The stock market in Hong Kong has all the ingredients it needs to whip up a sumptuous feast for investors next year. It is, as Merrill Lynch & Co. strategist Mark Matthews puts it, “the only market in Asia where growth is accelerating while monetary policy is easing and real rates are falling."

Consumer prices in Hong Kong rose 3.2% from a year earlier in October, double the previous month’s pace.

Inflation is expected to quicken well into 2008 as food becomes costlier and rents rise. Meanwhile, nominal interest rates are declining because surging capital flows into Hong Kong have left the banking system awash with cash. Hong Kong dollar deposit rates for three months have eased to 3.725%, almost a 2 percentage point fall since 17 October.

Positive outloook: Hong Kong is the only Asian market where growth is accelerating while monetary policy is easing and real rates are falling.

“The combination of rate cuts and accelerating inflation in 2008 will bring real interest rates down to levels last seen in 1997," say Morgan Stanley economists Denise Yam and Qing Wang in Hong Kong. “Low real rates will support asset prices."

The outlook for the rest of Asia isn’t so obviously sanguine. The consensus forecast for developing economies of Asia is of mild stagflation with the region’s fastest growing superstars—China, India and Vietnam—all slowing down somewhat in 2008.

Fitch Ratings’ forecast is for economic growth in emerging Asia to decelerate 1 percentage point to 7.7% next year. Inflation, the ratings company says, may be half a percentage point higher at 4.3%.

The likely scenario in China is of an “imported soft landing," says Morgan Stanley’s Wang. There is a 5% risk, he says, of a “gigantic policy mistake." In this scenario, the authorities in Beijing may end up choking domestic demand with aggressive monetary tightening even as a slowing global economy makes the Chinese export engine sputter.

Hong Kong has none of these risks. Since the Hong Kong monetary authority pegs the territory’s currency against the US dollar, it has to willy-nilly import the US monetary easing.

Bill Gross, who manages the world’s biggest bond fund at Pacific Investment Management Co., says the target for the overnight Fed funds rate may have to go to 3% or lower, from 4.25% at present.

Such aggressive monetary easing in the US, should it become necessary, may force the Hong Kong monetary authority to further increase supply of liquidity in the banking system in order to prevent the currency from appreciating beyond its trading range of 7.85 to 7.75 to the US dollar.

Interbank liquidity in Hong Kong has already swelled to HK$10.7 billion (Rs5,428 crore), a more than eightfold jump from mid-July. “All in all, we see more downside to Hong Kong dollar interest rates in the next six months," say Morgan Stanley economists Yam and Wang.

And that might push up equity valuations. The start of the much-anticipated “through-train," which will allow Chinese individuals to buy Hong Kong stocks, will see more of the surplus Chinese savings moving to the territory. The city is already a favourite investment destination for Chinese banks, asset managers and insurance companies under the so-called Qualified Domestic Institutional Investment plan. Credit Suisse Group says it favours Hong Kong equities in 2008 because “ample inflow of liquidity from Chinese private investors" is a key driver supporting the so-called H shares of mainland companies that trade in Hong Kong.

“In the new year, I expect the Hong Kong-listed China shares to outperform A shares in the mainland," Jing Ulrich, chairwoman of China equities at JPMorgan Chase & Co., said in an interview on Bloomberg Television this month.

The yuan-denominated A shares, the world’s best performing in 2007, have declined 10% so far this quarter, compared with an 8.5% drop in H shares.

While a slowing US economy may dent Hong Kong’s exports in 2008, the impact of that on the broader economy may not be too severe. The job market is at its tightest in more than nine years. That will keep wages—and consumer confidence—strong, even as rising asset prices prompt people to spend more.

Matthews of Merrill Lynch says Hong Kong developers and landlords could be good bets for investors. Negative real borrowing costs are a powerful force.

Jones Lang LaSalle Inc. says a drop in Hong Kong interest rates pushes up the capital value of Hong Kong luxury property. The magnitude of the gain is almost seven times bigger when inflation-adjusted returns on household savings are negative than when they are positive, the Chicago-based real-estate broker says.


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