August Ryan Lam, CFA

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Ryan Lam, CFA Senior Economist ryancwlam@hangseng.com Advance estimates of Hong Kong s GDP for the second quarter are due on August 15.

Barring revisions to historical data, Hong Kong s real GDP growth will likely come in at around 2.2% for the first half of this year.

1 Ryan Lam, CFA Senior Economist Advance estimates of Hong Kong s GDP for the second quarter are due on August 15. The GDP report is likely to feature a decline in growth, with economic expansion running at a belowtrend pace. Our tracking model points to 2% growth last quarter. Barring revisions to historical data, Hong Kong s real GDP growth will likely come in at around 2.2% for the first half of this year. A concerning element of recent developments is disappointing signals on the domestic front. Private consumption is set to contribute less to second-quarter growth compared with the first quarter, while a sharp retrenchment in investment is likely to act as a drag on growth. Stronger trade activity, predominantly in merchandise trading, should be one of the few bright spots in second-quarter GDP figures. An improvement in the trade balance would buffer the impact from the steep decline in domestic demand growth. For the second half, we project a broader-based lift in Asian exports as expansion in demand from advanced economies feeds into the region. On the domestic front, two factors are fuelling our forward-looking cautious optimism: first, substantial drags on consumption from the adverse wealth effect and high statistical base are likely to gradually dissipate over the coming months; and second, that these drags are now fading alongside an improvement in the investment environment. Steady growth of about 3.3% looks reasonable for the second half of Still, the GDP figures for the first half stand as a disappointment compared to our earlier forecasts. We are therefore revising our estimate of 2014 full-year GDP growth downward from 3.3% to 2.8%.

2 GDP growth likely to fall to around 2% The summer of 2014 has been much less eventful for Asian economies than the summer of The immediate pressures on current accounts have largely dissipated. Spill-over effects caused by heightened geopolitical tensions in Ukraine and the Middle East have been minimal. Investors appeared to have paid little attention to the disappointing US data, seeing as some of it is due to weather-induced weakness. Despite relative calm on the financial markets, the state of the global economic cycle is somewhat ambiguous. For Hong Kong, observers should have a clearer view of the city s economic health after the release of the preliminary estimate of second-quarter GDP growth on 15 August. We previously highlighted the risk of GDP growth remaining below 3% in the second quarter 1. Based on monthly indicators, our tracking model pegs second-quarter GDP growth at 2% 2 (Exhibit 1), following the 2.5% gain posted in the first quarter. The main features of our GDP projection are: (1) the weaker second-quarter growth rate largely reflects a temporary drag from investment retrenchment; (2) exports looks poised to step up after a period of sluggishness on the back of recovering overseas economies; and (3) the increase in external demand is still far from that required to significantly offset the sizeable decline in domestic demand growth, similar to the first quarter. Exhibit 1: Hong Kong s Economic Forecast (% YoY) 3Q13 4Q13 1Q14 2Q F Real GDP (F) Retail sales value Total exports Total imports Consumer prices Unemployment rate Note: (F) Forecast Source: Census & Statistics Department of HKSAR, Hang Seng Bank 1 Hong Kong Posts Steady GDP Growth, Hang Seng Economic Flash, May Changes throughout this report are on a year-on-year basis unless otherwise stated 2

3 Fundamental drivers look mixed Exhibit 2 shows the component-level breakdown of our forecasts. The key points are: Exhibit 2: Real GDP (% YoY, by expenditure) 3Q13 4Q13 1Q14 2Q14F Private Consumption Government Consumption Gross Domestic Fixed Capital Formation Exports of Goods & Services Imports of Goods & Services Real GDP Source: Census & Statistics Department of HKSAR, Hang Seng Bank Fixed investment was lacklustre. Investment variations tend to amplify the cycle. In a cyclical upturn, producers become optimistic. They invest in additional capacity and ramp up production. This is not the case for Hong Kong, however. Outside the inherently volatile inventory investment, improvement in investment is far from evident. Data for retained imports of capital goods points to a lacklustre spending on equipment and software (Exhibit 3). At 49.6, the average second quarter 2014 Purchasing Managers Index is at the lowest level since the second-quarter of 2013 (Exhibit 4), with companies appearing to have mainly carried out maintenance/renewal investment. It seems to us that corporate decisions to scale down investment is likely payback for the strong expansion in investment over past few years, suggesting machinery and software investment will no longer be the strong growth contributor that it was during recovery phase. 3

4 xxx Exhibit 3: Retained Imports of Capital Goods and Investment in Machinery (% YoY) Exhibit 4: Hong Kong Purchasing Managers Index Source: Census & Statistics Department of HKSAR, Hang Seng Bank Source: Markit, HSBC, Hang Seng Bank On a positive note, the decline in capital formation has not been exacerbated by a contraction in building activities. Our estimates point to a high single-digit gain in construction and building investment after a 10.2% increase in the first quarter. Public sector spending under this category is expected to remain the key driving force, albeit not at the same level as the 20.6% growth attained in the first quarter. Inventory build-up boosted second-quarter growth. This category is usually a wildcard. Better demand for manufactured goods and reduced uncertainty appear to have boosted inventory replenishment over the second quarter. While we only expect to see a normal rate of stock accumulation, it contrasts sharply with the massive liquidation of inventory that took place during the second quarter of Aided by this favourable base effect, a huge swing in inventory investment is expected to have made a sizeable contribution to second-quarter GDP, pushing up the growth rate by about 2 percentage points after having contributed 0.3 percentage points in the first quarter. From a forward-looking standpoint, however, actions to build up inventories is not a positive development as it presages a production correction. An expected slowdown in private consumption. After the brief pickup of 4.1% in the first quarter, retail sales value slipped 7.0% in the second quarter, the sharpest quarterly decline since The high base last year, reflecting rush demand for gold-related products in the second quarter of 2013, played a 4

5 particularly significant role in dull consumption recovery. However, the high base aside, there has also been a noticeable deterioration in other products. As depicted in Exhibit 5, excluding sales of jewellery, watches, clocks and valuable gifts, second-quarter retail sales were only up 2.5%. Exhibit 5: Retail Sales (% YoY) Exhibit 6: Tourist Arrivals (% YoY) Source: Census & Statistics Department of HKSAR, Hang Seng Bank Source: Census & Statistics Department of HKSAR, Hang Seng Bank As to what lies behind the deceleration, we are not convinced that it was closely tied to a marked slowdown in inbound tourism spending. Tourist arrivals did moderate in the second quarter but the deceleration in growth to 9.6% from 15.3% in the first quarter (Exhibit 6) was mild. That leaves per-capita spending by visitors. Quarterly data for spending per head is not currently available, but provided that there has only been minimal change in the composition mix of incoming visitors (Exhibit 7), we suspect poor domestic spending is largely to blame. As we have flagged previously, the adverse wealth effect stemming from falling equity and house prices has been the main culprit of a poor retail sales performance 3. A decline in marginal propensity to consume suggests this has been dragged more by a change in consumer confidence rather than income growth. This could be interpreted in a bullish way, however, as a recent stabilisation in asset markets would be consistent with strengthening consumption demand in the second half. 3 Private Consumption Showing Signs of Softness, Hang Seng Hong Kong Economic Monitor, June

6 Exhibit 7: Tourist Arrivals from the Mainland (% of total arrivals from the Mainland) Exports fared better. Trade data paints a more upbeat picture, with signs that an Asian export upswing could be getting underway. Accelerating from a soft patch, Hong Kong s total exports of goods stepped up from 0.7% in the first quarter to 4.8% in the second quarter. The pattern of Hong Kong s export growth closely mirrored that of its major trading partners, the US and mainland China. Tepid export growth in the first quarter reflected weather-related disruptions to demand in the US and the sharp slide in the Mainland s economic performance. Subsequent resumption of growth momentum in the US and easier monetary conditions on the Mainland have had a direct bearing on the city s stronger exports growth in the second quarter. The trajectory of services trade in the second quarter was not particularly favourable, however. An anticipated plunge in services exports attributable to falling travel-related services exports would keep the net exports contribution in check. Overall, net exports are likely to have subtracted modestly from secondquarter GDP growth. 6

7 How is the second half shaping up? If our forecast is correct, Hong Kong will have grown at close to 2% last quarter. Barring revisions to historical data, Hong Kong's real GDP growth will likely come in at 2.2% for the first half of Despite relatively disappointing growth for the first half, there were a host of temporary factors distorting the headline GDP figure, including continued strength in gold purchases last year, weather and policy-induced slowdowns in the US and on the Mainland as well as the adverse wealth effect. Any interpretation of first-half GDP growth and what it may indicate must therefore be undertaken and analysed with considerable caution and care. The key question is where the underlying growth rate will settle. Our view is that there are reasons to be more upbeat about the outlook for the third and fourth quarters of Coincident and leading indicators in advanced economies point to stronger growth in the quarters ahead. If the historical correlations between advanced economies and Asian exports hold, we project a broader-based lift in Asian exports in the second half as expansion in demand from advanced economies feeds into the region. Perhaps the more concerning element of recent developments is disappointing signals on the domestic front. Two factors are fuelling our forward-looking cautious optimism in domestic demand. The first is that the substantial drags of the adverse wealth effect and high statistical base are likely to gradually dissipate over the coming months. The second is that these drags are now fading alongside an improvement in the investment environment. Informing our view on consumer spending, we have updated our top-down consumption model, which is based on growth in exports, the jobless rate, and the effects of housing and stock market wealth. Our model predicts consumer spending in the % range for the second half. Coupled with a modest cyclical pickup in the business investment, we expect the economy to experience a broader-based recovery. Steady growth of about 3.3% looks reasonable for the second half of Still, the GDP figures for the first half stand as a disappointment 7

8 disappointment compared to our earlier forecasts. We are therefore revising our estimate of 2014 full-year GDP growth downward from 3.3% to 2.8%. Inflation remains well contained Concerning the outlook for inflation, Hong Kong inflation softened more than expected in recent months. Interestingly, the drivers of that change were primarily domestic housing and miscellaneous services. For the second half, we see the drivers of a gradual reflating in the Hong Kong economy as remaining in place. Measures of rental indices and vacancy rates suggest housing inflation will increase. At the same time, the firming in inflation excluding housing cost highlights a gradual building in demand-side inflationary pressures. Our outlook is for elevating housing inflation, plus a stable contribution from core goods, to push consumer prices inflation higher by year-end. Despite that, we now expect full-year CPI average inflation of 4.1%, down from our original estimate of 4.3%, reflecting softer than expected readings in the first half. 8

9 Hong Kong Economic Monthly Statistics GDP HKD bn Real growth yoy (%) yoy (%) yoy (%) HKD bn yoy (%) HKD bn yoy (%) HKD bn % yoy (%) , , , , , , , , , , , , , , , , , , , , , , , , F 2, , , F 2, , , Q Q Q , Q , Q Q2 N/A N/A , Jan 2013 N/A N/A Feb N/A N/A Mar N/A N/A Apr N/A N/A May N/A N/A Jun N/A N/A Jul N/A N/A Aug N/A N/A Sep N/A N/A Oct N/A N/A Nov N/A N/A Dec N/A N/A Jan 2014 N/A N/A Feb N/A N/A Mar N/A N/A Apr N/A N/A May N/A N/A Jun N/A N/A YTD , , Total Deposits Retail sales (value) Retail sales (volume) RMB Deposits Total Loans Foreign Trade Money supply (Total M3) Trade balance Office Rental Index HKD bn yoy (%) RMB bn yoy (%) HKD bn yoy (%) yoy (%) ytd (%) ytd (%) '000 yoy (%) , , , , , , , , , , , , , , , , , , , , , , , , F 10, N/A N/A 7, , F 11, N/A N/A 8, , Q , , , Q2 8, , , Q3 8, , , Q4 9, , , Q , , , Q2 9, , , Jan , , , Feb 8, , , Mar 8, , , Apr 8, , , May 8, , , Jun 8, , , Jul 8, , , Aug 8, , , Sep 8, , , Oct 8, , , Nov 9, , , Dec 9, , , Jan , , , Feb 9, , , Mar 9, , , Apr 9, , , May 9, , , Jun 9, , , YTD 9, , , Note: (F) Forecast Source: Census and Statistics Department of HKSAR, Hong Kong Monetary Authority, Rating and Valuation Department, Hong Kong Tourism Board, CEIC, Hang Seng Bank Exports Imports Residential Property Price Index Unemployment rate (s.a.) Tourist Arrivals Consumer prices 9

10 Hong Kong Retail Sales Volume Hong Kong Unemployment Rate Hong Kong Exports Volume Hong Kong Total Loans and Deposits Hong Kong CPI Inflation Hong Kong Property Prices (overall index, 1999 = 100) 10

Disclaimer This document has been issued by Hang Seng Bank Limited ( HASE ) and the information herein is based on sources believed to be reliable and the opinions contained herein are for reference

11 Disclaimer This document has been issued by Hang Seng Bank Limited ( HASE ) and the information herein is based on sources believed to be reliable and the opinions contained herein are for reference only and may not necessarily represent the view of HASE. The research analyst(s) who prepared this report certifies(y) that the views expressed herein accurately reflect the research analyst s(s) personal views about the financial instrument or investments and that no part of his/her/their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report. Nothing herein shall constitute as offers or solicitation of offers to buy or sell foreign exchange contracts, securities, financial instruments or other investments. Re-distribution of any part of this document by any means is strictly prohibited. The information contained in this document may be indicative only and has not been independently verified and no guarantee, representation, warranty or undertaking, express or implied is made as to the fairness, accuracy, completeness or correctness of any information, projections or opinions contained in this document or the basis upon which any such projections or opinions have been based and no responsibility or liability is accepted in relation to the use of or reliance on any information, projections or opinions whatsoever contained in this document. Investors must make their own assessment of the relevance, accuracy and adequacy of the information and opinions contained in this document and make such independent investigations as they may consider necessary or appropriate for the purpose of such assessment. All such information, projections and opinions are subject to change without notice. HASE and its affiliates may trade for their own account in, may have underwritten, or may have a position in, all or any of the securities or investments mentioned in this document. Brokerage or fees may be earned by HASE or its affiliates in respect of any business transacted by them in all or any of the securities or investments referred to in this document. The investments mentioned in this document may not be suitable for all investors. Investors must make investment decisions based on their own investment objectives, financial position and particular needs and consult their own professional advisers where necessary. This document is not intended to provide professional advice and should not be relied upon in that regard. No consideration has been given to the particular investment objectives, financial situation or particular needs of any recipient. Investment involves risk. Investors should note that value of investments can go down as well as up and past performance is not necessarily indicative of future performance. This document does not purport to identify all the risks that may be involved in the securities or investments referred to in this document. 11

A Challenging Start To The Year

Ryan Lam, CFA Senior Economist ryancwlam@hangseng.com A Challenging Start To The Year Hong Kong s real GDP rose 2.1% in the first quarter of 2015, down from 2.4% in the fourth quarter of last year and