Since February, Hong Kong stocks have underperformed overall, with the Hang Seng TECH Index, representing "core assets," performing particularly poorly. As of February 28, the Hang Seng Index declined 2.8% (compared to a 1.1% gain for the Shanghai Composite and a 0.9% drop for the S&P 500), while the Hang Seng TECH Index plummeted 10.1% (versus declines of 1.4% and 3.4% for the STAR 50 and Nasdaq, respectively). The Hang Seng TECH Index has retreated 20% from its October peak, breaching multiple technical support levels. The contrast is stark compared to South Korea's nearly 50% surge since the start of the year.

Among the driving factors, equity risk premium (reflecting sentiment and narratives) was the primary drag, contributing -14.7 percentage points, outweighing positive contributions from earnings and the risk-free rate. In terms of constituents, the top five weighted stocks alone accounted for a -6.0 ppt decline.

Why has the Hang Seng TECH Index underperformed so significantly? While the market has expressed concern over recent weakness in Hong Kong stocks, this outcome is not surprising. In an environment where the overall credit cycle is fluctuating and slowing, the remaining expanding sectors naturally attract capital. However, if the unique structure of these sectors is temporarily out of favor with the market, coupled with headwinds from capital flows, such performance becomes understandable.

First, the credit cycle determines the overall index's potential. It has been noted that China's credit cycle in 2026 may transition from a rapid recovery in 2025 to a phase of fluctuation or even periodic slowdown, leading to modest expectations for broad index performance. Second, industrial trends dictate the structure of sectoral strength. The overall fluctuating credit cycle necessitates a focus on structural opportunities, but recently, the composition within the Hang Seng TECH Index has fallen out of market favor, particularly the divergence between leaders and laggards, and beneficiaries versus casualties, under the AI narrative.

Third, the liquidity environment amplifies volatility. Beyond the above factors, the disparity in capital flows between the A-share and H-share markets is evident and more critical for Hong Kong stocks. For instance, macro factors include Trump's nomination of the "relatively hawkish" Kevin Warsh as the new Fed Chair, raising investor concerns about global liquidity tightening, which disproportionately affects Hong Kong stocks, especially long-duration assets like the Hang Seng TECH Index. On a micro level, the supply from Hong Kong IPOs and secondary offerings is significantly larger, while A-share market strength diverts attention from southbound flows, creating a seesaw effect between the two markets.

Looking ahead to 2026, surpassing the capital flow environment of 2025 will be challenging for Hong Kong stocks and likely inferior to that of A-shares. The reasons include: 1) Compared to the net inflow of HK$807.9 billion in 2024, the additional inflow in 2025 (totaling ~HK$1.4 trillion) was largely driven by ETFs (~HK$300 billion) and other transactional funds like private funds and retail investors. These flows are highly sensitive to market sentiment, making a significant exceedance of 2025 levels difficult unless market performance substantially surpasses expectations, especially as other categories like insurance funds remain relatively stable. 2) While the Fed is still likely to cut rates, uncertainty post-Warsh's nomination introduces more volatility for Hong Kong stocks. 3) Hong Kong IPO and secondary offering activities are expected to remain active, with an estimated scale of HK$1.1 trillion, far exceeding the ~HK$600 billion funding demand seen in 2025. Additionally, the unlocking of shares from the large number of 2025 IPOs, amounting to ~HK$1.8 trillion, could pose a potential pressure on Hong Kong stock market liquidity in 2026.

A potential upside surprise could come from foreign capital, particularly long-term foreign institutional investors. According to EPFR data, since 2025, passive foreign capital and non-European/American active foreign capital have already returned to, and even briefly overweighted, Chinese assets. However, long-term European and American funds have been slow to act and remain significantly underweight. These funds are substantial in size but have higher thresholds for re-entry, often prioritizing fundamental improvements. Since the beginning of 2026, there have been some signs of inflows from European funds. If this trend persists, Hong Kong stocks, as the first stop for returning capital, would be more sensitive. Estimates suggest that if active foreign funds return to a standard weighting for Chinese stocks under the EPFR口径, it could bring inflows of HK$500-550 billion, roughly equivalent to the total outflow during the period from March 2022 to the end of 2025.

**I. Foreign Capital: Signs of Inflows from Europe and US, but Sustainability Hinges on Fundamentals** Since 2025, foreign capital has partially flowed back into Chinese assets. Beyond passive funds, regional active funds, such as those from the Asia-Pacific, have shown significant inflows into Chinese assets since August, possibly influenced by the active A-share market and policies like anti-involution. However, Asia-Pacific funds constitute only a part of active foreign capital. The underweight position of European and American funds has not narrowed but has instead widened, creating a "dual divergence" pattern. Combined, the overall inflow from active foreign capital in 2025 remained subdued. However, since the start of this year, active foreign funds have seen seven consecutive weeks of inflows into the Chinese market, the first such streak since February 2023. Notably, active European and American funds have also shown signs of inflow.

When do active European and American funds typically flow into China? Historical review indicates that fundamental improvement is key. From 2016-2018, the inflow pace of European and American funds into Chinese assets was largely synchronized. Post-2018, active US funds typically lagged slightly behind European funds. Focusing on US funds, excluding very brief and unstable periods, there have been two major sustained inflow phases into Chinese assets since 2016 (May 2017-May 2018 and November 2020-February 2022), both primarily driven by improvements in fundamentals and corporate earnings.

- **First Phase (May 2017-May 2018):** Supply-side reforms and shantytown renovation monetization boosted corporate earnings expectations, coupled with the catalyst of MSCI including A-shares in June 2017, leading to sustained inflows from active US funds, peaking from late 2017 to early 2018, before reversing due to escalating US-China trade frictions in 2018. - **Second Phase (Nov 2020-Feb 2022):** China led the global recovery from pandemic disruptions, with a strong economic rebound aided by "order transfer" effects. High-growth industries like new energy gained global competitiveness, driving sustained inflows from active US funds through a combination of macro and industry factors, peaking around February-March 2021.

Besides these two major phases, there were three relatively brief inflow episodes (e.g., temporary cooling of trade friction in Jan 2019; increased stimulus in Jan-Feb 2020 to counter the pandemic; betting on economic recovery post-pandemic stabilization in Jan 2023), often influenced by events, but the initiation and failure to sustain were also linked to fundamental expectations.

Therefore, looking ahead, the sustainability of inflows from active foreign funds, especially from Europe and the US since the beginning of the year, remains contingent on fundamentals, which in turn depend on the trajectory of the credit cycle. Currently, weak income expectations and the cost-return inversion continue to constrain traditional private sector demand. Under a high base, the private sector social financing pulse may weaken further in 2026. If fiscal policy merely maintains 2025's support level as a counter-cyclical measure, the broad fiscal deficit pulse is also likely to decline. This implies that, under a baseline scenario where policy primarily acts as a stabilizer, China's credit cycle may fluctuate and slow overall in 2026, while industrial trends persist. A decisive turn upward in China's credit cycle hinges on the policy tone set during the Two Sessions regarding the scale and direction of measures: first, whether there will be substantial aggregate stimulus, and second, whether policies will focus on boosting domestic demand, repairing household balance sheets (e.g., income, social security, property), and mitigating systemic risks (e.g., debt resolution). If policy only serves to stabilize, China's credit cycle is likely to fluctuate or even weaken periodically (with Q2 potentially being a weaker phase within the year). Under the baseline scenario, Hong Kong stock earnings growth for 2026 is estimated at 3-4%, weaker than the 6% in 2025 and also below the estimated 4-5% for A-shares in 2026.

From a short-term perspective, renewed expectations for Fed easing and RMB appreciation could help improve Hong Kong's liquidity environment, but these are secondary to fundamentals as the dominant logic.

- **Will Fed Rate Cuts Drive Capital Inflows?** Fed monetary policy has some influence, but fundamentals are key. If Fed rate cut expectations rise, narrowing the interest rate differential with other countries and weakening the USD, it theoretically benefits Chinese assets. Trump's nomination of Kevin Warsh, with his "relatively hawkish" stance, impacts short-term market sentiment. However, rate cuts do not necessarily guarantee foreign capital回流; interest rate differentials are not the sole factor. For example, during the 2019 rate cut cycle, weak domestic fundamentals combined with trade friction led to continued foreign outflows. Conversely, during the 2017 rate hike cycle, foreign capital continued to流入, underscoring that the intrinsic fundamentals of Chinese assets are paramount. Regarding quantitative tightening, Warsh advocates significant Fed "downsizing"; selling long-term bonds could push up term premiums, raising long-end rates and partially offsetting the impact of rate cuts. While immediate implementation is difficult, related developments warrant close attention. - **Will RMB Appreciation Drive Capital Inflows?** RMB appreciation breaking through key levels might boost sentiment, but a strong currency does not automatically mean a strong stock market. Japan's experience from 1990-1995, where the yen appreciated 98% while the stock market overall declined, serves as an example. The fundamental link between exchange rates and stocks lies in macro fundamentals. If the logic "stronger currency = better fundamentals/capital inflows" holds true, foreign inflows would be more sustainable. Ultimately, fundamentals remain the underlying driver.

If active foreign funds return to a standard weighting for Chinese stocks, it could bring inflows of HK$500-550 billion, benefiting sectors like banks, e-commerce, and technology hardware. 1) **Overall Scale:** Based on EPFR data, as of Dec 2025, active foreign funds' allocation to Chinese equities was ~6.8%, underweight by ~1.01 ppt. Statically, a return to standard weighting would imply inflows of ~HK$500-550 billion, roughly matching the outflow scale from March 2022 to end-2025. 2) **Sector Structure:** Based on 13F filings as of end-2025, top foreign asset managers (top 20 by AUM in Chinese stocks) prefer internet (including media & entertainment, discretionary consumption), globally competitive Chinese manufacturing leaders, and banks. Compared to MSCI China sector weights, these institutions are primarily underweight banks, e-commerce, and technology hardware, while overweight capital goods and media & entertainment. Considering both allocation and underweight levels, sectors like banks, e-commerce, and technology hardware could benefit more if active foreign capital continues to回流 Chinese stocks.

**II. Southbound Flows: 2025 Surge Driven by ETFs and Transactional Funds; Exceeding 2025 Levels Difficult in 2026** Southbound inflows into Hong Kong stocks were approximately HK$800 billion in 2024 and ~HK$1.4 trillion in 2025. What will be the support from southbound flows in 2026, and which segments might be the main contributors? To answer this, the structure of 2025 southbound flows must first be dissected.

1. **Why the 2025 Surge? ETFs and Retail/Private Funds; Active Equity Not the Main Driver** The surge in southbound inflows in 2025 was not primarily driven by active equity funds. ETFs and transactional funds like private funds and retail investors were likely the main drivers. - **Active Mutual Funds:** The Hong Kong stock holdings of active equity-oriented mutual funds rose then fell in 2025, not being the main driver. By Q4 2025, their HK stock allocation as a percentage of equity investments edged up to 26.4% from 25.6% in Q4 2024; the holding value was ~RMB 427.7 billion, up ~RMB 100 billion (~30.5%) from RMB 327.8 billion in Q4 2024. Estimating quarterly flows suggests active mutual funds流入 approximately HK$17 billion into Hong Kong stocks in 2025. - **Non-Active Mutual Funds:** The overall HK stock allocation of mutual funds rose to 44.0% of equity investments in Q4 2025 from 36.2% in Q4 2024. Total AUM increased from RMB 2.24 trillion to ~RMB 3.76 trillion, with HK stock holdings rising from ~RMB 690 billion to ~RMB 1.27 trillion, an increase of nearly RMB 600 billion (>80%). Estimated overall mutual fund inflows into HK stocks in 2025 were ~HK$450-460 billion. Excluding active funds, non-active equity mutual funds流入 ~HK$430-440 billion. - **ETFs grew rapidly.** Inflows into ETFs eligible to invest in Hong Kong stocks (excluding QDII) were ~RMB 300 billion in 2025. As these ETFs allocate ~90% to HK stocks, this corresponds to ~HK$300 billion流入, making them the primary source of mutual fund inflows into HK stocks for the year. Based on H1 2025 data, institutional holdings (excluding feeder funds) accounted for ~70%, including insurance funds, pensions, etc.; the remaining ~30% were feeder funds (primarily off-exchange retail) and individual investors. - **Insurance Funds:** Based on data from the National Financial Regulatory Administration, insurers' direct stock holdings reached ~RMB 3,734.5 billion in Q4 2025, up ~RMB 1.3 trillion (~54%) from RMB 2,428 billion in Q4 2024. Assuming a HK:A-share ratio of ~1:4 for the incremental equity holdings, and accounting for price effects, estimated inflows from insurance funds into HK stocks under the "stocks" category in 2025 were ~HK$160 billion. Additionally, insurers have some equity holdings classified as "long-term equity investments." Based on analysis of major shareholder changes in HK stocks and client communication, estimated inflows under this category for major insurers were ~HK$65 billion. Combined, insurance fund inflows into HK stocks in 2025 totaled ~HK$230 billion. - The remaining ~HK$700 billion, due to data limitations, is difficult to accurately split but is speculated to belong more to private funds (including dedicated portfolio products) and even retail investors. These funds have strong transactional characteristics, aligning with the pattern of southbound flows fluctuating with market performance.

2. **2026 Outlook? Mutual Funds and Insurers Expected to Contribute ~HK$650-750 Billion; Overall Scale Unlikely to Exceed 2025** Looking to 2026, mutual funds and insurance funds are projected to contribute inflows of HK$650-750 billion. - **Active Mutual Funds:** New mutual fund regulations might affect active equity funds' willingness to allocate to HK stocks, as the current benchmark weighting for HK stocks is only 17%. Under a baseline scenario, assuming the HK stock allocation ratio remains near current levels, and considering the current total AUM of active equity funds (~RMB 1.9 trillion) and maintaining the 2025 new fund issuance pace (~RMB 165 billion), potential additional inflow space is ~HK$40 billion. Under an optimistic scenario where the allocation ratio returns to 30%, the potential space is ~HK$120 billion. - **Insurance Funds:** Insurers still have strong incentives to increase allocations to dividend-yielding assets, but the A-H premium for banks (leading dividend stocks) is relatively low, and the proportion of HK dividend stocks with yields exceeding 5% is at a historically low comparable level. Additionally, decisions regarding long-term equity investments are uncertain and harder to forecast, influenced by valuation levels (low P/E, akin to payback period). For the existing stock portfolio, assume the HK:A-share ratio remains stable. For incremental funds, assuming the growth in funds available for investment from new premiums in 2026 matches 2025 (~RMB 5.2 trillion, with total funds reaching ~RMB 38.5 trillion in Q4 2025 vs. ~RMB 33.3 trillion in Q4 2024), and ~30% of new funds are allocated to A-shares with a maintained HK:A-share ratio of 1:4, the incremental inflow could be ~HK$350 billion. - **ETFs,** a major surprise in 2025 southbound flows, face difficulty in significantly increasing their scale further in 2026. ETF growth is hard to predict precisely and is influenced by market sentiment. A simple linear extrapolation based on monthly averages since late 2024 suggests potential annual inflows of HK$250-300 billion from non-QDII ETFs eligible for HK stocks. - **Other transactional investors,** another major contributor last year, are a key variable for 2026 southbound flows. However, the scale of these funds is difficult to fully disentangle and predict, and is itself correlated with market sentiment. Considering the projected trajectory of China's credit cycle, if Hong Kong stocks in 2026 are unlikely to "replicate" the upward momentum of 2025 based on credit cycle assessments (the baseline forecast for the Hang Seng Index is 28,000-29,000 points), the contribution from these sentiment-driven investors to southbound flow规模 is also unlikely to exceed last year's level.

3. **Southbound Inflow Rhythm: Influenced by A-Share Strength, but HK-Specific Sectors Remain Key Focus** The rhythm of southbound inflows is also affected by the "seesaw effect" between A-shares and H-shares, where A-share strength diverts attention from southbound flows. For example, in 2025, Q1 saw DeepSeek-led revaluation of Chinese assets, with the Hang Seng TECH Index leading gains and attracting strong southbound inflows. Q2, after US reciprocal tariffs, saw US stocks supported by strong AI leader earnings and capex, while HK's new consumption and biotech sectors gained traction, maintaining high southbound inflows. July-August witnessed domestic deposit "activation" and capital entering the market, coupled with the A-share tech/compute theme under the US-China mapping logic, allowing A-shares to catch up, while southbound flows weakened. September saw "easy monetary policy" expectations rise and AI narratives strengthen for Chinese internet leaders, briefly leading HK markets and attracting renewed southbound allocation. However, post-October, as HK's characteristic sectors (dividends, internet, new consumption, biotech) were not the market focus, and with high overseas bond yields and accelerated HK IPO pace, HK underperformed again, and southbound inflow intensity slowed in Q4.

Nevertheless, even if the overall HK market performs weakly, its unique sectors retain scarce allocation value for southbound funds. These include dividend-yielding stocks, technology (primarily internet and AI models, with less hardware focus compared to A-shares), consumption (especially new consumption), and select quality biotech stocks, which are key attractions. Strong cyclical sectors are led by major companies but have lower weightings than in A-shares. The dividend sector offers higher yields than A-shares, providing defensive attributes.

**III. IPOs and Secondary Offerings: Potential ~HK$1.1 Trillion in 2026, Far Exceeding 2025's HK$600 Billion** The Hong Kong IPO market warmed significantly in 2025. Mainboard IPO proceeds totaled ~HK$286.9 billion, ranking first globally and exceeding the combined totals of 2023 and 2024. This was largely due to the appeal to leading companies – even though CATL's HK$41 billion fundraising was only ~3% of its market cap, it became the year's largest global IPO. Concurrently, HK mainboard secondary fundraising was also active in 2025, with post-listing fundraising of ~HK$323.7 billion, also exceeding the sum of the previous two years, indicating funding demand already higher than IPOs.

The active IPO and secondary fundraising in 2025 sets the stage for 2026 funding demand. Looking ahead, IPOs and secondary offerings in 2026 could require ~HK$1.1 trillion in funding. Based on the current queue of listings and potential fundraising sizes, HK IPO fundraising could increase from last year's HK$285.8 billion to ~HK$440 billion in 2026. Meanwhile, HK secondary fundraising is also rising noticeably. Over the past decade, secondary fundraising in HK has typically been about 1.5 times IPO fundraising. Combined, this implies nearly HK$1.1 trillion in funding demand. Additionally, share unlocks could pose potential liquidity pressure, with an estimated HK$1.8 trillion in unlocks projected for 2026 based on current data.

In the short term, this funding demand from IPOs and secondary offerings will pressure the market, especially if market performance is lackluster. Long-term, more IPOs, especially from leading companies, help address HK's structural "imbalance," strengthening its role as China's offshore asset center and its "super-connector" status for foreign capital, creating a positive feedback loop between quality companies and沉淀 capital.

**IV. Asset Implications: Tight Capital Balance Coupled with Fluctuating Credit Cycle Points to More Structural Market in 2026** In summary, Hong Kong stock market liquidity may face pressure in 2026. On the supply side, the baseline estimable规模 is ~HK$0.8-1.0 trillion, with an optimistic scenario of HK$1.2-1.3 trillion, closely matching the estimated HK$1.1 trillion funding demand. 1) **Active Foreign Capital:** If their allocation to Chinese assets recovers to the 2020-2025 average level (underweight by ~0.58 ppt), it could correspond to inflows of ~HK$200-250 billion. Optimistically, if they return to standard weighting, inflows could be HK$500-550 billion. 2) **Southbound Flows (Estimable Part):** Mutual funds (~HK$300-400 billion) and insurance funds (~HK$350 billion) together could contribute HK$650-750 billion. Additionally, the HK$1.8 trillion unlock规模 represents a potential pressure.

A tight capital balance combined with structurally expanding credit cycles suggests the market in 2026 may be more structural compared to 2025, requiring配置 to closely follow the direction of credit expansion. 1) Under the baseline scenario, China's credit cycle is expected to fluctuate or even slow periodically, with particular pressure in Q2. The baseline Hang Seng Index target range of 28,000-29,000 from the annual outlook is maintained. 2) The配置 strategy should still follow credit expansion directions. Among the four major areas – AI/tech, cyclicals, consumption, and dividends – AI/tech and cyclicals remain the primary medium-term themes, aligning with the main directions of current credit expansion. The tight liquidity environment underscores the importance of structural opportunities, necessitating轮动 to find them. Based on sector轮动 scoring models, sectors like internet, tech hardware, and new consumption can be prioritized for short-term布局. Sectors with strong fundamentals but lower trading scores, such as financials, biotech, and non-ferrous metals, warrant monitoring for opportunities, better suited as medium-term core holdings or left-side配置 rather than short-term additions. 3) Conditions for Hong Kong stocks to outperform again include:升温 in Fed easing expectations, HK-specific sectors returning to market focus, and weak A-shares prompting southbound inflows.