Why Hong Kong Matters for Aussie Investors

Monday, 25 May 2020
Melbourne, Australia
By Greg Canavan

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The Hong Kong stock exchange, the Hang Seng, dropped 5.5% on Friday. It was the largest one-day fall since 2015. It’s down another 1.5% at time of writing today, while the Aussie market is again up strongly.

Why are prices falling, and why does it matter for Aussie investors?

I’ll attempt to answer these questions in today’s Insider.

But first, a quick follow-up from Friday’s video.

Apologies for the fact that some of the charts weren’t clear. We’ve fixed that up now. You can view a clean version of the recording here.

A reader asked me to explain what I meant when I said I’m looking for ‘other risk assets’ to turn down with the Aussie dollar.

I meant predominantly assets like stock markets, but it could also include commodity prices too. So if the Aussie dollar declines along with stocks, while defensive or ‘risk off’ assets like the US dollar and bonds rise, then you’ll know global capital might be calling time on this historic rally.

Now, getting back to Hong Kong…

Why did its stock market plunge on Friday, with weakness continuing today?

It appears as though the communists are coming for them. From The Wall Street Journal

HONG KONG—China signaled it will impose new national-security laws on Hong Kong, dealing a blow to the territory’s autonomy as Beijing seeks to stamp out widespread pro-democracy protests that have challenged leader Xi Jinping.

The surprise move would override Hong Kong’s system of self-governance and reflects growing frustrations within China’s leadership over the long-running and at times violent unrest that began last summer and has often targeted the Communist Party and other symbols of Chinese rule.

Enacting new security restrictions could further undermine the Western-style rule of law and freedoms that have underpinned Hong Kong’s role as a global financial center and that Beijing pledged to uphold as a part of the territory’s handover from the U.K. in 1997 after more than a century of British rule.’

The new laws would outlaw treason, secession, sedition, and subversion against China’s central government.

So, let’s get this straight…

Last year, China’s dictatorship tried to introduce an extradition bill that would see Hong Kong citizens dragged into the mainland’s judicial system. It sparked months of riots.

Now, so as not to risk more riots and unrest, China is coming down on Hong Kong even harder with laws that will end its political and judicial independence.

Why is China acting so aggressively? Given its handling of the pandemic, the world is watching. And not in a good way.

On Friday, it kicked off its National People’s Congress. For the first time since 1994, it didn’t commit to an economic growth target.

Debt to GDP was 317% at the end of the first quarter.

It’s in a trade war with the US and just started one with Australia.

And now it is having another go at Hong Kong. Doing so will result in capital fleeing the island, as it becomes increasingly certain that China won’t allow Hong Kong’s freedoms to continue. Freedom of speech, free elections, and free flowing capital are now all under threat.

Which is why investors dumped stocks on Friday.

Why does this matter to you?

Well, it turns out the Aussie dollar and the Hang Seng Index have quite the correlation. You can see this in the chart below, which shows both asset prices since the start of 2018.

The Insider

Source: Optuma

It’s always easy to rationalise something when the evidence is right in front of you. But in this case, the correlation makes sense. The Hang Seng peaked in early 2018, along with the Aussie dollar.

Hong Kong stocks are a play on global and Chinese growth, as is the Aussie dollar.

While many stock markets around the world surged to new highs in 2019 and early 2020 on the back of Fed liquidity, the Hang Seng and the Aussie remained well below their peaks.

Why?

I think it was a reflection of China being a victim of the trade war with the US.

Note the sharp divergence between the two prices following Friday’s sharemarket plunge. This increases the chances that the Aussie dollar will resume its falls in the weeks ahead.

Hong Kong currency peg to break?

Capital fleeing Hong Kong via the sharemarket could well be a prelude to capital again trying to flee China.

I wrote about the coming pressure on the yuan/US dollar exchange rate in a recent Insider. You can access it here.

But before that scenario plays out, you’ll likely see the Hong Kong dollar peg to the greenback break. For nearly 40 years this currency peg has been in effect.

Because Hong Kong pegs its currency and allows the free flow of capital to and from the economy, it means it ‘imports’ US monetary policy. Under the laws of economics, a country can’t have an independent monetary policy, a fixed exchange rate, and freely flowing capital. It must choose two.

Hong Kong has a fixed exchange rate and free capital flows.  

China’s heavy handedness will speed up capital outflows. People will want to sell their assets, property, etc, and get away from the clutches of the communists. To maintain the peg, the Hong Kong Monetary Authority must buy up Hong Kong dollars and sell greenbacks. 

The problem is, it doesn’t have a huge arsenal of reserves to maintain the peg. According to a Financial Times report from January, the monetary authority had just US$7 billion in excess reserves.

That could run out quickly.

I therefore see it as a growing probability that the Hong Kong currency peg will break in the months to come.

Capital fleeing Honkers is capital fleeing China. That will likely be bearish for the Aussie dollar, which in turn will be bearish for Aussie stocks (and probably stocks globally).

While everyone is worried about a second wave of the virus inflicting another bout of economic damage, I’m more concerned about the effect of a belligerent China on the global economy.

I’ll be writing about this topic in depth this week in my Crisis & Opportunity newsletter. To get access, click here.

Continue below for the ‘Week Ahead’ update from Pivot Trader’s Murray Dawes.

Cheers,
Greg


Spike and Failure
By Murray Dawes

 

We are entering an interesting phase in this short squeeze since the crash.

The E-mini S&P 500 futures looks like it wants to break out to the upside, but there should be a wall of selling ready to meet the buyers not far above where we are now.

A short squeeze will usually go on for longer and rally further than anyone expects. The market needs to get the bulls fired up again and cause many bears to throw in the towel before prices will be ready to tip over again.

The sell zone of a wave in my theory of price action is a retracement of 75% to 87.5%. That means that almost the entire previous wave is often retraced before prices finally start selling off again.

The sell zone of the whole wave down in the crash sits between 3,090 and 3,250. The current price is at 2,965, which is only 4% below the bottom of the sell zone. We could reach it in a matter of days.

Traders will want to start planning what they want to do if we do see a spike up into the sell zone of the wave down in the crash.

I reveal a potential option strategy in today’s ‘Week Ahead’ update above that could be considered if we get a solid signal that momentum is shifting back to the downside from the sell zone.

I also reveal one of my methods for assessing short-term momentum. My main method involves analysing the daily and weekly sell pivots from the key zones, but the slope of key moving averages can also help.

Regards,

Murray Dawes,
Editor, Pivot Trader