Bond Purchases. On January 10, the People's Bank of China announced that it would suspend open market treasury bond purchases starting January 2025, with plans to resume based on the supply and demand situation in the treasury bond market. On one hand, recent rapid declines in Chinese treasury bond yields have reached historical lows, reducing investment cost-effectiveness. On the other hand, the market has quickly priced in expectations for interest rate cuts following the government's earlier mention of "moderate easing" in monetary policy.

4) Outflow of Overseas Active Funds Slows, Passive Funds Continue to Inflow, and Southbound Capital Inflows Accelerate. EPFR data shows that as of January 8, the outflow of overseas active funds from the Chinese stock market slowed to $9.866 million (compared to an outflow of $220 million the previous week), marking 13 consecutive weeks of outflow. In contrast, overseas passive funds continued to inflow $360 million (compared to an inflow of $460 million the previous week). Meanwhile, southbound capital inflows accelerated significantly compared to the previous week, with inflows exceeding HKD 10 billion for three consecutive days, averaging HKD 9.78 billion per day.

Chart: This week, the outflow of overseas active funds slowed, while southbound capital inflows accelerated.

Source: EPFR, Wind, CICC Research Department

Authors: Liu Gang (S0080512030003), Zhang Weihuan, et al., Source: Kevin Strategy Research, Original Title: "Hong Kong Stocks: Reasons and Prospects for the Year-End Adjustment"

Risk Warning and Disclaimer

The market has risks, and investment requires caution. This article does not constitute personal investment advice and does not take into account the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. Investment based on this is at one's own risk