With the Federal Reserve finally accomplishing a lift-off in interest rates in December last year, equity investors might want to spend more time looking at the shape of the US yield curve rather than just glancing at changes to Fed Funds rate expectations.
Last week, the US 10-year treasury yields touched a record low.
Although the movement in US short rates does impact monetary conditions in Hong Kong through the operations of the fixed convertibility undertaking of the Hong Kong peg, equities are long duration assets and they are priced off the long end of the yield curve.
Even though the Fed has raised the cash rate, the long end of the bond market has collapsed from 2.3 percent to around 1.4 percent.
The cash rate went up 25 basis points but long rates have dropped by around 90bp since then.
It could be argued that since December, US monetary policy has actually eased rather than tightened.
In this respect, the current interest rate cycle in the United States has a different complexion when compared with previous periods of monetary tightening.
Firstly, expectations for future rate hikes have dissolved over the past six months.
Secondly, lower inflation and growth expectations have flattened the long end of the US yield curve.
Thirdly, US treasury issuance has dropped as tax receipts have improved and budget deficit projections have narrowed.
Lastly, the introduction of negative deposit rates in Europe and Japan has incentivized the reach for yield and treasury yields have become attractive to overseas buyers.
The latent buying power of global insurance, pension and income funds to match their future liabilities has risen dramatically as global interest rates have descended to near zero in most developed markets.
In turn, “this reach for yield” has gripped all global financial asset prices in some ways as desperation to “earn income” as central banks have adopted ever more unconventional monetary policies.
Global equities have also become part of the “reach for yield” despite the fact that earnings growth has been modest to negative in most markets since 2012.
Indeed, global equity market performance has become more correlated to inflows into high yield global bond funds, a proxy for risk appetite towards income or yield products as treasury yields have fallen.
Despite the breaking of the naira, Nigeria’s currency, from its dollar peg and the pressure on the Middle East currency pegs, the Hong Kong dollar has been relatively sanguine.
Indeed, the decline in the renminbi has also not caused a spill-over to Hong Kong’s money markets.
The exchange fund notes have tracked the move in US bond yields just as theory would suggest under the operation of a currency board.
However, Hong Kong’s equity market has failed to necessarily reflect the desire for income compared with other global markets.
Ironically, despite an equity dividend yield of close to 4 percent, which is well covered and with a large population of stocks trading below 1.25 times book, global investors have ignored the value on offer.
It appears that concerns over China’s currency and worries over US interest rates have left Hong Kong’s stocks behind their developed world peers.
Since 1990, Hong Kong’s dividend yield has never been higher than both the treasury yield and Fed Funds cash rate as it is presently. The same is almost true for the S&P dividend yield.
Furthermore, the quality of cash backing the Hong Kong dividend yield is the highest in the past two decades.
The bottom line is that the Hong Kong equity market offers one of the highest developed world dividend yields at a time when global bond yields have plunged in many cases into negative territory.
Concerns over China and worries about the pace of US interest rate hikes seem to have hurt sentiment.
Hong Kong stocks stand to benefit from the global “reach for yield”.
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