Hong Kong has solidified its position as one of the globe's premier financial hubs, ranking third in global financial centers and boasting the seventh largest stock exchange. With a staggering market capitalization of approximately $45 trillion, a foreign reserve of $421.4 billion, and a GDP reaching $382.05 billion, the figures are impressive. However, beneath the surface lies the troubling reality of the Hang Seng Index, which has faced persistent undervaluation characterized by a rolling Price-Earnings (PE) ratio languishing at around 10.45 and a Price-Book (PB) ratio hovering merely at 0.94 over the last decade.

Particularly telling is the fact that since 2008, the Hang Seng Index has consistently been at the bottom of the valuation ladder among major global stock markets. As of late November, the index's rolling PE ratio dipped to a worryingly low 8.57, while the PB ratio was even more distressing at 0.94. This is a notable increase from the abysmally low values recorded in October 2022, which represented the lowest valuations of global capital markets since the turn of the millennium—rolling PE ratios at 6.77 and PB ratios at 0.75.

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To put this in context, it is instructive to compare these figures to averages from other significant markets worldwide over the past decade. For instance, Shanghai's Composite Index's rolling PE stands at 14.38, with a PB of 1.52, while Japan's Nikkei 225 pushes ahead with a PE of 19.1 and a PB of 1.78. The behemoth S&P 500 in the U.S. has an even higher rolling PE of 23.86 and a PB of 3.62. In comparison, the relatively new entrant, the MSCI India Index, shows a rolling PE of 28.82 and a PB of 3.78. These stark statistics highlight just how undervalued the Hang Seng market truly is; its average PE evaluation stands at a mere 54.7% of Japan's and 52.8% of America's figures. When assessed by PB, those numbers drop to 43.8% and 25.9%, respectively.

One might assume that this stark undervaluation of the Hang Seng is a characteristic peculiar to its market. However, the international investment community views the Hang Seng as a barometer of core assets and economic expectations for the region. It serves as a key conduit for foreign capital flowing into and out of the larger financial markets, evidenced by the existence of derivatives closely tied to the Hang Seng, such as A50 futures, the Golden Dragon Index, and various FTSE China ETFs.

This persistent undervaluation of the Hang Seng not only influences its own market dynamics but also resonates across the Chinese mainland stock markets, further complicating the market's struggle to gain momentum. The interconnectedness among the Shanghai, Hong Kong, and Shenzhen markets exacerbates this stagnation, often resulting in closely aligned growth figures across the three regions.

A critical question arises: What underlies the prolonged undervaluation of the Hang Seng? Today, we delve deep into the valuation challenges facing this iconic market.

Firstly, the influence of the U.S. dollar cycle and concerns surrounding liquidity in a pegged currency system cannot be overlooked.

It's puzzling to see so many reputable companies within the Hang Seng trading at PE ratios below 10 and PB ratios under 1. The crux of the problem lies in the liquidity constraints stemming from Hong Kong's fixed exchange rate tied to the U.S. dollar.

In smaller international free-market economies, maintaining a stable foreign exchange earning capacity is crucial. Without a robust ability to hedge against currency fluctuations, these regions must affix their currencies to those of major trading partners. In Hong Kong's case, this has meant firmly linking its currency to the U.S. dollar.

Since 1983, the Hong Kong Monetary Authority has implemented a linked exchange rate system, fixing the Hong Kong dollar to the U.S. dollar at a range of approximately 7.8. This system guarantees that any trading entity holding Hong Kong dollars can redeem them at a fixed rate for U.S. dollars using the foreign reserves held by the authority. However, no exchange rate system is infallibly optimal across all possible scenarios, and while the linked rate reduces the risk associated with currency fluctuations—bolstering Hong Kong's status as a free port and significant financial center—it also constrains the use of independent monetary policy necessary for growth and demand stimulation.

The efficiency of this system relies heavily on the confidence of currency holders, requiring the economy and market structures to demonstrate alignment with the economic expectations of the country to which the currency is pegged. As it stands, since Hong Kong's return to China in 1997, the currency has navigated through various international financial storms while maintaining stability. However, it is critical to acknowledge the shift from reliance solely on the U.S. economy to a deep interconnection with the domestic Chinese economy.

The synchronization issue creates dissonance within the economic cycles connected to the pegged currencies, obligating Hong Kong's monetary and capital markets to cater to U.S. monetary policies while simultaneously bearing the brunt of the ebbs and flows of China’s real economy.

Moreover, Hong Kong finds itself grappling with a structural misalignment between interest rate policies and economic fundamentals due to the fixed exchange rate system. Particularly troubling is the fact that we currently find ourselves in a rare cycle of declining domestic rates accompanied by strengthening foreign exchange values. The tightening cash flows challenge the territory with dual pressures of capital outflow and potential devaluation of the Hong Kong dollar, compounded by deflationary pressures in the market environment.

To maintain its stature as a key player in the global financial landscape, it is imperative that Hong Kong staunchly defends the stability of its linked exchange rate system. This necessitates infusions of substantial liquidity into the market to limit the effects of U.S. dollar maneuvers within the local financial landscape. However, since the Hong Kong dollar is tethered to the dollar, any moves to bolster liquidity must also rely on dollar supply, a situation fraught with complications as local currency value is also linked to the U.S. dollar.

In 2018, a notable innovation emerged with the introduction of RMB liquidity injection tools in the form of stock connect schemes, facilitating the flow of RMB into Hong Kong’s financial systems effectively alleviating liquidity constraints in the Hang Seng market. However, as RMB enters the market constrained by the pegged exchange philosophy, the cross-valuation recalibrates but does not resolve the underlying liquidity issues as effective capital remains overshadowed by the weighted influence of the U.S. dollar.

Consequently, the current liquidity predicament facing the Hang Seng market can largely be traced to the inadequacies of the monetary mechanism to meet the new dynamics of Hong Kong's evolving economic landscape. Hong Kong's linked exchange rate system is caught in a precarious stalemate that hinders effective reform efforts. On one side, continuing with the regime poses heightened risks and costs, exacerbating the potential for capital flight, while on the other hand, any unanticipated adjustment of the system could lead to severe credit depreciation of the Hong Kong dollar, risking an aggressive sell-off from global capital.

Broadly speaking, addressing these liquidity challenges appears contingent on the internationalization of the RMB and synchronized economic cycles between Hong Kong and mainland China. In the long term, this may lay the groundwork for a pivot from a fixed exchange system to a one that is tied to a basket of currencies ultimately reflecting economic strengths.

Secondly, a historical context of market structure factors into the cheapness and profitability of stocks.

In the stock market, the conglomerate presence of foreign, local, and mainland capital has formed a triad where foreign institutional investments account for around 39% of the market's overall capitalization, local intermediaries around 38%, and mainland intermediaries 13%. Interestingly, the Hong Kong Stock Connect only represents about 10% of the capitalization.

This diverse capital structure creates an inconsistency, where over 70% of investors derive their interests from over 90% of listed companies that are not locally matched, resulting in navigational challenges leading to new issue phenomena such as share price decline, fundraising obstacles, and inadequate liquidity.

This peculiar environment contributes to the prevalence of a strong ‘Matthew Effect' within the market; the top 5% of large companies absorb more than 70% of market liquidity. This structural segmentation exacerbates the imbalance of liquidity in the Hang Seng index.

It’s also worth mentioning that around 70% of investors in the Hang Seng are institutional in nature, with over half of them being foreign capital. When coupled with a vast array of derivatives existing within the market, this creates a 'slow' cycle characterized by 'fast' moving reactions. Specifically, institutional investors in Hong Kong exhibit an evident trend of 'waiting to see before acting,' leading to a lag in responses to policy changes and creating volatile trading conditions where failure to meet expectations can evoke immediate short-sell reactions.

Moreover, with a significant focus on financial services and real estate, sectors that traditionally carry low valuations tend to drag down the overall stock market valuations. This backwardness is particularly pronounced in major weighted industries that have difficulty making counter-cyclical adjustments and thus provoke investors to raise their discount factors—further impacting the market's intrinsic value.

Let's clarify: a discount factor is a crucial variable employed in cash flow adjustments to transmute future values into current values, thereby increasing suggests a decline in future profits.

Ultimately, the current capital structure reflects one of the most ideal setups for foreign capital, leveraging anticipated management and a tightly bound dollar regime to maintain strategic advantage.

Lastly, it's essential to understand the cyclical games between expectations and reality.

In the current economic climate, we're well aware that investments are leaning towards a calculated gamble on luck. The cycle renders the defensive strategies a tougher challenge, prompting investors to believe that their most successful investment has been the acquisition of beautifully dominant assets. Yet, the outlook suggests a pivotal liquidity shift on a global scale is in the making, indicating that the prolonged strength of the dollar and U.S. credit jeopardy can’t persist indefinitely within the existing financial frameworks.

In this context, whether it be next year or five years from now, a comeback seems assured. Moreover, the Hang Seng has begun to seize opportunities amidst economic restructuring by welcoming investments into emerging sectors such as technology and innovative pharmaceuticals, hinting at potential improvements in its capital structure. It's noteworthy that the Hang Seng's highest rolling PE in the past two decades was 23.81, presenting a staggering 2.83 times discount compared to today's closure prices.

This provides a glimmer of hope. The extent of the Hang Seng's undervaluation brings about optimism for substantial rebounds in strength during cyclical upswing periods. Such significant gaps in valuation within the market are a rarity.

Thus, with stable exchange rates, there may come a point when market habits of discounting the Hang Seng’s evaluations shift. When it eventually breaks free from underpricing, it likely heralds a positive shift for seeing growth not just within Hong Kong, but also for interactions with mainland securities—as evidenced by recent trends.