Friday, March 21, 2008

Different Falls For Different Markets

The above chart shows the year to date returns for the selected markets. The US markets, though hogging the negative headlines, did not perform that badly. That's largely because the correction was a bank-centric, its a banking problem rather than a widespread consumer issue (for now). We may even be able to explain China's sharp correction owing to inflated valuations and tough anti-inflationary measures being instituted. However, the hidden lever has been the USD weakness. If the dollar had not been losing ground so much this year, the US stock prices would have been down a lot more. By weakening the dollar, it an immediate way to acknowledge that yes US economic fundamentals are pretty stuffed. Its like giving yourself a red card for wild infractions of the past.

The resource rich nations did not really fall by that much. Look at Brazil, Australia, South Africa and Canada. This lends some weight to the decoupling theory. Markets are obviously less correlated to the US than before.

The strange market was the HK market which fell the most, almost doubling US losses. It was supposed to be biggest beneficiary from the weak USD and Fed's rate cuts. The HK peg would make HK more competitive, and the rate cuts would result in an attraction of hot money into the economy. What went wrong? It looked like HK markets are now more closely correlated to China. If thats the case, then this is a big misread by investors. Is HK market dominated by mainland investors? Obviously no. In fact, the zero interest rates for depositors in HK would really force HKMA to consider revaluing the HKD, thus lending weight to have more HKD assets - property and stocks.

The strongest reason I can think of for HK to mirror China's stock movements is the perception that growth for HK companies are tied very closely now to China's fortunes. There is a lot of weight to that perception. Although many HK companies are in the export markets, many are still not international enough in its revenue stream. As a matter of fact, HK regained momentum in its economic prowess over the last 6 years largely due to being a service hub for China companies, and the fact that a lot of HK companies have invested early into China projects.

This will make HK finances a lot harder to manage. You now have the stock markets following China's, but your monetary policy follows the US. China's stock prices may be tanking but the economy is still buzzing. While US economy is grappling with a credit implosion and a slowing economy, HK's economy is still buzzing and grappling with inflationary pressures as well. What kind of central bank would be able to address the growth, inflation, prices and employment issue adequately for HK when it's monetary policy follows that of another country??!!

It was okay when HK economy exported primarily to the US, and most international goods and services were priced in USD. HKMA cannot afford to defend the peg anymore. The performance of HK stock prices for the first 3 months this year clearly shows that the "end is near" for the peg. To profit, one would be wise to hold as many HKD denominated assets in 2008.

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