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HK stocks: Between a rock and a hard place

A panel outside a bank displays the morning trading of CSI300 index, the largest listed companies in Shanghai and Shenzhen, and the Shanghai Composite Index, in Hong Kong, China, on July 9, 2015.
Bobby Yip | Reuters
A panel outside a bank displays the morning trading of CSI300 index, the largest listed companies in Shanghai and Shenzhen, and the Shanghai Composite Index, in Hong Kong, China, on July 9, 2015.

Hong Kong stocks may look like an attractive bargain but approach the market with caution, say strategists, as it's caught between the double threat of higher U.S. interest rates and increasingly soft economic conditions in China.

After suffering a sharp sell-off this summer, the market is trading at nine times price-to-earnings (PE), its lowest in over three years, and making Hong Kong stocks some of the cheapest in the world. By comparison, China's Shanghai Composite and the U.S. S&P 500 are trading at PE ratios of 13.3 and 18.4 respectively.

"Hong Kong stocks are trapped between the U.S. and China," said Uwe Parpart, managing director and head of research at Reorient Financial Markets.

"In the U.S., there's a rate hike threat, which is especially bad for Hong Kong property stocks," he said. Property, financial and mainland Chinese companies dominate the Hang Seng Index, which is down 10.5 percent so far this year.

The Hong Kong dollar's peg to the U.S. dollar means that the territory's interest rates are effectively linked to those set by the Federal Reserve. Rising interest rates are expected to weigh heavily on Hong Kong's property market, which has been buoyed by near-record low borrowing costs and excess liquidity in recent years.

Separately the increased exposure of Hong Kong corporates to the mainland makes them vulnerable to any significant economic slowdown in China.

"I think the market is going to trade sideways through the end of the year," said Parpart, unless China steps on the stimulus pedal once again.

"I want to see looser monetary policy in China now while the U.S. is still on hold. If they do cut rates, I would recommend taking a look at Hong Kong-listed Chinese banks as they are significantly undervalued, otherwise caution will have to prevail," Parpart said.

Herald van der Linde, head of equity strategy for Asia-Pacific at HSBC, agreed that cheap valuations alone did not make a strong enough case to ramp up exposure to Hong Kong equities.

"Hong Kong, and for that matter the rest of Asia, offers good value already. However, with considerable uncertainty to growth across the region, it is difficult to see how Asian stocks, and Hong Kong is no exception, can perform well," he said.

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In order for negative perceptions of the market to shift, a few things needed to happen, said van der Linde.

"I could see reasons for Hong Kong to perform will if the right catalysts are in place. Analysts starting to upgrade earnings or, for example, a recovery in Chinese growth that spills over into Hong Kong," he said.

Stephen Corry, chief investment strategist at LGT, who is currently neutral on Hong Kong equities, said fresh impetus for the market could arise if Hong Kong investors – who are currently repatriating money from offshore yuan deposits on expectations of the currency weakening – decide to plough the cash into stocks.

"The big question is what will Hong Kong investors do with this fresh money? There is no return on bank deposits, so maybe they will seek high-yielding equities or return to domestic real estate even though these appear overvalued currently," Corry said.