While there was a relief rally in Shanghai as the PBOC stayed put, the mood in Hong Kong is rather subdued with volumes lower than average. Not much is expected during the next two weeks; there will be the usual window dressing and profit taking. We may have a rally in early January but trading in the coming months will be done under the fear of further tightening by the PBOC, a new European crisis and lackluster economic news from the U.S.

INDICES 1 week 4 weeks YTD Hang Seng Index -1.9% -3.8% 3.9% HS China Enterprises -1.5% -5.3% -2.5% FTSE/Xinhua A50 0.2% -0.5% -21.2% Shanghai Composite 1.9% 0.2% -11.7% CSI 300 2.0% 1.5% -9.4% US ETFs EWH -2.0% -3.7% 17.2% FXI -1.9% -5.6% -1.3% PGJ -3.0% -4.8% 4.8%

But a lot of this has already been discounted by the market. The last time China experienced a bout of inflation, especially for food, the PBOC raised interest rates by 2%. That was from May 2006 to August 2008, from the sam e level where it stands today (5.56%) to a high of 7.47%.

In October 2007, interest rates passed 7% at about the same time as the CSI300 Index was making an historical high, up 396%. (Yes, that’s almost 5 times from 1172 to 5821) from May 2006 to the high of October 2007. So it is not all bleak ahead of us.

This time the PBOC started tightening through increases in the banks reserve requirement in January. Soon after, the market reversed trend and was down 28% by July. By the time (on October 19) the PBOC actually announced its first rate hike since December 2007 the market had already recovered three quarters of the drawdown.

The PBOC has already raised rates by 0.25%. How much more ahead of us? A survey by Bloomberg made at the time of the recent hike put the range between 0.5% and 1% to come. Still in order not to increase the pressure on the yuan, the PBOC is said to prefer to raise the reserve requirement to mop up liquidity in the system. This prob ably means a lot of volatility, down on fears of further tightening and up on signs that the PBOC is almost done.

All the mainland indices were up last week, most of the gain coming from last Monday’s relief rally. Marketd just drifted the rest of the week. The CSI 300 was up 2% on the week, the third weekly gains in a row.

With energy prices up, the energy sector (about 8% of the index) was up 4.8% on the week. The only sector to move down was financials. They are the heaviest in the index, and were dragged down by the lingering fears of new tightening and the news that Shanghai ordered halts on lending to companies for purchases of fixed assets. Banks should be supported by the unconfirmed news that banks will not have to cut their lending spree; Beijing will allow new loans in 2011 at about the same level as 2010.

SECTORS – CHINA 1 week 4 weeks YTD CSI300 Energy 4.8% 5.0% -13.3% CSI300 Materials 2.9% 2.8% -1.6% CSI300 Industrials 2.4% 4. 3% 3.9% CSI300 Cons. Discretionary 2.9% -0.9% -3.0% CSI300 Cons. Staples 3.5% 6.2% 21.6% CSI300 Healthcare 2.7% 1.3% 30.5% CSI300 Financials -0.4% -2.0% -25.3% CSI300 Technology 2.2% 1.3% 23.9% CSI300 Telecom 5.5% 9.6% -13.7% CSI300 Utilities 1.8% 0.6% -16.8% SECTORS – HONG KONG 1 week 4 weeks YTD HS Financials -1.7% -4.7% -1.4% HS Utilities -1.2% -1.7% 11.1% HS Property -1.6% -5.6% 4.3% HS Commerce & Industry -2.4% -2.4% 10.2%

In Hong Kong, many fund managers took profits ahead of the year end as the Hang Seng Index is barely in the green for the year. Being a more open market than the mainland’s, the Hong Kong market was also affected by the uncertainty in Europe. We should expect more window dressing this week. The selling pressure affected all sectors. The worst performers though were mainland companies listed in Hong Kong: China Resources, down 8.2%, China Merchants Holdings, down 6.8%, Ping An Insurance (PNGAY.PK), down 6.5%, C OSCO Pacific (CICOF.PK), down 5.2%.

FXI performance mirrored the drop of mainland shares listed in Hong Kong. Air China (AICAF.PK) continued its slide, down another 8.7% on the week. All airline stocks dropped following comments from the IATA to the effect that slower global economic growth and rising fuel costs may hurt airline profits next year. Ping An Insurance, off 6.5% on profit taking. China Unicom (CHU), up 4.4%, was the best performer, keeping the momentum of the previous week following the announcement of a new service plan.

The Shanghai Composite Index is the broadest base index encompassing all listed A and B shares listed in Shanghai.

The CSI300 comprises the 300 largest A shares listed in Shanghai and Shenzhen.

The Hang Seng China Enterprises Index covers 40 “H” shares issued by mainland companies listed in Hong Kong.

The Hang Seng Index currently covers the 43 largest Hong Kong listed companies by capitalizati on. These HK listed companies include a number of mainland Chinese companies.

EWH tracks the MSCI Hong Kong Index which is substantially different from the Hang Seng Index.

FXI tracks the FTSE/Xinhua 25 Index which includes the 25 largest mainland companies listed in Hong Kong.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.