Why Hong Kong unrest scares markets

A protester raises his umbrellas in front of tear gas which was fired by riot police to disperse protesters in Hong Kong, September 28, 2014.
Tyrone Siu | Reuters
A protester raises his umbrellas in front of tear gas which was fired by riot police to disperse protesters in Hong Kong, September 28, 2014.

Unrest in Hong Kong is spooking markets for fear it could escalate, challenging Beijing to make a measured political response, at a time when Chinese and global growth are at the heart of market anxiety.

Worries about soft Chinese growth and European weakness has made investors uneasy, while the U.S. Federal Reserve signals it is moving away from easy policy and getting closer to returning to a more normal interest rate environment as the U.S. economy gets stronger.

A wave of weekend protests in Hong Kong extended into Monday with thousands defying a government call to end street blockades, after police used tear gas, pepper spray and batons to break up a sit-in by students and other residents seeking democratic elections in the former British colony.

Risk to US market
Risk to US market   

On Wall Street, some strategists see no long-term impact as of now, and they said the protests stretching across Hong Kong's main shopping and business districts are not like the student uprisings that led to a violent crackdown by the Chinese government 25 years ago in Tiananmen Square.

"This is something that officials in Beijing really don't want to have deal with right now. It's been simmering for a long while, and it has to do with how Hong Kong views itself in the 'one country, two systems,' " said Paul Christopher, chief international investment strategist at Wells Fargo Advisors.

Christopher said a violent government response does not now seem a likely outcome. "That's something they do out in the Western regions. That's not something you do in your front yard. It could get bad, but that's not my forecast."

Christopher said China would not likely risk harming Hong Kong's important economic role as a gateway for trade into the mainland. It is also a key banking hub, where Chinese banks and companies seek offshore funding.

"It's coinciding with an economic slowdown and structural reform," said Marc Chandler, chief currency strategist at Brown Brothers Harriman. Brown said it's not clear that China won't use force if Hong Kong police fail to stabilize the situation but it could take other action like curtail the election altogether.

Read MoreHere's how the protests will hit Hong Kong's economy

Protests are expected to escalate Wednesday, China's National Day holiday. Residents of Macau plan to rally that day, and pro-democracy supporters from other countries are expected to protest.

"The big fear is that this proves too much for Chinese officials so they sacrifice reform for stability, so they slow down financial reforms and other types of reform. I think that is the risk people are not articulating," he said. Chandler said the events are taking away from a significant event in China's capital markets this month.

"Hong Kong and Shanghai stock markets are going to be tied together. People who have an account in Hong Kong can collectively buy up to $3 billion a day in Chinese stocks…. This is another way that there's an internationalization of Chinese markets. This is very important, but it's going to be overshadowed by what's happening in Hong Kong."

He said Hong Kong's role as a financial center is critical to Chinese companies; but it's importance could be less important as the mainland develops over time. Hong Kong stocks fell nearly 2 percent Monday, while Shanghai stocks were about a half percent higher.

Wall Street was also eyeing the ability of the financial industry to conduct business amid the protests. There were reports that some firms, such as BlackRock, kept offices open but let nonessential staff work from home. Meanwhile, dozens of bank branches were reported closed.

Read MoreImages of Hong Kong's violent weekend

HSBC said its main building in "Central" remained open, operating normally Monday but it also notes that business continuity arrangements are in place so it can continue to serve customers.

When Hong Kong was returned to Chinese rule in 1997, it was promised new elections for chief executive by 2017. Protesters are responding to Beijing's decision in August to limit candidates for chief executive, and protesters are calling for the resignation of Hong Kong Chief Executive Leung Chun-ying.

The Hong Kong Federation of Students called Sunday for an indefinite strike, and the Hong Kong Professional Teachers' Union Monday called for a general strike by teachers.

"This is just the first internationally visible salvo in this dispute that's been going on for some years now. It's not going to go away, and it's only the first round," said Christopher. "It's not going to be an upset in terms of the markets, already being close to highs. There's already been some caution and it emanates from the weak data in Europe, it emanates from weak data in China, and September data might not be much better in China, and then you've got the Fed and what the Fed will do."

"It's one more nuance," he said, adding that markets are also nervous about Brazil's election, the upcoming referendum in Catalonia to split from Spain, and Russian sanctions for its meddling in Ukraine.

Read MoreHong Kong protests 'worrying,' says WPP CEO

As China data continue to look weak, they have disappointed investors who had expected a broad, sweeping stimulus to deal with the economy. The stimulus has been targeted instead, and Christopher said China has sought to avoid chronic "intravenous" type stimulus, not wanting to prop up an economy growing at 7 percent.

"There's been a big sigh of relief that lasted since last January. There were all these fears about wealth management products defaulting and in a synchronized, sequential collapse of the financial system," he said, adding that as the economy slows, those worries bubble up.

Christopher said social unrest is one key indicator he watches for China because it is an important sign in an economy where the government manages the data, but he stresses that the Hong Kong situation is different than the western China issues.

"You have idiosyncratic issues about how Hong Kong is politically connected to China. The fact you have this coming up is probably a headache for what China wants or needs. I don't think this is a big deal. We're going into the holiday period," he said. Oct. 1 is the start of China's seven-day National Day holiday. "There's a lot to lose, and no one side really wants to wipe out the other," he said.

Read MoreBlog: Protests grow as night falls

The White House called on authorities on Monday to show restraint and protesters to be peaceful, but it also supported universal suffrage in Hong Kong and said it supported the people's aspiration for a choice of candidates.

A Chinese government official in a statement earlier said "Hong Kong is China's Hong Kong" and warned against foreign interference.

By CNBC's Patti Domm.