Improving mainland economic data and hopes for export gains as the U.S. economy recovers have boosted Hong Kong stocks but some players, including Goldman Sachs (GS), are sounding warnings.
Hong Kong shares (Hong Kong Stock Exchange: .HSI-HK), the most accessible way for foreign investors to play on China equities, have climbed more than 11 percent since the beginning of July, even as most emerging markets have sold off.
But drivers underlying the gains may stymie the rally as the U.S. economic recovery, and the Federal Reserve's moves to taper its asset purchases, boost interest rates and strengthen the U.S. dolla (New York Board of Trade (Futures): =USD)r.
The Hong Kong dollar's (Exchange:HKD=) peg to its U.S. counterpart likely won't offer the immunity from foreign exchange risks investors are seeking, Goldman Sachs said in a note.
Instead, the rising U.S. dollar - with the Hong Kong dollar riding on its coattails - will tighten financial conditions, weigh asset prices, including property prices and slow domestic demand in the protectorate, Goldman said.
"We expect these potential developments, in turn, to slow earnings growth and compress valuations, thereby constraining equity returns upside," Goldman said, adding it viewed Hong Kong shares as "fairly priced."
It expects Hong Kong's shares to underperform regional markets over the next 12 months as valuations aren't compelling and investor positioning is already heavy. It expects a 50 basis point rise in rates over a short period would translate into a 10 percent valuation downside for the market.
Goldman rates the Hong Kong market at underweight and advises staying cautious on defensive and highly geared stocks as they are sensitive to higher rates. To play on beneficiaries of higher rates, it suggests taking long positions in HSBC (London Stock Exchange: HSBA-GB)and AIA (Hong Kong Stock Exchange: 1299-HK), while selling Hong Kong & China Gas and Link REIT short.
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It sees retailer Luk Fook and casinos Galaxy (Hong Kong Stock Exchange: 27-HK)and Sands China (Hong Kong Stock Exchange: 1928-HK) as benefiting, while it rates industrial play NWS and property stock Great Eagle at sell.
Others also see headwinds for Hong Kong's market.
"Rising rates in this environment is not going to be positive," said Suan Teck Kin, treasury economist at UOB, citing concerns about consumer debt, not just in Hong Kong, but across Asia. "All this leverage is not going to be pretty when you have a rising rate environment."
He believes the rally in Hong Kong shares is likely done, with the good Chinese data priced in. "You will probably see more downgrades on outlook and growth forecasts going forward," he said.
(Read more: Hong Kong on Track to Regain IPO Sizzle )
To be sure, some analysts still expect gains. Guillermo Felices, an analyst at Barclays, expects a China bounce, although he isn't certain whether it will be sustainable.
"Markets have priced in a great deal of pessimism about China over the past few months," he said in a note last week. "Forecasters have come a very long way in recalibrating their views on China" in the wake of recent improvements in the mainland's data
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