Source: Kevin Strategy Research Authors: Liu Gang Zhang Weihan, etc.

After the interest rate cut, how big is the rebound space?

Market trend review

Boosted by the 'unconventional' 50bp rate cut by the Federal Reserve, the Hong Kong stock market surged significantly last week, with the Hang Seng Index rising by 5.1% in a week to above 18,000 points, and the Hang Seng Technology soaring by 6.4%. Hang Seng State-owned Enterprises and MSCI Chinese Index also rose by 5.1% and 4.4% respectively. Meanwhile, the Hong Kong stock market witnessed a long-awaited sector-wide rally, with sectors directly benefiting from the Federal Reserve and local rate cuts, along with real estate (+7.8%), raw materials (+6.6%), and optional consumer goods leading the gains, while diversified finance (+1.5%) and information technology (+1.7%) had relatively lower increases.

Chart: Last week, the MSCI Chinese Index rebounded significantly, with real estate and raw materials leading the gains, but with relatively limited increases in diversified finance and information technology.

Since the peak at the end of May, the Hong Kong stock market has fallen nearly 10%. Since mid-May, we have been reminding investors that this round of rebound is mainly driven by the funding side and emotions. Therefore, with the market entering the overbought range, investors' divergences and profit-taking are not surprising. Assuming that the risk premium is fully restored to the level of the high point at the beginning of 2023, the corresponding target index level of the first stage of the Hang Seng Index is 19,000-20,000 points (see May 12th "The market is approaching our first stage target" and May 26th "not surprisingly taking profits"). In the past few weeks, overseas funds, especially value-oriented active foreign funds, have flowed out again. The outflow scale this week has increased from USD 93.24 million last week to USD 340 million. This can also provide proof ("Active Foreign Funds Maintain Weakness"). However, with the recent continuous decline of the market, especially A shares falling below 3,000 points again, concerns about the Hong Kong stock market falling to the previous low are also increasing. In this regard, we are not so worried, although we have always believed that further upward momentum needs more catalysts to start, it will not completely give up all the gains, and the Hang Seng Index around 18,000 points can get some support, and looking back at this week's market performance also confirms our previous judgment ("temporary pause or end of rebound"). In addition, compared with A shares, which have returned all gains since March, the Hong Kong stock market has shown obvious resilience, which is consistent with our judgment that the Hong Kong stock market is better than A shares ("The Hong Kong stock market still has a comparative advantage").

The most anticipated event for global investors last week was the official start of the Federal Reserve's interest rate cut, marking the first rate cut since the significant easing by the Federal Reserve in March 2020 due to the COVID-19 pandemic, and also signaling the end of the tightening cycle since the rapid and significant rate hikes by the Federal Reserve in response to inflation since March 2022. Although the rate cut was already a market consensus, whether it would be 25bp or 50bp, remained ambiguous until the 'shoe dropped', and each has its own pros and cons. The final outcome exceeded the widespread expectations on Wall Street, with an uncommon 50bp 'unconventional' rate cut to kick off.

"Unconventional" rate cuts have the benefit of swiftly addressing potential but not yet evident growth pressures, but the downside is that they can easily make the market worry about solidifying concerns of a recession. After all, historically speaking, these "unconventional" rate cuts are usually extreme measures, such as the Internet bubble in 2001, the financial crisis in 2007, and the 2020 pandemic. It is for this reason that Fed Chair Powell is making efforts to create an image of being ahead of the market and able to do more at any time, but not being forced to do more due to recession pressures, by emphasizing the absence of recession signs, not linearly extrapolating the rate cut path, stating that the natural interest rate is higher than historical levels, and showing a dot plot with a far more gradual path than the market expects.

From the short-term global market reactions, the sentiment is positive, with loose trading dominating. The S&P 500 index hit a historical high, with greater gains in growth-style stocks. In this context, as we have pointed out in multiple reports, Hong Kong stocks are more resilient in the short term due to their sensitivity to external liquidity and the Hong Kong dollar's pegged exchange rate system which follows the Fed's rate cuts. Last week, Hong Kong stocks rebounded significantly to recover lost ground, while A-shares continued to show lackluster performance. This differential performance is a good example. So, how significant is the impact of the rate cut, and how much more room for rebound is there?

1) Why does the Hong Kong stock market show more resilience after the Fed rate cut? For the Chinese market, including Hong Kong stocks, the key observation after the Fed rate cut is how the peripheral easing effects are transmitted, and how domestic policies respond in this environment.

Compared to A-shares, due to the Hong Kong dollar's pegged exchange rate with the US dollar, the transmission of Fed monetary policy is more direct for Hong Kong stocks. After the Fed's rate cut, the Hong Kong Monetary Authority immediately lowered the benchmark rate from 5.75% to 5.25%, and local Hong Kong banks also lowered their best loan rates by 25 basis points, reducing the local financing costs in Hong Kong, directly improving the Hong Kong dollar liquidity environment, and providing a more direct transmission of the Fed's easing effects.

In contrast, due to various constraints such as interest differentials and exchange rates, the unexpected decision by the LPR to stand still on Friday in September meant that the loose overseas environment could not be effectively transmitted, which also explains the significant differences in the A-share and Hong Kong stock markets these past couple of days. Additionally, differences in the industry structures of Hong Kong stocks lead to better profits ("Finding Profit Bright Spots and Areas of Exceeding Expectations: A Preview of Hong Kong's 2024 Interim Report"), more thorough valuation and position clearances, all of which are reasons why Hong Kong stocks have greater resilience.

Chart: Recently, there has been a clear differentiation trend between the Hong Kong stock market and A-shares. The performance after the Fed rate cut is even more apparent.

Chart: Following the Federal Reserve's rate cut, Hong Kong Monetary Authority, Hong Kong commercial banks also lowered the prime loan rate by 25 basis points last week.

2) Which sectors in the Hong Kong stock market are expected to outperform in the short term? The extent of industry benefits also depends on the sensitivity to loose transmission using the same logic.

Firstly, with the rate cut by the Federal Reserve, growth sectors more sensitive to interest rates, such as Hang Seng technology, biotechnology, and technology growth, are expected to directly benefit in market performance. This is also the logic behind the biotechnology sector leading since the rapid decline in US Treasury rates in July.

Secondly, under the linked exchange rate system, the rate cut by the Hong Kong Monetary Authority and local banks will directly reduce the local financing costs in Hong Kong. Local dividends, consumption, and even real estate are expected to benefit. The MSCI Hong Kong Index nearly led all major global indices last week, with sectors like discretionary consumer and finance leading.

Lastly, as we determine that this round of US rate cuts does not signal a deep recession, the rapid rate decline can boost sectors sensitive to US rates such as increased demand in real estate, which in turn boosts related export chains. Recently, some export real estate chain sectors like the appliance sector have also performed well.

Chart: The MSCI Hong Kong local index almost led all major global indices last week, with sectors like discretionary consumer, industrial, and finance leading.

How is the funding situation? Is foreign investment flowing in? From the transmission mechanism perspective, during the Fed rate cut cycle, the narrowing of the interest rate differential between the United States and other countries and the temporary weakness of the dollar help alleviate the pressure of capital outflows in emerging markets. In addition, although rate cuts do not necessarily mean "recession," they are often accompanied by a temporary decline in U.S. growth, which may provide an incentive for funds to flow out in search of higher returns.

In last week's rebound in the Hong Kong stock market, we noticed an accelerated inflow of southbound funds. Due to the EPFR statistical caliber only covering until Wednesday, it was unable to capture the fund changes on Thursday and Friday after the rate cut. Last week, overseas active funds continued to flow into A-shares and Hong Kong stocks, albeit with a narrowing scale of inflow. However, we believe that there should be a re-entry of some trading funds. This week's data will provide a clearer picture.

As for longer-term fund inflows, they are not solely determined by the rate cut. Historical experience shows that among the three factors determining foreign capital inflows (overseas liquidity, geopolitical factors, and domestic fundamentals), domestic fundamentals and policy efforts are often more important. During the Fed rate cut in 2019, despite the continued outflow of foreign capital from market due to relatively weak domestic fundamentals and factors like China-U.S. trade friction, it vividly demonstrated that domestic fundamentals and policies are more important. Even in 2017, when the Fed raised interest rates, foreign capital continued to flow into the Chinese market, indicating a significant market increase.

Chart: During the 2019 Fed rate cut period, foreign capital continued to flow out of China despite the relatively weak domestic fundamentals and factors like China-U.S. trade frictions.

How much room is there for this round of rebound? Historical experience from six rounds of Fed interest rate cuts since the 1990s shows that in the short term, the Hang Seng Index has more elasticity, with an average increase of 3.8% one month after the rate cut. However, this simple historical data that does not differentiate macro backgrounds can only serve as a rough reference, and more attention should be paid to historical stages similar to the current one.

We believe that the current situation is more similar to the 2019 cycle, where there is no inevitability of a U.S. recession and strong domestic stimulus. In the 2019 cycle, the significant rebounds in A-shares and Hong Kong stocks precisely occurred in the period of January to March when Powell signaled the end of rate hikes, rather than in the formal rate cuts from July to September. The reason lies in the fact that when Powell signaled the end of rate hikes in early 2019, China also decided to cut the reserve requirement, leading to resonance both internally and externally.

In contrast, after April, the policy reiterated the 'monetary policy floodgate' and moved opposite to the Fed's easing, so even if the Fed cuts rates in July, A-shares and Hong Kong stocks overall remained volatile. Referring to the 2019 experience, growth stocks strengthened after the rate cut, with healthcare, consumer discretionary, and information technology sectors leading the way; the RMB exchange rate did not appreciate significantly; foreign capital continued to flow out until September 2020 before turning into inflows. In other words, while Fed rate cuts can bring about phase-wise greater elasticity, the long-term and sustained rise still comes from domestic growth and policies.

Chart: Taking 2019 as an example, the market saw a significant rebound due to loose domestic policies in January to March, but after April, even with the Fed rate cut, the market still showed a structural trend.

In the 4.4% rebound of the MSCI China Index last week, the risk premium played a leading role, contributing over 4 percentage points, while the risk-free interest rate made a minor contribution of about 0.3 percentage points. Our calculations:

1) Considering that current 10-year U.S. Treasury bond rates have fallen to 3.6-3.7%, fully pricing in rate cut expectations, assuming U.S. bond rates remain at 3.7-3.8%, and the risk premium returns to the 5-year average of 7% (currently 8.7%, May's low point was around 6.7%, and the early 2023 low was 6.1%), this corresponds to the Hang Seng Index being around 19,500-20,500 points.

Larger room for maneuver requires follow-up policy efforts to promote fundamental repair, currently we calculate the full year growth from bottom-up perspective to be 2% (the market's consensus expectation of around 10% may be too optimistic). However, this expectation has not been met in the short term, and the failed interest rate cut expectation in September indicates that the threshold for expected 'strong stimulus' remains high. The subsequent reduction of existing home loan rates, the possibility of further interest rate cuts, and greater fiscal support are all directions that need attention.

Chart: In the rebound process of the Hong Kong stock market over the past week, the risk-free rate contributed approximately 0.3ppt while the decline in risk premium contributed over 4ppt.

Chart: If the 10-year U.S. T-note remains at 3.7-3.8%, and the risk premium falls back to the mean level since 2018, Hong Kong stocks are expected to rebound to the 19,500-20,500 range.

Chart: Larger room for maneuver requires follow-up policy efforts to promote fundamental repair and profit growth.

Operationally, in the short term, the resilience of Hong Kong stocks is still greater than A-shares due to sensitivity to external liquidity and Hong Kong's following of interest rate cuts. At the industry level, attention can continue to be focused on interest rate-sensitive growth stocks (internet, technology growth, biotechnology, etc.), Hong Kong's local dividends and real estate, as well as the export chain driven by US real estate demand.

However, in the medium term, we also suggest not to overly extrapolate short-term resilience, similar to the logic of rebound in April-May. The structural market scenario of wide-range oscillations (high dividends + technology growth) remains the main trend until greater fiscal support is seen.

First of all, high dividends, as a stable 'cash' return asset in response to the long-term overall return decline, still have long-term allocation value. It is advisable to intervene again opportunistically during recent pullbacks. However, internally, dividends following the economic environment transmit in the order of cyclical dividends, bank dividends, defensive dividends, national debt, and cash.

Secondly, sectors supported by certain policies or improving economic conditions are still expected to benefit from positive stimuli and demonstrate significant resilience, such as those with their own industry prosperity (internet, gaming, education) or technology growth supported by policies (technology hardware and semiconductors).

Chart: In 2019, the domestic market rebounded significantly due to the loose domestic policy from January to March, but even after the Fed cut interest rates, the market still showed a structural market trend after April.

Chart: Performance of the SSE Composite Index after each rate cut

Chart: Performance of the Hang Seng Index in Hong Kong after each rate cut

Chart: Hong Kong stocks rebound significantly and outperform A shares in the early stages of interest rate cuts, with a higher probability of rising

Specifically, the main logic that supports our above views and the changes that need to be focused on this week are mainly as follows:

The Fed's rate cut announcement landed, with a 50bp unconventional beginning that exceeded market expectations. On September 19th, Beijing time, the Fed officially began cutting rates, but the magnitude of the cut was surprising, starting with a 50bp "unconventional" approach, lowering the federal funds rate to 4.75%-5%. Historically, a 50bp rate cut has only occurred in times of economic or market emergencies, such as the tech bubble in January 2001, the financial crisis in September 2007, and the pandemic in March 2020. At the same time, the updated 'dot plot' expects two more rate cuts totaling 50bp by the end of the year, 4 cuts of 100bp in 2025, 2 cuts of 50bp in 2026, plus this 50bp cut, resulting in an overall cut of 250bp, with the interest rate endpoint at 2.75-3%. In order to dispel linear extrapolation of the current rate cut path, Powell also emphasized that there is no fixed rate path set, it can be accelerated, slowed down, or even paused, depending on each meeting's circumstances. He also emphasized that there are no signs of a recession, the labor market is cooling, but victory has not been achieved on the inflation issue.

The recovery of domestic per capita tourism consumption during the Mid-Autumn Festival holiday in 2024 was better than that of 2019. According to the data from the Cultural and Tourism Ministry's datacenter, there were 10.7 million domestic trips during the holiday, a 6.3% increase from the same period in 2019; domestic tourists spent a total of 51.047 billion yuan on their trips, an 8.0% increase from the same period in 2019; per capita tourism consumption has recovered to 101.6% of the same period in 2019, surpassing the recovery levels of New Year's Day, Spring Festival, Qingming Festival, Labor Day, and Dragon Boat Festival this year, achieving a new high in recovery levels. Especially this year, despite facing a strong typhoon in the East China region during Mid-Autumn, it was still able to achieve a good recovery. The upcoming Golden Week in October is also worth paying attention to.

The September LPR temporarily remains unchanged. The LPR quote data announced by the central bank on September 20 showed that the 1-year and 5-year LPR quotes remained unchanged at 3.35% and 3.85% respectively. This temporary pause in the LPR might be due to considerations of the continuous decline in bank net interest margins in recent years and constraints such as the exchange rates of RMB. Recently, the director of the monetary policy department at the central bank, Zou Lan, clearly pointed out that short-term interest rate cuts may still be constrained by factors such as 'deposit relocation' and the narrowing of bank net interest margins. Therefore, the central bank needs to comprehensively consider the impact of future policies such as lowering mortgage rates and interest rate cuts on bank net interest margins.

This week, there was continued inflow of Southbound funds, while active overseas funds continued to outflow. Specifically, data from EPFR shows that as of September 18, active overseas mutual funds continued to flow out of overseas Chinese A-share markets, with outflows of around $0.15 billion, slightly lower than the $0.25 billion in the previous week, marking 71 consecutive weeks of outflows. At the same time, passive overseas funds outflows increased to $0.18 billion (compared to $0.1 billion outflows in the previous week). However, the direction of foreign funds after the Fed rate cut will need to wait for next week's data to be reflected. Southbound funds continued to flow in this week, with inflows of 6 billion Hong Kong dollars in just two trading days, narrowing from the 12.53 billion Hong Kong dollars inflow in the previous week.

Chart: As of last Wednesday, active overseas funds continued to flow out of overseas Chinese A-share markets.

Editor/Lambor