UBS | The launch of the Shenzhen-Hong Kong Stock Connect program this year was recently confirmed by top Chinese government officials. We estimate that about 505/218 Shenzhen/HK stocks could be introduced into the existing Shanghai-Hong Kong Stock Connect, leading to over 70% of the A-share market cap and 84% of the Hong Kong market cap to be mutually open. As another step in China’s capital-account opening, the implications for investors will be far reaching, enhancing the connectivity of the mainland and Hong Kong stock markets and unveiling new opportunities for investors on both sides.
Northbound trade: More balanced China exposure but higher valuation
For international investors, Shenzhen-HK Connect will expand access to sectors such as healthcare, materials, consumer and IT, leading to more balanced China exposure. The Shenzhen market provides more opportunities in liquid small-cap stocks, high-growth sectors and non-SOEs. While Shenzhen stocks as a whole have shown significantly stronger earnings growth compared with their Shanghai counterparts in recent years, they have also commanded much higher valuations due to local investors’ preferences for growth and small caps. In our view, that could overshadow northbound flow in the initial phase after the launch.
Southbound trade: Similar program in a very different context
In Jan 2016, cumulative southbound flow surpassed northbound flow under ShanghaiHK Connect. The HKEx also reported mainland Chinese investors almost doubled their weight in HK stock trading to 9% in 2015. In the context of abundant domestic liquidity, Rmb depreciation pressure and tight control over cross-border fund flows via underground channels, we expect the launch of Shenzhen-HK Connect, as an official avenue for offshore investment, to further propel southbound trade. More importantly, the scope of eligible stocks will expand to HK-listed mid-/small caps, which match the risk appetite of Chinese investors. The valuation gap among mid-/small caps is strikingly wide – 72x PER for the A-share ChiNext board and 16x for the Hang Seng Mid-/Smallcap Index.
Shenzhen-HK Connect could be a stock-pickers’ game. Despite the high valuation of the overall Shenzhen market, quality stocks can be found with high growth potential and large market caps to fit international investors’ appetite. Meanwhile, some of the sweet spot of southbound trade has relatively healthy fundamentals as well as sufficient liquidity for international investors.
*Image: Jay Sterling Austin