Source: CICC Research Author: Liu Gang, Zhang Weihan

summary

There was a clear rebound in overseas Chinese stock markets on Friday, driven by positive developments in the US debt ceiling issue and market expectations that the country would introduce stronger favorable policies. Previously, after the market clearly entered the oversold region and the risk premium was already at a high level, short back-up transactions may also be the main driving force behind the rapid rebound in the market.This strong rebound mitigated the pessimism that has recently engulfed the market, and has once again verified our previous judgment that the market has downside protection and is effectively supported near the 18,000 mark of the Hang Seng Index.

As to whether the aftermath of this round of rebound is sustainable, on the one hand, we thinkThe market has good downside protection in this position. The policy is expected to continue its previous backstopping practice of preventing downside risks, combined with the possibility that the Federal Reserve's monetary policy will not further accelerate tightening. These two factors are still sufficient to provide downside protection for the market. Furthermore, the market currently takes into account many pessimistic expectations, so the risk-pay-for-cost ratio of the current level of the market is indeed attractive. But on the other hand,The precondition for the market to open up more upward space is still a more positive growth outlookThis is also the main driving force for attracting the return of overseas capital. Conversely, the market is likely to continue the pattern of range-bound fluctuations. In this context, we recommend investors to:1) Trading FluctuationsThat is, buying on dips when the market is oversold, and profits are thrown back when expectations are sufficient;2) Trade structured opportunities and adopt a “dumbbell” strategy(State-owned enterprises with the potential to increase dividend ratios plus growth sectors such as the internet and technology; the healthcare sector may benefit from greater flexibility after the Fed's easing shift).

Main text

Can the rebound continue?

Market trend review

After enduring multiple rounds of sell-off pressure over the past two weeks, taking back all gains since the beginning of the year, the Hong Kong stock market experienced a strong rebound on Friday, finally achieving its first weekly rise since May. Overall, the Hang Seng Technology Index, which accounts for a relatively high growth sector, surged 3.6%, while the MSCI China Index, Hang Seng State-owned Enterprises Index, and Hang Seng Index rose 1.5%, 1.5%, and 1.1% respectively. On the sector side, the media, entertainment and real estate sectors led the way, rising 4.5% and 3.2% respectively, while the transportation and energy sectors lagged behind, falling 5.0% and 2.3%, respectively.

Chart: The MSCI China Index rose slightly by 1.5% last week, with the media and entertainment sector leading the way

Market outlook

There was a clear rebound in overseas Chinese stock markets on Friday, driven by positive developments in the US debt ceiling issue and market expectations that the country would introduce stronger favorable policies. At the same time, after the market clearly entered the oversold region (the relative strength indicator fell below 30), short back-up trading may also be the main driver of the rapid rebound in the market (the Hong Kong stock short selling ratio fell from a high of 20% on Wednesday to around 15% on Friday).Such a strong rebound has eased the pessimism that has recently engulfed the market, and has also confirmed our previous judgment that the market has downside protection and is effectively supported near the 18,000 mark of the Hang Seng Index.However, the question that needs to be answered now isHow sustainable is this round of market rebound?

Chart: The market was oversold last week

Chart: The market's implied risk premium also climbed to its highest level since November 2022

On the one hand, we think the market has good downside protection in this position.Although it is not very urgent at the domestic policy level to rush to introduce a new round of large-scale stimulus measures in the short term, it is expected that the policy will continue its previous backstopping practices to prevent downside risks, and the possibility that the Fed's monetary policy will not accelerate tightening further, these two factors are still sufficient to provide downward protection to the market. Furthermore, after a sharp decline in the previous period, the Hong Kong stock market has shown clear signs of overselling in various dimensions such as the RSI oversold index and the share of short sales transactions. At the same time, the overall market, such as the Hang Seng Index, has also broken down (below 1 times P/B), and Hang Seng State-owned Enterprises have fallen below 0.9 times. This all shows that the market has taken into account more pessimistic expectations.Therefore, the risk-return price-performance ratio of the current level market is indeed attractive.

Chart: The ratio of short sales transactions has also risen rapidly and sharply

However, on the other hand, we believe that the premise for the market to open up more upward space is still a more positive growth outlook. This is also the main driving force for attracting the return of overseas capital.Although the extremely low valuation level is sufficient to provide downward protection to the market, it is difficult to open up the market's upward space. A more optimistic outlook for economic growth is still essential if the market wants to completely escape the range fluctuation trend since March. The improvement of economic growth prospects depends on the beginning of a credit expansion cycle. In other words, if new driving forces appear in the market (we think the relaxation of real estate policies and increased leverage by government departments may be key measures), the market is expected to have more room to rise, which in turn will attract the return of overseas capital and the appreciation of the renminbi (this also explains why the market was so sensitive to policy expectations last Friday). Conversely, the market is likely to continue the pattern of range-bound fluctuations.

As far as the present is concerned, domestic economic growth momentum has indeed slowed, and more policy support may be needed.The official manufacturing PMI fell 0.4 percentage points month-on-month in May, and was in a contraction zone for the second month in a row. The non-manufacturing PMI for May also fell back to 54.5 from 56.4 in April. This sluggish performance in the field of economic activity is compounded by weaker than expected economic and financial data released in the past few weeks, causing the market to worry about whether the domestic economic recovery trend has lost momentum since the epidemic policy was optimized at the end of last year. At the same time, this judgment has led to widespread speculation in the market that further stimulus measures may be introduced at the domestic policy level in the future (especially in the real estate industry in major cities) to restore upward economic growth momentum. Externally, the resolution of the US debt ceiling crisis and the rising possibility that the Fed may suspend another rate hike at this month's FOMC meeting helped improve market sentiment and contributed to a decline in the US dollar index and 10-year US bond interest rates, which had previously risen sharply. Meanwhile, the overall employment growth rate in the US is higher than expected, but the sharp rise in the unemployment rate announced last Friday may provide support for the Federal Reserve to suspend interest rate hikes this month, prompting the Fed to evaluate the potential impact and wait for a better decision in July.

In this context,We recommend investors: 1) Trading fluctuationsThat is, buying on dips when the market is oversold, and profits are thrown back when expectations are sufficient;2) Trade structured opportunities and adopt a “dumbbell” strategy(State-owned enterprises with the potential to increase dividend ratios plus growth sectors such as the internet and technology; the healthcare sector may benefit from greater flexibility after the Fed's easing shift).

Specifically, the main logic underpinning our opinion and the factors we needed to focus on last week mainly included:

1) The overall manufacturing industry weakened in May, and the service sector declined somewhat but was still at a high level.Affected by the release of demand from the previous backlog of orders and insufficient demand, the Chinese procurement manufacturing PMI in May was 48.8%, lower than the market forecast of 49.5%. It fell 0.4ppt from the previous month and was in a contraction range for two consecutive months. Among them, the on-hand orders index was 46.1%, down 0.7ppt from the previous month, and the support effect of backlog orders was exhausted; the new orders index was 48.3%, down 0.5ppt from the previous month, and demand in the manufacturing market weakened; by industry, the PMI of the basic raw materials industry fell 2.1ppt to 45.8% from the previous month. In the service sector in May, the base figure for the previous period was high. The operating activity index fell 1.3ppt to 53.8% month-on-month, but it was still in the expansion range and the absolute value was at an all-time high [1].

Chart: China's manufacturing PMI continued to be in a contraction zone in May

2) The US Senate voted to pass the debt ceiling bill.The FRA Act decided to suspend the debt ceiling until January 2025, during which time the Ministry of Finance is allowed to continue issuing debt to support debt repayment and other expenses. After the suspension period, the debt ceiling is reset to the original debt ceiling plus additional debt during the suspension period. As a condition, the bill limits government spending for the 2024 and 2025 fiscal years, but the extent and areas covered are relatively “friendly” compared to previous versions. The debt ceiling issue has been basically resolved to prevent the US from facing a technical default (the X-date for potential default risk is June 5), which will help boost market sentiment and risk appetite in the short term.

3) The US non-farm payroll data for May exceeded expectations.The number of non-farm workers employed in the US increased by 339,000 in May, far higher than market expectations of 190,000. Service industries such as education, health, and professional and business services remain major contributors. The labor participation rate remained at 62.6%, the same as in April, but the unemployment rate rose sharply from 3.4% to 3.7% in May. Also, the growth rate of the average hourly wage fell back to 0.3% month-on-month, lower than the previous value of 0.5%. The new strength of non-agricultural farmers in the US, and the credit card delinquency rate continues to rise. Overall, it shows that the employment demand of low-income people is rising, and the supply of employment is increasing, which will help to bridge the employment gap and reduce wages.

4) Liquidity: Southbound Capital and Overseas Active Funds both flowed out of overseas Chinese stock markets last week.Specifically, data from EPFR shows that overseas active funds flowed out of overseas Chinese stock markets last week, reaching 523.8 million US dollars. Meanwhile, investors from mainland China also reduced their holdings of Hong Kong stocks by a total of HK$6.9 billion through the Hong Kong Stock Connect last week.

Chart: Southbound Capital and Overseas Active Funds both flowed out of overseas Chinese stock markets last week

Investment advice

Although the Hong Kong stock market may lack direction in the short term and continue to fluctuate in a narrow range, we believe that there are still structural opportunities in the market, similar to the second half of 2019. In terms of configuration strategy,We recommend investors continue to participate in the opportunities brought about by market fluctuations or adopt a dumbbell allocation strategyIt focuses on state-owned enterprises with high dividend potential (dividend cash flow) and high-quality growth sectors with good profits (operating cash flow, such as the Internet, software and hardware, and some healthcare sectors), as well as investment targets that benefit from the Federal Reserve's future policy shifts.

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