Source: China International Capital Corporation Insight

After breaking through 24,000 points to set a new high the previous week, Hong Kong stocks fluctuated and corrected last week. Although the market rebounded significantly last Friday, in terms of indices, the Hang Seng Technology fell by 2.6%, the Hang Seng Index dropped by 1.1%, and the Hang Seng China Enterprises and MSCI Chinese Index decreased by 0.4% and 0.1% respectively. In terms of sectors, Consumer Staples (+3.8%), Diversified Finance (+3.5%), and Insurance (+3.5%) led the gains, while Media and Entertainment (-1.9%), Information Technology (-1.7%), and Consumer Discretionary (-1.1%) lagged behind. The performance on Friday showed signs of diffusion towards the broader consumer stocks, while the previously leading technology sector fell behind.

Chart 1: In the past week, Consumer Staples and Diversified Finance led the gains in Hong Kong stocks, while Media & Entertainment and Information Technology declined.

However, what is "inconsistent" with the market trend is that southbound funds continued to flow in significantly, becoming the focus of attention. After a record net inflow two weeks ago, surpassing the highest since 2021, last Monday (with a net inflow of 29.6 billion HKD) and Wednesday (with a net inflow of 26.2 billion HKD) each set new highs for single-day net inflows since the launch of the Shanghai-Hong Kong Stock Connect. Correspondingly, this round of foreign capital has flowed in but not substantially, primarily dominated by passive and trading funds, with only partial active capital returning (mainly from the Asia-Pacific region, but still configured or slightly overweight). This indicates that, on one hand, southbound funds may be one of the main forces in this round, while on the other hand, it also shows that southbound funds cannot exert absolute "pricing power." Therefore, reviewing the historical circumstances and impacts of substantial southbound inflows and estimating future inflow space and "pricing power" becomes an important reference for judging the sustainability of this market rebound. We will provide a detailed analysis in this article.

1. What are the characteristics of this round of southbound inflows? Large scale and fast speed, potentially being a main force; Individuals and private equity are active, while public insurance funds continue to allocate; High dividends have shifted towards technology stocks.

This round of southbound inflows started in October last year and accelerated after the Spring Festival, showing large scale and fast speed. The average daily net inflow exceeded 5 billion HKD in November, January, and February, while since the beginning of this year, there have been 10 trading days with a single-day net inflow exceeding 10 billion HKD among 27 trading days. For the whole year of 2024, southbound capital is expected to flow in 807.87 billion HKD, averaging 3.47 billion HKD daily; since the beginning of this year, a total of 375.53 billion HKD has flowed in, averaging 8.16 billion HKD daily, more than double that of last year. Thanks to the rapid and substantial inflow of southbound funds, their trading volume once accounted for 33.7% of the main board trading volume of the Hong Kong Stock Exchange, while the market value of southbound holdings reached 10.5% of the total market value of the Hong Kong main board, both hitting historical highs. At the same time, the AH premium also narrowed to a recent low of 130.5%.

From the background of the occurrence, the narrative of the revaluation of technology stocks and Chinese Assets triggered by DeepSeek after the Spring Festival is the main catalyst for the recent inflow of southbound funds, especially becoming more evident in the recent two weeks. Previously, when the market just broke through the previous market high in early October, some investors had an outflow due to the need to recover losses.

At the same time, EPFR shows that although foreign capital has slightly flowed back into the Chinese market as a whole, the scale and speed are clearly lower than last year’s "924" market, mainly led by passive and trading funds, while active funds continue to flow out overall. According to our communications with overseas clients, some LO active fund inflows are currently still dominated by funds from the Asia Pacific and Emerging Markets regions, which are likely already standardized or even overweight, but are temporarily unwilling to significantly increase positions at this location; meanwhile, no significant inflow has been seen from European and American funds.

Chart 2: Active foreign capital is still flowing out overall, while passive foreign capital is slowly flowing back.

From the source perspective, the continuous inflow from the south may come from the activity of individuals and private equity, as well as the continued allocation by public funds and insurance capital. Since the details of the investor composition of the southbound funds have not been disclosed, it is difficult to obtain a complete picture. However, based on various information, we find: 1) There has been a rapid increase in net inflows of ETF funds that can invest in Hong Kong stocks, reaching a monthly record high, mainly from individual investors; 2) Recently, some small and medium-cap symbols in Hong Kong stocks have experienced abnormal volatility, similar to the performance characteristics of certain small and mid-cap A-shares, indicating that speculative capital and private equity funds may have participated, including funds that previously invested in U.S. stocks rapidly switching to Hong Kong stocks under the narrative of "the East rises while the West falls"; 3) Some insurance capital continues to allocate high-dividend symbols in Hong Kong stocks and has slightly increased its allocation to the technology sector; 4) Mainland public funds are also significantly increasing their allocation to Hong Kong technology stocks.

Chart 3: Recently, the monthly net inflow scale of ETF funds that can invest in Hong Kong stocks reached a historical high, with individual investors likely being the main buyers.

From the perspective of flow, it gradually shifts from high dividends to technology. At the end of last year, high dividends were still one of the main directions for Southbound capital allocation, but since February, Southbound capital inflows have begun to highly focus on technology stocks. Since the Spring Festival, Southbound capital has increased shareholding in the top ten stocks by a total of 133.09 billion Hong Kong dollars, accounting for 55% of the overall inflow. Among these, Alibaba alone received a net inflow of 73.46 billion Hong Kong dollars, accounting for 31% of all inflows. Looking at the distribution of the top ten stocks, apart from the dividend sector that has always been favored by Southbound capital (accounting for 15% of all inflows), technology stocks have become the focal point of this round of investment (Alibaba, Kuaishou, Li Auto, Tencent, and Xpeng Motors collectively received 40% of the overall inflow).

Chart 4: High-dividend and technology stocks have been the main sectors for Southbound capital's increase in holdings since the beginning of the year.

2. What are the circumstances of previous large inflows of Southbound capital? It often occurs during periods of heightened sentiment, with the direction depending on the market environment.

We have outlined three periods of accelerated inflow since the opening of the Shenzhen-Hong Kong Stock Connect, finding that accelerated inflows of Southbound capital often occur during times of heightened market sentiment. This is related to the nature of Southbound trend trading and the tendency to 'chase prices and sell high,' thus short-term inflow peaks often correspond to peak stages of the market. In terms of direction, the inflow of Southbound capital each round is more related to the current market environment, such as core assets or high-dividend stocks that have valuation advantages compared to A-shares, or new economy and Internet sectors that are lacking in A-shares.

Chart 5: Monthly average net buys of Southbound Stock Connect.

• From the end of 2014 to the beginning of 2015: The Connect mechanism launched, and the GEM saw a significant rise, stimulating southbound funds to catch up.

Background: 1) The Shanghai-Hong Kong Stock Connect officially launched: In November 2014, the Shanghai-Hong Kong Stock Connect officially launched, allowing mainland investors to directly invest in Hong Kong stocks via the stock connect, which substantially opened the inflow channel for southbound funds. 2) The surge in the GEM stimulated catch-up buying from the south: From the second half of 2014 to June 2015, the A-shares experienced a leveraged bull market, with the SSE Composite Index soaring from 2,000 points to over 5,000 points, and the AH premium quickly rising from 101 in November 2014 to a high point of 130 in mid-2015. Meanwhile, the valuation of Hong Kong stocks remained at a relatively low level, as the dynamic valuation of the Hang Seng Index was still around 10x in November 2014; 3) Policy dividends catalyze State-owned Enterprise Concepts: In March 2015, the government work report emphasized deepening the reform of State-owned assets and enterprises, and Hong Kong-listed Chinese central enterprises were sought after by funds.

Structural features: According to the disclosure of the top ten active stocks in the cross-border connect, the stocks with the highest inflow during this period, such as Hanergy Thin Film Power Group, Haitong Securities, and Jinyi Commercial Group, are now all delisted. In addition, MINSHENG BANK, CHINA OILFIELD, China CITIC Bank Corporation, and Zijin Mining Group also saw significant inflow.

Inflow continuation: After the inflow peak in April, the market peaked in May. In May 2015, the valuation bubble driven by the "leverage bull" rapidly burst, and market selling sentiment spread to Hong Kong stocks. Meanwhile, the expectation of interest rate hikes by the Federal Reserve heated up, and the USD rose, which also suppressed market valuations.

• From the end of 2017 to the beginning of 2018: The shed renovation pushed Mainland Real Estate stocks to surge, while the "asset shortage" increased the attractiveness of dividends in Hong Kong stocks.

Background: 1) The property cycle driven by shed renovation promoted the surge of Mainland Real Estate stocks in Hong Kong in 2017; 2) The "asset shortage" increased the appeal of dividend sectors in Hong Kong stocks: At the end of 2017, the emphasis on deleveraging in domestic finance led to a contraction of non-standard assets, and insurance and bank wealth management funds urgently needed high-yield assets. High dividend blue chips in Hong Kong stocks met the demand for "long-term holding + dividend orientation" from insurance funds, becoming an alternative choice.

Structural characteristics: Primarily high dividend central state-owned enterprises. From September 2017 to February 2018, the top 15 stocks with the largest capital inflow were basically high dividend central state-owned enterprises, with a total inflow of 33.12 billion HKD, accounting for 13%. The top five were CM BANK, Zijin Mining Group, China CITIC Bank Corporation, ASMPT, and BOC HONG KONG.

Subsequent inflows: After hitting a peak in January, there was a pullback in February. Affected by the unexpected results of the USA non-farm payroll, which triggered concerns about interest rate hikes, US stocks plummeted and dragged down the Hong Kong market. At the same time, in January 2018, the USA announced increased tariffs on imported photovoltaic products and Washing Machines, leading to initial concerns about US-China trade friction.

• From the end of 2020 to the beginning of 2021: Core asset market, the return of US-listed Chinese stocks, and the expansion of public funds and corporate annuities.

Background: 1) Core asset market: Core assets in the A-shares such as Consumer and Pharmaceuticals (like Moutai and Contemporary Amperex Technology) surged in 2020, with dynamic PE generally exceeding 50 times. Hong Kong stocks with similar symbols (like ANTA SPORTS and WUXI BIO) had higher cost-effectiveness, pushing funds to "high-cut-low". At the same time, the Hang Seng AH Stocks premium index maintained above 140, with significant price differences in sectors like Finance and Energy. 2) The return of US-listed Chinese stocks and the listing of technology leaders: Due to the impact of US regulatory scrutiny on China-listed companies, many US-listed Chinese stocks (like NetEase, JD.com, New Oriental, etc.) chose to list again in Hong Kong in 2020, attracting mainland funds chasing technology assets. At the same time, Kuaishou's listing in February 2021 also became a focus for southbound capital. 3) Expansion of mainland public funds and increase in corporate annuity allocation ratio: In January 2021, the scale of newly issued funds exceeded 500 billion yuan, with a significant rise in demand for new public fund allocations. At the same time, by the end of 2020, the asset allocation ratio of corporate annuities increased from 30% to 40%, and for the first time, allowed annuity funds to invest in Hong Kong Stock Connect stocks, with an investment ratio not exceeding 20% of the net value of entrusted assets, boosting the demand for asset allocation in the Hong Kong stock market.

Structural characteristics: Highly concentrated in the top five leaders. In January and February 2021, there was a noticeable "head concentration" of fund inflows, with the top five stocks with the largest inflow totaling 268.4 billion HKD, accounting for 86%, which were Tencent, CHINA MOBILE, CNOOC, Semiconductor Manufacturing International Corporation, and Meituan.

Subsequent inflows: Overseas disturbances dragged down the Hong Kong market. Affected by rising US debt, rising interest rate expectations, the "three red lines" in the real estate sector, as well as policies related to education and the Internet, the Hong Kong stock market started to pull back in mid-February. Following this, southbound inflows began to slow down, and the increase in stamp duty in late February further intensified the outflow pressure.

• In addition, in March 2020, mainland funds moving south to 'buy the dip' also led to a brief surge in southbound capital inflows.

Background: 1) Valuation low point after a sharp decline: Affected by the rapid global spread of the pandemic, the Hang Seng Index fell 9.7% in a single month, with dynamic PE reaching 8.7, the lowest since 2011. 2) Defensive sectors and Internet benefitted: The economic recovery expectations brought by the pandemic's initial control in China demonstrated strong defensive characteristics for Chinese assets, while the Internet sector benefitted from the rapid penetration of online scenarios during the pandemic. 3) Post-interest rate cuts by the central bank led to liquidity easing: To combat the disturbances brought by the pandemic, the central bank released liquidity through methods such as cutting the reserve requirement ratio and medium-term lending facility (MLF) operations in March 2020.

Structural characteristics: primarily high dividends, supplemented by leading Internet companies. In March 2020, southbound funds increased their holdings in the top five stocks, with an inflow of 71.31 billion HKD, accounting for 51% of all southbound funds that month, including: China Construction Bank, Tencent, Industrial And Commercial Bank Of China, HSBC, and Agricultural Bank Of China.

Subsequent inflow: Risk appetite improvement has led to a slowdown in inflows. After April, market risk appetite rose, and funds gradually flowed out of safe-haven assets. At the same time, the Chinese policy has gained momentum, coupled with the rapid rise of the pandemic being controlled, making A-shares more attractive and diverting demand for southbound allocation.

Does the southbound have 'pricing power'? It has phased and localized effects, but there is no 'absolute pricing power'.

From a long-term trend perspective, during the stage of large inflows of southbound funds, there is indeed a phenomenon of 'pricing power' continuously rising in specific stocks and sectors, typified by high dividends in the past two years.

The phase of 'pricing power' when southbound funds flow in rapidly. Since the launch of the Shanghai-Hong Kong Stock Connect in 2014, continuous inflow of southbound funds has gradually increased the trading market value and shareholding ratio of southbound transactions. From the subsequent impacts of each major inflow in the past, each corresponds to a significant increase in the trading volume and shareholding ratio of the Hong Kong Stock Connect: March 2015, January-February 2021, and this round of market relate to 30-day trading accounting for 10%, 17%, and 30% of the Main Board of the Hong Kong Stock Exchange; shareholding accounts for 2.9%, 4.9%, and 10% of the total market value of the exchange, which has now reached a historical high.

Chart 6: The shareholding of the Hong Kong Stock Connect accounts for 10% of the total market value, setting a historical high.

Chart 7: The increase in the share of southbound trading volume often corresponds to a narrowing of the AH premium.

The local 'pricing power' of dividend stocks and small cap stocks. We have surveyed stocks with a southbound holding percentage of over 30% and found that they are primarily small cap stocks (Market Cap below 5 billion HKD) and dividend stocks. From the perspective of the southbound capital's holding structure in 2024, two-thirds of the top 15 stocks with increased southbound holdings are high-dividend symbols. This is also reflected in the AH premium, where the majority of companies listed in both markets are state-owned enterprises and traditional sectors. The market cap proportion of sectors such as finance, energy, telecommunications, and public utilities accounts for about 80%. Historically, every significant inflow of southbound capital often corresponds to a rapid decline in the AH premium.

Chart 8: The A/H premium has dropped from 141% to 131%.

Chart 9: The pricing power of southbound trading is reflected in small cap stocks and dividend stocks.

However, the aforementioned "pricing power" is indeed temporary and localized. In the future, as southbound capital increases, it may further strengthen, but in an open market like Hong Kong stocks, two factors determine that southbound capital cannot have "absolute pricing power."

Short selling mechanism: The short selling mechanism allows overseas investors to first borrow securities from others to sell without needing to hold positions. Since 2000, the proportion of short selling in the Hong Kong stock market has risen in stages, and during periods of significant market volatility, it has even exceeded 20%, which often plays an important role in the short-term price movements. In contrast, southbound capital currently cannot participate in short selling.

Major shareholders' placement: Since southbound capital cannot participate in private placements and share allocations, coupled with the "lightning placement" mechanism of Hong Kong stocks, southbound capital faces significant short-term supply pressure. Unlike the months-long review process for refinancing in the A-share market, the unique lightning placement model in the Hong Kong stock market allows listed companies to complete the issuance of new shares or the placement of old shares within one day after board of directors decision. As of mid-March, we find that the placement scale in Hong Kong stocks has reached 47.4 billion Hong Kong dollars, which is already more than half of the historical highest value in January 2021 (86 billion Hong Kong dollars), which is worth noting.

Chart 10: Since March, the total amount of placements in Hong Kong stocks has reached 47.4 billion Hong Kong dollars, exceeding more than half of the historical peak in January 2021.

Four, how much space is left? It is estimated that there is still 600-800 billion Hong Kong dollars, with a holding ratio of 15%.

Since the beginning of the year, southbound funds have accumulated an inflow of 375.53 billion Hong Kong dollars, with an average daily inflow of 8.16 billion Hong Kong dollars, which is more than twice the daily average of 3.47 billion Hong Kong dollars in 2024. If this trend is extrapolated linearly, the total inflow for the year could reach 1.8 to 2 trillion Hong Kong dollars. So, how much space is left? A top-down estimate of various investors (insurance funds, public funds, private equity, and individuals) suggests that the inflow space is around 600-800 billion Hong Kong dollars. Specifically,

Insurance funds: If the proportion of Hong Kong stocks in equity investment increases to 20%, the space is about 300-350 billion Hong Kong dollars. According to the National Financial Regulatory Administration, as of the fourth quarter of 2024, the total investment in stocks and securities investment funds in the insurance industry (including property and life insurance) amounted to 4.1 trillion RMB, accounting for 12.4% of its available funds of 33.3 trillion RMB, with the current proportion of Hong Kong stocks in equity investments around 15%. Assuming that the proportion of equity assets held by insurance funds slightly rises to 15% and the proportion of Hong Kong stocks increases to 20%, it could bring in an additional 200-250 billion RMB in funds. Regarding new premiums, if this year's new premium increase remains at 3 trillion RMB, with 15% allocated to equity assets and 20% to Hong Kong stocks, it is expected to bring an additional 80-100 billion RMB. Both amounts total approximately 350 billion Hong Kong dollars.

Chart 11: If the proportion of Hong Kong stocks in equity investments rises to 20%, the space is about 300-350 billion Hong Kong dollars.

Private equity funds: If the allocation to Hong Kong stocks increases by 5%, the space is about 150-200 billion Hong Kong dollars. According to the China Securities Investment Fund Association, as of the end of last December, there were 0.144 million domestic private equity funds in existence, with a scale of 19.9 trillion RMB. Among them, there were 0.088 million private securities investment funds with a scale of 5.2 trillion RMB. If the allocation ratio to Hong Kong stocks increases by 5% compared to the end of last year, it could potentially bring in 150-200 billion Hong Kong dollars.

Active equity public funds: If the allocation to Hong Kong stocks rises to 40-45%, the space is about 250 billion Hong Kong dollars. As of the end of 2024, public fund quarterly reports show that there are 2083 active equity funds in mainland that can invest in Hong Kong stocks, holding 323.6 billion RMB in Hong Kong stocks, accounting for 25.9% of a total stock market value of 1.25 trillion RMB, the highest since 2020. The investment proportion for funds not labeled 'Hong Kong stocks' cannot exceed 50%; if the proportion rises to 40-45%, it is expected to bring approximately 250 billion Hong Kong dollars in additional funds.

Chart 12: As of Q4 2024, the holdings of Hong Kong Stocks account for 25.9% of the market value of actively managed equity funds available for investment in mainland Hong Kong Stocks.

Individual investors (mainly in ETFs): If the allocation ratio for Hong Kong Stocks is increased by 5%, the space would be approximately 250 billion HKD. Recently, during the upward trend, the inflow of funds into Hong Kong Stock ETFs has rapidly increased. Currently, among the 171 ETFs available for investment in Hong Kong Stocks, there has been a net inflow of 22.15 billion yuan in the past month, setting a new monthly net inflow record.

In December 2024, the National Balance Sheet Research Center of the Chinese Academy of Social Sciences released the "China National Balance Sheet 1978-2022," showing that as of the end of 2022, the total investment in stocks by the household sector was approximately 22.6 trillion RMB. Meanwhile, the 2024 "Shanghai Stock Exchange Statistical Yearbook" indicates that as of 2023, the proportion of individual investors with a total stock market value below 1 million RMB is 22.5%. Considering the current 500,000 RMB capital threshold for activating Hong Kong Stock Connect trading, it is possible that these individual investors will increasingly use ETFs for allocation. Assuming a 5% increase in allocation, it is expected to bring in 250 billion HKD.

By aggregating the above four types of investors, we estimate that the inflow of southbound funds this year could reach 950 billion to -1.1 trillion HKD. After deducting the 375.5 billion HKD that has already flowed in since the beginning of the year, the corresponding incremental space is about 600 to 800 billion HKD. Since the opening of the Hong Kong Stock Connect at the end of 2014, nearly 4.1 trillion HKD has flowed in from the south, with a total market value of holdings close to 4.5 trillion HKD. If another 800 billion HKD flows in, the total scale of southbound funds will reach approximately 5.3 trillion HKD, accounting for about 15% of the total market capitalization of all Hong Kong Stock Connect symbols. However, apart from the relatively stable long-term inflow of Insurance funds, the inflow and speed of other types of funds are greatly influenced by the market, especially given the difficulty in assuming the upper limit of allocation ratios, thus the relatively certain incremental funds are around 300 billion HKD.

Further from a bottom-up perspective, 1) The attractiveness of the dividend sector to funds other than Insurance is declining. Considering the Hong Kong stock dividend tax (20% for individual investors holding H Stocks, and up to 28% for Red Chips; corporate investors are exempt from tax if held for 12 months), when the AH premium converges to 125%, the dividend yield of Hong Kong Stocks no longer has an advantage over A-shares. In the current round of market trends, the AH premium has fallen from 141% before the Spring Festival holiday to 130.5%. Currently, there are fewer stocks with a dividend yield of over 4% and an AH premium above 125%. 2) In the Technology sector, during the current rise, the southbound inflow of the five largest stocks: Alibaba, Kuaishou, Li Auto, Tencent, and XPeng Motors accounts for 40% of the total. Their current southbound holding ratios are 7.8%, 11.6%, 17.4%, 20.2%, and 17.3%, respectively. If it is assumed that the other stocks all reach the same level as Xiaomi (20%), then this would correspond to the Technology sector generating approximately 730 billion HKD. In the future, exemptions from dividend tax, lowering thresholds for individual investors, and the inclusion of more symbols and products are expected to further increase the inflow of southbound funds.

Chart 13: The AH premium for symbols with a dividend yield greater than 5% is basically below 125%.

Chart 14: If it is assumed that other stocks reach the same level as Xiaomi (20%), it corresponds to approximately 730 billion HKD driven by technology stocks.

Future Focus: March 17, China's January-February economic data, March 18, China's trade data, March 20, Federal Reserve FOMC.

Editor/jayden