Chart 1: Five-year Performance of the JCI, KLCI and STI

Chart 2: Price of Coal and Crude Palm Oil

Keynotes

• Hong Kong is officially out of recession in 2Q 2009
• Benign interest rate environment supports a sustainable economic recovery
• Current estimates are reasonable,, but too conservative in our opinion
• We expect earnings to stay flat in 2009, and rise by 21.1% in 2010 and 23.5% in 2011
• Our 2011 HSI target: 30,000 – 37,000

The Hong Kong economy has been in recession since the third quarter of 2008, after negative quarter-on-quarter GDP growth for two consecutive quarters (2Q 08and 3Q 08). In the first quarter of 2009, the economy shrank 7.8% quarter-on-quarter, which was even worse than the second quarter of 2003 amidst the outbreak of SARS. Four consecutive quarters of declining GDP have been recorded between 2008 and 2009. Though it’s not comparable to the 1998 Asian Financial Crisis when Hong Kong suffered from five consecutive quarters of decline, these figures still suggest the current downturn to be one of the worst recessions on record.

However, we believe that the worst has passed and the recovery has taken place. The economy expanded 3.3% quarter-on-quarter in the second quarter of 2009, the fastest pace in almost six years. The figure has beaten the market consensus of 1.2% growth, marking an economic turnaround. On the year-on-year basis, the second quarter GDP growth was still negative; however, the contraction has reduced to -3.8% from -7.8% in the first quarter.

In terms of the GDP components, exports was up more than expected by 11.6% quarter-on-quarter while a largest rise in nearly six years was recorded in consumer spending. The rebound has also enticed the corporations into spending more. Hence, corporate investment (non-seasonally adjusted) climbed 3.4% in the second quarter. It shows the economy has stopped deteriorating and is on course for an early recovery from the recession.

A Faster-than-Expected Recovery

Recently, there are more encouraging signs of a faster-than-expected recovery. For example, Hong Kong exports fell by the least in seven months in June 2009. The positive growth of exports is expected to be seen as early as August 2009. In addition, the Purchasing Managers’ Index rose for a ninth consecutive month in July 2009 while retail sales showed a smaller year-on-year decline in recent months as consumer confidence improved. Home sales also surge to a 17-month high as low interest rate encourages buyers to enter the market. These economic figures, as prelude, signal that a sustainable recovery for Hong Kong is under way.

Benign Interest Rate Environment Supports the Sustainable Economic Recovery

Since March 2009, strong capital inflows have continued to keep the Hong Kong Dollar spot rate to stay on the 7.75 strong side of the convertibility zone. In order to maintain the exchange-rate stability, Hong Kong Monetary Authority has injected HKD into the market, directly boosting the aggregate balance of the local interbank market. The historical low interest rate contributed by the excessive liquidity help to justify the local asset markets rally in the past few months.

Property prices in Hong Kong climbed as the Centa-city Leading Index which tracks secondary residential property prices showed an increase of 25% since 2009 as at 27 July 2009. The property transaction also rose by a large margin of 58% in the same period to 14039, hitting one and a half years’ high. Hang Seng Index surged over 34% year-to-date as at 14 August 2009. The balance sheet effects and the wealth effects of asset prices have made positive contribution on the local consumption and corporate investment.

Besides, the abundant liquidity led by the net capital inflow has lowered the borrowing costs. It could help to support a modest recovery in domestic credit in the second quarter of 2009 following the two consecutive quarter drops. We expect the easing liquidity situation and the improving economic activity to increase the money multiplier and gradually accelerate the recovery of bank loans, hence supporting a sustainable recovery of the economy.

Revision of Earnings Outlook

The earnings season has been kicked off, with Hong Kong listed companies reporting results for the second quarter of 2009. HSBC Holdings, Europe’s biggest bank, which had been expected to post a US$600 million loss, surprisingly reported a pre-tax profit of US$3.35 billion in the first half of 2009. Hong Kong’s property developer, Chung Kong Holdings reported a 5% growth in net profit year-on-year in the first half of 2009.

In addition, out of the 12 Hang Seng Index’s member swhich reported its second-quarter or first half earnings, 7 of them (i.e,-more than half) reported earnings better than the consensus estimation. The earnings surprise (as compared to consensus) varies from 6.8% to 335%. As Hong Kong and Asia have just passed the inflection point of the economic cycle, we believe that the consensus is slow in their forecasts, and will likely revise earnings and the target prices upwards a few quarters down the road as corporate earnings and economic data surprise to the upside.

Table 1 shows the earnings revision in last month. There are a total of 36 earnings forecast revisions for 2010 earnings for the top 10 weightings for the Hang Seng Index. 72% of the revision has led to an upward adjustment. It shows that analysts are becoming more optimistic for companies’ profitability in 2010. We believe that more earnings revision is coming in the second half of 2009.

According to the market consensus, as of 17 August 2009, the earnings growth in 2009 is estimated to drop by 2.7%. It will climb in 2010 and 2011 by 18.3% and 20.4% respectively (see Table 1 and Chart 2). Based on the aggressive earnings revision as shown in table 1, we believe that the current market consensus estimated earnings is still too conservative. Table 2 and Chart 2 show our in-house estimated earnings growth for the next 3 years. We are looking forward to seeing the market’s earnings integer to beat 2007’s level by 2011.

On 31 October, 2007, Hang Seng Index reached an all-time high and closed at 31,638 points. Based on the estimated earnings growth, we will see the Hang Seng Index to reach its all time high again by 2011 at 33,400 point if we based on a fair value PE multiple of 18X. A PE level of 18X incorporated the relatively higher valuation among the Chinese H-Share and Red Chips in the index. The H-Share and Red Chips accounted for more than half of the market capitalisation of the Hang Seng Index. In fact, our target range for the Hang Seng Index for 2011 is from 30,000 (conservative) to 37,000 (aggressive)!

As at 17 August 2009, estimated PE for Hong Kong is at 16.2X and 13.9X for 2009 and 2010 respectively. We are still bullish on the Hong Kong market due to its attractive valuation and potential earnings growth in the next 3 years. We maintain Hong Kong market at a “very attractive” rating of 4.5 stars.