Earnings uncertainty will stifle Hong Kong rally The Hang Seng has had its best start to the year since the mid-1990s, rising 12.5 per cent over the past month. Even so, by standard valuation metrics, Hong Kong's benchmark stock index still looks cheap. It is trading on a price-to-earnings ratio of about 9.4, a discount to the Asia-wide average of 12 and much lower than its own long-term average of about 14. The question for investors is whether the Hang Seng represents a bargain, or whether the seductive p/e ratio is a value trap. "I'm quite optimistic at least for the next couple of months that the rally can continue," says Arnout van Rijn, who manages about $2bn of Asian equities for Robeco. A wave of global liquidity is pushing stocks up from London to New York, unleashed by the US Federal Reserve's promise to keep interest rates lower for longer and the European Central Bank's move to pump hundreds of billions of euros into the region's banking system. Meanwhile, in Asia, many investors expect the People's Bank of China will allow credit growth to accelerate in the coming months. Yet, in spite of these monetary tailwinds, analysts warn that piling in to the Hang Seng purely on the basis of its low p/e ratio would be a mistake. Judged by metrics other than earnings, the Hang Seng is less attractive than it first appears. Excluding financial stocks, the Hang Seng trades on a price-to-cashflow multiple of about 10, a premium to the regional average for Asia of about 7.5, according to Mr van Rijn of Robeco. The index is trading on a price-to-book ratio of about 1.5, close to the average of global stocks tracked by FTSE. But perhaps the most important reason to be cautious is that the capitalisation-weighted index of 48 stocks is highly concentrated in sectors whose earnings outlook is highly uncertain. About half of the index is comprised of Chinese state-owned enterprises, mainly financial groups. The rest includes Hong Kong conglomerates, trading companies and property developers, which are under pressure from a declining housing market, as well as HSBC, the London-based bank, which has the largest weighting in the index, of 15 per cent. Three of the largest Chinese lenders - China Construction Bank, Industrial & Commercial Bank of China, and Bank of China - represent 17 per cent of the index. Their profits could suffer badly in the coming years, analysts reckon. In 2009 and 2010, the Chinese government engineered one of the largest stimulus programmes in history by forcing the banking sector to go on a lending spree. Ever since then investors have worried that much of this lending will eventually turn bad, an outcome that would crush earnings. The sharp increase of debt in the economy over the past three years also means that the Chinese government would be playing with fire were it to engineer another lending binge on anywhere near the scale of the last one, analysts say. "Concerns about banks" longer-term asset quality means that equity investors will probably reward China's next stage of easing measures much less than they did back in the 2009 grand stimulus package," says Dorris Chen of BNP Paribas. Besides the banks, the shares of other state-owned Chinese companies listed in Hong Kong have also struggled over the past year. Part of the reason is a growing awareness that the Communist Party committees of state-owned enterprises do not always share the same priorities as their minority shareholders. As long as a company remains a state-owned enterprise (SOE), the Party holds sway over important decisions such as the nomination of top executives, asset acquisitions and disposals, and annual budgets. Take China Mobile, the second biggest stock in the Hang Seng, with an 8 per cent weighting. Although the company has a 70 per cent share of the Chinese mobile services market, its shares have traded more or less unchanged for the past three years. The company's underperformance relative to peers on the Hong Kong index has been due at least in part to Beijing's insistence that it adopt a homegrown technology for its "third generation" wireless services. Other Hong Kong SOEs may face similar pressures. The Party's latest five-year plan has a focus on "income distribution reform." One way to boost household incomes would be to cut some of the long-standing subsidies for state-owned enterprises, says Michael Kurt at Nomura. "We expect household income growth would, in effect, be "paid for" by reducing corporate profits" share of GDP," he says. Chinese companies across many sectors are already facing falling margins and a deceleration in earnings growth. That suggests the "easy days of high growth and high profitability are over," according to BNP Paribas, which means any upside for stocks could be limited. Watch a video of the interview with Arnout van Rijn www.ft.com/vanrijn