Hong Kong stocks are entering a window for renewed allocation opportunities.
Morgan Stanley's latest China equity strategy report argues that the rebound logic for Hong Kong stocks in the third quarter is strengthening, driven by improving corporate earnings expectations, room for overseas capital to return, and a more favorable global market environment. The firm advises investors to increase their Hong Kong stock allocations now and has raised its base case target for the Hang Seng Index to 28,400 points.
Morgan Stanley highlights that Hong Kong stocks are currently benefiting from two main themes: fundamental improvements and a better liquidity environment.
On one hand, second-quarter earnings previews indicate a significant easing of downward earnings revision pressure, with profit expectations stabilizing for heavyweight sectors like internet and e-commerce. On the other hand, global market volatility has triggered sustained covering of financing short positions previously established against the Hong Kong market, while overseas active funds remain notably underweight Chinese assets, providing a capital base for further upside in Hong Kong stocks.
Earnings revision slowdown, with internet sector as a core support
Morgan Stanley believes the core logic behind this Hong Kong stock recovery is the improvement in earnings expectations. Looking at second-quarter earnings previews, the proportion of net positive earnings pre-announcements among MSCI China constituents has risen to near-historic highs, indicating that corporate earnings are gradually bottoming out.
The most notable improvement is seen in the internet and e-commerce sectors. The report notes that since regulatory authorities strengthened constraints on price competition in mid-April, price wars in the e-commerce industry have notably eased, significantly reducing downward earnings revision pressure for internet platform companies.
Meanwhile, the AI industry is providing new catalysts. As China continues to roll out new-generation large language models and integrate AI capabilities into existing product ecosystems, market concerns about excessive capital expenditure expansion and profit pressure on major domestic cloud providers have eased.
Consensus data shows that MSCI China's consumer discretionary sector is expected to see EPS growth of 29% in 2026, the information technology sector 42%, and the materials sector an even higher 117%, all reflecting strengthening earnings recovery momentum.
Foreign capital remains underweight, ample room for return
Morgan Stanley argues that overseas capital remains the largest potential source of incremental inflows for Hong Kong stocks. To date, allocations to Chinese stocks by global and emerging market active funds remain significantly below their benchmark weights. Since the start of 2026, inflows into the Chinese market from overseas mutual funds are only about half of the total for the full year 2025, with the majority coming from passive funds, while active capital has not yet seen a notable return.
From a positioning perspective, global active funds are still overweight Tencent by about 0.9 percentage points, while Alibaba remains underweight by 2.6 percentage points. In the semiconductor sector, domestic equipment and chip companies like Montage Technology and AMEC have received higher active allocations, indicating that institutional funds continue to position around the domestic substitution theme.
Exchange rate factors also provide support. Morgan Stanley's China economics team expects the USD/CNY exchange rate to appreciate to 6.72 and 6.75 by the end of Q3 2026 and year-end, respectively (meaning relative renminbi strength), which should help boost overseas capital's willingness to allocate to Chinese assets.
Limited IPO lock-up expiry pressure, Hong Kong financing activity continues to rise
Addressing market concerns about IPO share lock-up expirations, Morgan Stanley believes they will not pose a systemic risk. The report notes that July and September 2026 correspond to the second-largest and largest lock-up expiry months in the past five years, with the information technology and materials sectors accounting for about 66% of the total expiration value in the second half of the year.
However, based on historical experience, large lock-up expiry months have not necessarily corresponded with weak market performance. Furthermore, the accumulated IPO lock-up expiration pressure since May has been steadily digested, so the impact on the index is expected to be limited, more akin to short-term liquidity events.
Meanwhile, the primary market in Hong Kong continues to recover. Hong Kong's IPO fundraising volume reached $37 billion in 2025 and has further increased to $41.5 billion year-to-date in 2026, maintaining its position as one of the world's most active IPO markets.
Allocation advice: Overweight internet, capitalize on Southbound capital event-driven opportunities
In terms of sector allocation, Morgan Stanley advises investors to re-allocate to the internet sector, listing it as one of the most favored overweight directions in the current Hong Kong stock market to capture the recovery opportunity. Additionally, the firm plans to initiate an event-driven strategy related to Stock Connect additions and removals in early August, with a positioning period of about one month. Morgan Stanley expects that the new batch of stocks eligible for Southbound trading via Stock Connect in September 2026 could cover sectors including information technology, industrials, and healthcare, potentially attracting capital attention to these areas.
Morgan Stanley stated that its China/Hong Kong key focus list has generated a cumulative return of 113.5% since inception, outperforming the MSCI China Index by 70.6 percentage points. Looking ahead, the firm advises investors to reassess their Hong Kong stock allocations in late summer to capture structural opportunities arising from changes in the global market environment.
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