A placebo or just a painkiller

While Waiting for Godot is seen as a manifestation of the idea that tomorrow never comes, the rate-cut waiting game has been a long and arduous journey. But fortunately, every trail has its end.

"Since early this year, we've been sending a reassuring message to our investors — hold on, once the US Federal Reserve starts lowering interest rates, everything will be alright," says Hong Kong-based investment manager Ben Lai.

Managing a US dollar-denominated multiasset fund with all its investors coming from the Chinese mainland, Lai began gradually ramping up exposure to battered Hong Kong stocks in February, betting on a sharp turnaround amid growing hopes that US interest rates will come down.

Local stocks have since staged a rally, becoming the best performing key market globally in April and capping the longest winning streak since 2018. After a yearslong sell-off amid extreme pessimism, the benchmark Hang Seng Index managed to restore a semblance of calm with fluctuations in between losses and gains. Yet, many investors resorted to awaiting a clearer buying signal and compelling reasons to join the fray.

With more than half of his $30 million portfolio allocated to Hong Kong equities, Lai has been under mounting redemption pressure with clients mired in chronic disappointment. Having repeated mantras for months, he has joined the chorus of optimism, believing the tide is finally turning in Hong Kong's favor.

The Fed will hold its next scheduled meeting on Sept 17 and 18 — the last before the US presidential election on Nov 5 — and an interest-rate cut is virtually locked in, which would be the first since March 2020 when COVID-19 reared its head.

To be sure, Hong Kong stocks have had a strong record of riding out crises. Based on rough calculations, the HSI had surged more than 130 percent in the 16 months following the Asian financial storm in the late 1990s, gained nearly 60 percent in the 10 months after the deadly SARS outbreak in 2003, and climbed about 70 percent for eight months on the heels of the global financial crisis in 2007-08. The latest such instance came in October 2022 when the gauge soared over 50 percent in a mere three months as the pandemic neared its end.

Would it duplicate the bull-run pattern this time round?

Kevin Liu Gang, managing director and chief offshore China and overseas portfolio strategic analyst of CICC Research, describes the "near-term boost to liquidity and market sentiment for the city's stock market" as "the most direct but typically short-lived impact of a Fed rate cut". Specific growth sectors like biotech may be favored to get a lift on the back of their higher sensitivity to liquidity.

Other "indirect and marginal impacts on Hong Kong's capital market and economy" come from likely cuts in the mortgage-linked lending rate for the world's least affordable housing market. "This will help reduce funding costs for both corporates and households, potentially boding well for the local property market," says Liu.

Eying domestic policies

Since the Fed initiated the most aggressive tightening cycle in decades in 2022, "higher-for-longer" interest rates stand as one of the twin headwinds weighing on Hong Kong due to the city's currency peg to the greenback. "The slower growth in financial and professional services has been a sore point of the local economy in the past few years. This has had a spillover effect on the downstream sectors, such as retail sales," says Gary Ng Cheuk-yan, senior economist for Asia Pacific at Natixis Corporate and Investment Banking.

Impending rate cuts would alleviate the pain, says Lynn Song Lin, Hong Kong-based chief economist for Greater China at European bank ING. But the other half of the equation is the narrative around China's economy and markets, where investors are still crying out for a big-bang approach to stabilizing asset prices, restoring confidence and continuing reform and opening-up.

With a market value of around $3.9 trillion, Hong Kong is home to one of the world's top-ranked stock markets, and known for its growing links with the Chinese mainland. The number of mainland companies listed in the special administrative region has surged to 1,466 so far — accounting for 56 percent of all companies that have gone public in the city — up 67 percent from a decade ago, as data from the city's stock exchange operator Hong Kong Exchanges and Clearing Ltd show.

By the end of last month, this main force had accounted for 78 percent of the market's total market capitalization and 86 percent of total turnover, compared with 5 percent and 11 percent, respectively, in 1993, when Tsingtao Brewery's first-ever listing in Hong Kong marked a gigantic step forward for the nation's capital markets with cheers.

There's also a waiting game. Many investors are now struggling to stay on top of macro and policy developments in the world's second-largest economy with their record-low exposure to oversold Hong Kong stocks, even though a September rate cut is, essentially, seen as a done deal, says Pang Ming, Hong Kong-based chief economist and head of research for Greater China at global real estate services firm JLL.

This is perhaps where Warren Buffett's quote again comes into play — that it's wise for investors "to be fearful when others are greedy and greedy when others are fearful". Since the Fed gave its strongest hint yet of imminent lower interest rates late last month, the exhilaration has been almost fully priced in by investors. Last month alone, the HSI capped a 4 percent rally although it was still 9 percent lower than its peak in May.

Without much upside to come, Liu believes investors could still enjoy the bargain fest and ride the short-term rally, with just a kind reminder - they'd better keep track of the direction of domestic policies to determine when to take their profits and quit the game.

Another piece of good news is that the downside risk for Hong Kong stocks is viewed as equally limited, thanks to the already lower valuation and positioning.

After three years of derating, Liu sees the valuation of H-shares, especially the market's "core assets" - the internet sector - as "compelling". At the same time, the percentage of mainland stocks held by various foreign funds has plunged from 15 percent in early 2021 to an all-time low of 5 percent, according to fund flows data provider EPFR. These factors have made Hong Kong stocks more resilient.

Besides all the short-term hype, Pang believes the structural shift and long-term trends should be taken seriously. As a vivid example of some fundamental changes, the so-called neutral rate of interest, seen as key to balancing economies, may not stay low at 2.5 percent even if inflationary menace retreats. Instead, they're likely to hover at around 3.5 percent, as the inflation dragon could hardly be slain amid uncertainties over geopolitical storms, demographic shifts and the deglobalization trend.

Dynamic landscape

Behind the scenes of the Fed rate-cut fervor, today's market sees no shortage of players lacking the experience of adventuring across a full economic cycle, or the slightest idea about what the world used to be like before the Fed's unprecedented and unlimited easing efforts since the onset of COVID-19.

History doesn't repeat itself, but it often rhymes, though not the same as in the past. Some historic global norms are just fading away, such as stocks and bonds now trading more closely in sync than at any time in decades. The once-negative correlation between the two asset classes, where bonds ride to the rescue when stocks take a hit, is basically the by-product of low inflation.

But that is an enduring piece of investing conventional wisdom in the era of "great moderation" - the period of low inflation and relative economic stability that kicked in during the 1990s or even as early as 1980s, and came to an abrupt halt amid the pandemic.

With climate change and geopolitical shocks looming large, coupled with a combination of regionalization and supplychain rationalization and diversification, "there's the brew for a more volatile inflation era" and the old, good days for the "great moderation" are long gone, according to a research note by investment services firm Charles Schwab.

"This means we cannot stick to our ways of navigating today's dynamic economic and geopolitical landscape," says Pang.

The post-pandemic years have revived memories of the temperamental era - a period preceding the "great moderation" marked by heightened economic fluctuations with more frequent recessions, but sharper expansion, greater inflation and geopolitical volatility.

Accompanying the somewhat unfamiliar inflationary, economic and geopolitical landscape is the long, protracted guessing game between the Fed and its global audience, much of whose history has been solely defined by the "great moderation" backdrop.

As investors bank on 2024 as a rate-cut bonanza year, the market has been "smacked in the face" as many as eight times by the Fed's delays in bringing rates down, based on Pang's research. At the heart of the mismatched expectations is a policymaking headache facing the world's central banks, if not only the Fed, amid conflicting signals from tricky indicators.

In the midst of uncertainties, chaos, complexity and ambiguity, the significance of rebuilding expectations cannot be overestimated, warns Pang. "A rate cut is just a catalyst. It can never solve all the problems in one go."

"Any mild reduction would only be a painkiller for Hong Kong," says Ng. "Still, it would be better than nothing for sure."

The hard fact is that lower interest rates may make capital rotate back to non-US dollar-denominated assets, albeit not necessarily China-related assets, as some foreign investors are forced to practice the so-called "Asia ex-China" trade under the threat of geopolitical tensions.

Speaking on condition of anonymity, a Hong Kong-based strategist points to a massive jump in the assets of emerging markets' mutual funds and exchange-traded funds that exclude China in recent months. "You can easily see the double standards. They (global investors) threaten to steer clear of China-related stocks, demanding a higher level of policy transparency and clarity. Ironically, they don't care about what it's like in emerging markets at all."

At the end of the day, there's still a mental game to play. Whether a Fed rate reduction would be standard 25 basis points or more aggressive 50 basis points may lead to a different story unfolding. A big drop could spook investors into thinking that the economy is in a lot worse shape, while a moderate cut might be interpreted as policymakers' reluctance to declare an elusive, challenging victory over inflation.

Apparently, the latest major US economic puzzle pieces point to the arguably stubborn inflation, and signs of deterioration in employment and manufacturing. As of Thursday, the odds of a 25-basis-point cut in September rose to 87 percent from 60 percent a week earlier, according to the CME FedWatch tool.