By all counts, Hong Kong and China stocks have had a roller-coaster year in 2018. 

The Hang Seng index, after rallying in January to a record high above 33,000, pulled back more than 25 percent to just above 24,500 as US-China trade tensions escalated through the summer. 

We recently saw a rebound as President Trump signaled a possible rapprochement. We believe this nascent recovery may have more room to run in the near term, based on our assessment of some of the underlying drivers of markets this year.

Softer trade stance

First, there is an increasing likelihood that the US and China are likely to reach some form of trade pact soon, perhaps at the G20 meeting later in November.

While it is never easy to read political tea leaves, one reason why we see a potential “light at the end of the tunnel” for the US-China spat is that US stocks have started to pull back lately as the trade tensions escalated. 

Any reversal in the US equity bull market undermines President Trump’s stance that the US was “winning the trade war.” This rhetoric worked as long as US stocks were rising (and outperforming global stocks) through the summer, while equities in China fell. 

However, the recent drawdown in US stocks potentially brings to the fore the potential harmful effects trade tensions could have on the US economy, such as through higher input costs or disruptions to the supply chain. 

As worries about the US economy grow, it could encourage the US administration to soften its trade stance with China. Any turnaround here could potentially act as a catalyst for a recovery in Chinese equities in the near-term.

Resilient fundamentals

Another key near-term driver of Hong Kong/China equities is the excessively cautious positioning of global investors. 

As global volatility rose in October, hedge funds reduced their risk-appetite in their allocations, while leverage among investors declined significantly. 

Against this risk-averse market backdrop, global fundamentals remain resilient. Specifically, global macroeconomic data remains robust, with US growth delivering positive surprise in Q3; corporate fundamentals remains constructive (although US earnings growth is likely to have peaked, earnings are still expected to keep growing over the next 12 months); and US financial conditions remain more supportive than during the 2015 and 2016 equity market sell-off, justifying a gradual Fed rate hiking path.

Meanwhile, Hong Kong/China stocks have become inexpensive from a historical perspective – the Hang Seng index is trading at a valuation of 10x forward earnings, a significant discount to its historical average P/E of 13x. 

These factors raise the prospects for a return of risk appetite in the coming months as investors turn their focus back to underlying data.

China supporting growth

Finally, we are seeing China increasingly rolling out stimulus measures to support growth. 

So far, Beijing’s reflationary policies have primarily come in three forms: a) China’s provincial governments announcing fiscal stimulus packages and fast-tracking infrastructure investments, b) the government cutting personal taxes (by raising tax brackets, starting Oct. 1), and c) the central bank further easing monetary policy through further cuts in the bank reserve requirement ratio and by letting the currency weaken since summer.

We expect China’s evolving fiscal and monetary easing policies to take up some of the slack as US reflationary boost from last year’s tax cuts gradually fade.

While economic and market fundamentals remain supportive for an equity market rebound in the near-term, we need to watch a few technical indicators closely: taking the 12-month range for the Hang Seng index and applying Fibonacci analysis, we get the following major technical support levels: 30,000 (62 percent retracement); 29,000 (50 percent retracement) and 28,000 (38 percent retracement). 

The index has a greater chance of a medium-term recovery if it sustainably rebounds from any of these support levels.

US-China frictions here to stay

Despite potential short-term relief of US-China trade tensions, there is scope for more frictions over the long-term as China’s economy overtakes the US in scale and continues to catch-up with the developed economies in terms of sophistication. 

How the world accommodates the two seemingly competing concepts – namely President Xi’s “Made in China 2025” (which involves making China more technologically advanced) and President Trump’s “Make America Great Again” – will keep investors guessing and markets increasingly volatile over the coming year.

This is one of the key reasons why we believe maintaining a diversified allocation across asset classes – equities, bonds, gold and alternative assets, besides keeping some reserve ammunition in cash – remains prudent for medium-to-long-term investors. 

By Daniel Lam

Daniel Lam is a senior cross-asset strategist at Standard Chartered Private Bank. -- Ed.