Market participants largely agree on how fundamentals will influence the medium-term trajectory of Hong Kong stocks, with the key variable resting on the global liquidity environment. In our view, a weaker US dollar driven by credibility challenges, coupled with a stronger renminbi, should help narrow the AH premium once again and support a re-rating of Hong Kong financial assets. That said, for the broader market, the current backdrop of a soft dollar differs from last year's environment of loosening global financial conditions and a risk-on stance; the direction of tighter liquidity has not changed. The 10-year US Treasury yield is likely to fluctuate at elevated levels, further FX intervention or rate hikes by Japan remain possible, and the August central bank symposium is a key focus. With Hong Kong adopting a "tighten short-end, control long-end" approach overseas and the HKD remaining soft, HIBOR could move higher. Given limited incremental liquidity support and the fact that the earnings season has not been fully priced in, earnings delivery becomes more critical. We maintain a balanced allocation: low-volatility dividend stocks (such as banks) as the core holding; watch dairy and select retail names that may confirm an operational bottom in interim results; position in the AI chain (e.g., wafer foundries) as an offensive play with a small position to capture oversold bounces; and while CXO and innovative drug leaders have high earnings delivery, their short-term risk-reward has deteriorated, so the pace of gains may slow.

Fundamentals: Innovative drugs lead in upward revisions and breadth

As of August 21, the FactSet consensus 2026 earnings estimate for Hong Kong non-financials (referred to as earnings expectations) fell 0.1% over the past four weeks, with the decline narrowing, and rose 0.2% over the past week, with upward revisions accounting for 47%. For the full sample, earnings expectations rose 1.2% over the past four weeks, with financials being the main contributor. By sector, innovative drugs saw accelerating upward revisions (up 6.2% over four weeks, up 3.8% over one week), with the share of upward revisions climbing to 68%, showing strength in both magnitude and breadth. High-dividend names maintained upward revisions (up 1.0% over four weeks). Consumer discretionary saw widening downward revisions (down 1.3% over four weeks), though the upward revision ratio was 59%, with the drag concentrated in heavyweight stocks while most constituents were still being revised up. Internet names saw a widening decline (down 2.4% over four weeks). At the industry level, consumer services saw narrowing downward revisions (down 1.0% over four weeks, up 0.4% over one week). Retail trade turned from decline to increase (roughly flat over four weeks), with the upward revision ratio rising above half to 50%. Power and utilities also turned from decline to increase (up 0.3% over four weeks). Textiles and apparel saw widening downward revisions (down 3.2% over four weeks, down 0.8% over one week), with the upward revision ratio falling below half to 45%. Food and beverage saw a widening decline (down 1.1% over four weeks), with the upward revision ratio retreating to 39%, as both magnitude and breadth weakened.

Fund flows: Active foreign capital turns to inflows, southbound turns to net outflows

1) Foreign capital: As of Wednesday, EPFR data showed net foreign inflows of USD 630 million into Hong Kong stocks, accelerating from the previous week's USD 110 million. Active foreign capital turned to net inflows of USD 50 million, while passive foreign capital continued with net inflows of USD 580 million. 2) Short selling: The latest weekly average short-selling ratio for Hong Kong stocks rose 2.4 percentage points to 12.1%, ending three consecutive weeks of declines. The short position ratio stood at 2.53%, largely unchanged. 3) Southbound: This week turned to net outflows of approximately HKD 11.6 billion (versus roughly zero the previous week). Retail trade, banks, and media saw the largest inflows, while electronics, consumer services, and telecommunications saw the largest outflows.

Market sentiment: Sentiment rises to optimistic levels, price-based indicators take over

The Hong Kong stock sentiment index read 63.0, up from 59.8 last week, staying above the 50 neutral level for the fourth consecutive week. By attribution, the rebound in the AH premium (up 14 to 70), gold-implied exchange rate (up 6 to 84), and HSI RSI (up 7 to 56) were the main drivers. Southbound net inflows/buying intensity stayed flat at the bottom (0/0), while futures basis and put/call ratios edged lower. Over the past year, the sentiment index timing strategy has delivered excess returns of approximately 10% for pure long and 22% for long-short.

Allocation: Stay balanced, watch earnings

Macro-wise, upside risks to US Treasury yields remain, capping further valuation recovery. Micro-level earnings signals will be the key to determining whether Hong Kong stocks can break higher. Standing at a "crossroads," we continue to recommend a balanced allocation across three directions. First, the fundamental gap between Hong Kong stocks and A-shares or US stocks may narrow, but the magnitude is still limited and awaits interim results confirmation. Meanwhile, financing demand remains significant on the funding side, so low-volatility dividend stocks, such as banks, remain the core holding. Second, consumer names that may confirm an operational cycle bottom in interim results, such as dairy and select retail, offer reasonable risk-reward from a medium-term perspective. Third, the AI chain, such as wafer foundries, where funding pressure persists but demand fundamentals remain intact, warrants a small position to capture oversold bounces. CXO and innovative drug leaders have high earnings delivery, but their short-term cost-effectiveness has declined, and the pace of gains may slow.

Risks: Geopolitical volatility, policy support falling short of expectations

Geopolitical conflict risk: Geopolitical tensions may dampen risk appetite, leading to foreign capital outflows and sharply higher market volatility, causing market movements to diverge from our views.

Policy support falling short of expectations: If overheating markets lead to reduced policy support, it could reverse the current upward valuation trend or compress trading activity, causing market movements to diverge from our views.