gain most from Fed cut

The silver lining of a financial crisis is never easy to find. This time, Asian stocks, including Hong Kong shares, may benefit from the Federal Reserve’s attempt to deal with the US subprime mortgage debacle.

That is especially so if the Fed lowers official short-term interest rates to prevent the liquidity squeeze and credit crunch from harming US economic growth.

Hong Kong is a special case in point. Because its dollar is pegged to the US currency, the Asian city’s monetary policy mirrors its American counterpart. That means whatever steps the Fed takes to stimulate the economy will be an unintended fillip to Hong Kong.

There, however, the similarities end. While US growth has slowed to a 1.8-percent year-over-year rate, Hong Kong’s gross domestic product is expanding at a 5.6-percent pace.

The US budget deficit is 3.6 percent of GDP, and its current-account deficit equals 6.4 percent. Hong Kong, by contrast, sports a budget surplus of 1 percent of GDP and a massive current-account surplus equal to 11.4 percent of GDP.

Hong Kong’s economy is prospering from its close ties to China’s economy, which expanded an annual 11.9 percent in the second quarter. And the Hong Kong dollar’s rigid peg to the US currency has translated into a 10-percent depreciation against the Chinese yuan since 2005 and a 5-percent decline on a trade-weighted basis.

Meanwhile, the combination of a strong financial-services industry, healthy property market, a nine year-low unemployment rate of 4.2 percent and growing tourism from mainland China has resulted in a booming consumer sector. Hong Kong’s retail sales soared 14 percent in June from a year earlier.

‘Fresh stimulus’

“The increasing odds of Federal Reserve policy easing in the wake of the mini-meltdown in the US credit markets will add fresh stimulus to Hong Kong’s already strong domestic demand, and will be a tremendous boost to its interest-rate sensitive economy and stock market,” says Yan Wang, Montreal-based head of China strategy at BCA Research Ltd.

Bottom line: A Fed rate cut would be the equivalent of adding a turbo charger to a Ferrari engine.

Financial services, property and utilities—three interest rate-sensitive industry groups—account for a hefty 58 percent of the market value of Hong Kong’s benchmark Hang Seng Index.

Hong Kong shares are also taking a pounding in the current stock-market decline. The Hang Seng Index fell 7.1 percent from July 19 through August 15. The Standard & Poor’s 500 Index lost 9.4 percent in the same period. Both would get a boost from a Fed rate reduction.

Fed cut effect

The case for other Asian stocks is similar, though the transmission impact of a Fed rate cut is less direct.

“The mess in US-originated structured finance represents for the Asian equity asset class, in the longer term, a gigantic buying opportunity,” says Christopher Wood, Hong Kong-based chief global market strategist at CLSA Asia-Pacific Markets. “Asia- and emerging-asset markets will be the likely bubble beneficiaries of the coming Fed easing.”

“We have been struck by the relative resilience of emerging-equity markets; 2007 is different from the emerging-market crises of 1997 and 1998,” said Tim Harris, London-based strategist for JPMorgan Private Bank, in an August 13 report.

Developing countries’ external finances are sound; they are attracting foreign direct investment; and many Asian and Middle Eastern nations are building sizable currency reserves, he said.

‘Very positive’

In April, the International Monetary Fund noted the global demand for Asian electronic goods, the rise in intraregional trade, the US’s declining importance as a destination for most Asian countries’ exports—China being a major exception—and receding inflation pressures.

“Against this background, the near-term outlook for growth in the region remains very positive,” it said.

“Remain long Asian and emerging-market equities and be short everything that makes its money out of securitized finance,” Wood says. “You want to be short any investment with an acronym and the word ‘guaranty’ in it.”

Wang recommends buying Hong Kong property and utility stocks on price weakness. Historically, the two sectors have closely tracked Fed interest-rate changes, which means their respective sub-indexes have underperformed since the Fed started tightening monetary policy in mid-2004. With price-earnings ratios of 12.3 and 13.4, respectively, the two groups are also trading at a 23 percent and 13 percent discount to the overall market.

Inflation threat

Calling a rate cut isn’t easy. As recently as August 7, the Fed said inflation was its “predominant” concern. In other words, you don’t fight inflation with lower interest rates.

To their credit, Fed chairman Ben Bernanke and his colleagues don’t want to be seen bailing out a bunch of banks, hedge funds and other speculators. They also want to avoid being accused of creating new bubbles.

So don’t expect the Fed to cut rates until stock prices fall more and commodity values are lower. That means investors can expect Asian equities to drop along with the rest of the stock market, victims of the collateral damage spreading from the credit markets, Wood says.

Still, that hasn’t stopped traders from betting the US central bank will reduce its target rate for federal-funds—the one banks charge one another for overnight loans—from 5.25 percent.

Traders see a 64-percent chance the Fed will cut the rate to 5 percent in September, according to fed-funds futures prices. A month ago, the odds were 8 percent.

What’s more, futures prices indicate there is an 86-percent chance the rate will be lower yet, at 4.75 percent, in October. A month ago, that probability was zero.

If and when the Fed moves, it will be to rescue the US economy. Better hope it isn’t too late. Because no matter how attractive Asian stocks look, they won’t weather a US recession very well.

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