The Hang Seng Property Index (HSP) has had a rough few years in performance, not only has the benchmark for Hong Kong property stocks massively derated since the peak in 2018, but it is now arguably stuck at a level seen as early as Q4 1996 – which is 27 years ago!
But with the index now loitering at the bottom of its trading range since 2007, and inflation very much returning after a long period of disinflation in the global economy, could an argument be made for investing in the sector again for some inflation hedged outperformance in the coming months or years? We will start by looking at how inflation might pan out in the coming months…
Inflation likely rising higher and for longer
Although benefiting from a strong USD which ameliorated upward price pressures which has been a global phenomenon, inflation in Hong Kong is unlikely to stay too low for much longer, especially now that the world is heading increasingly towards: a) deindustrialisation in the west thanks to zero-carbon madness; b) deglobalisation due to increasing polarisation of the BRICS vs 5-eyes power blocs; and c) continued world war 3 risks which could erupt at any moment – further destroying already badly disrupted supply chains post covid lockdowns.
In this context, we have done a technical analysis derived forecast of HK’s inflation for the next two years, and the result is shown in the red line in Chart 1. As is customary in past inflationary cycles, whenever the CPI rises (red arrows), property as an inflation hedge becomes sought after, resulting in the HSP dividend yield trading at increasing discount to inflation (green arrows):
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Chart 1: Base Case market might buy property stocks as inflation hedges, even when they yield 2ppts lower than inflation…
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Chart 2: And in a more extreme scenario, even 5ppts less, should world affairs become more perilous
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We believe this pattern will repeat in the coming 2-3 years, resulting in the HSP yield discount to CPI to hit what is quite achievable -2% levels by end-2025 (rightmost green arrow in Chart 1). But given how extreme geopolitical crisis could play out in the near future, perhaps a more pronounced -5% discount might not be out of the question (rightmost green arrow in Chart 2).
To visualise how the yield discount translates to HSP index performance, we have put them on the same chart. One clear pattern that emerges is that the relative yields of property stocks are highly cyclical against underlying inflation, as seen by the multi-year discount-premium swings (green arrows). We are likely on a “premium to discount” run right now, and this may be a big safety factor in favour of property stocks – when inflation rises, market required yields could still hold at their current levels, or at worse, rise by a much smaller magnitude compared to inflation itself, resulting in a potential discount in the coming months:
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Chart 3: Possible more than doubling of HSP assuming dividends stayed constant while yields trade at discount to inflation
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HSP index as implied in our base case scenario of yields at a 2%-point discount to CPI suggest a possible new all-time high in HSP price in Q1 2025, but having first drop further in the near term (red line above).
So how does index movements (capital return), dividend yields (income return) interact with inflation over the cycles? We have decomposed the total return profile (orange line in Chart 4) into its components – blue area represents dividend yield and green area capital movements, and the main patterns that emerge are:
a) Capital returns are almost always more volatile than both the yield and inflation movements, but tends to move in the same direction as inflation (ie green arrows follow red arrows in Chart 4);
b) Dividend yields on the other end tends to be the more stable element of the three, but also by and large is swayed by the trends in CPI (see magnified view in Chart 5, where blue arrows tend to also follow red arrows):
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Chart 4: Capital fluctuation is more pronounced than inflation/dividend yield
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Chart 5: Dividend yields likely to rise but may be overtaken by inflation in coming months
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To conclude, we think the rightmost blue arrow in Chart 5 will rise as inflation accelerates, but could be overtaken by the latter in the coming 2-3 years, partly also cushioned by the current near record high dividend yields trading in the sector – a good safety margin in deed.
Long cycle of yield premium cycle favours property stocks
The premium-discount oscillation we alluded to in Chart 3 above is represented in a more schematic way in the summary chart below – this suggests that stocks remain cheap as they now stand compared to inflation, and as the pendulum swings to the other extreme (likely reached in 2026), stocks will then be expensive and investors should sell at that time:
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Chart 6: Relative value is like a pendulum – swinging from one extreme to the other
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Of course, such cycles will vary in both the magnitude (e.g., next cycle could end at the red dotted line of -4.5% or so, or exceed the prior extreme to go beyond -7%) and frequency (so the 9 year time frame that we assumed it will reach the expensive extreme might take more or less in reality). We will obviously assess whether the extreme is reached when we see it, but it is safe to say that at the current levels, stocks are not a high-risk way to hedge against the oncoming inflationary wave.
We will in the next instalment look into whether stocks are a better hedge compared to bonds, or HSI or even physical property by employing similar premium/discount analyses. Watch this space…
The author would like to thank Wong Ngai Fung Wallace from The University of Hong Kong majoring in Wealth Management and Chen Hailan from The University of Hong Kong majoring in Economics and Finance for assisting in data collection, analysis, and drafting this article.
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