HONGKONG (Sept 4): UBS Group AG lowered its target for Hong Kong’s benchmark stock gauge by 25%, saying its worst-case scenario for the city is coming true as the economy weakens and tourism arrivals decline.

The Hang Seng Index will slide to 19,775 as slowing growth in the city and China weigh on corporate earnings, UBS analyst Spencer Leung wrote in a report dated Sept. 2. That’s a 5.5% drop from the last close and implies a 16% decline for 2015. In December, UBS’s target for the end of 2015 was 26,484 and the 19,775 level was the "black-sky" of four possible outcomes.

“On the back of slower economic growth in China and more signs that a U.S. rate hike is approaching, we believe the current valuation of Hong Kong equity may not be attractive enough to compensate for potential earnings downside," Leung said in the report. “Our black-sky scenario could be a better portrayal of the challenges in the current environment."

Hong Kong stocks are being buffeted by a global sell-off, China’s equity rout and a downturn in tourism that’s hurting shop rents and retail sales. The Hang Seng Index last month entered a bear market, and is the developed world’s worst- performing stock gauge this quarter.

Earnings Decline

The Hong Kong equity measure slid 0.6% as of 1:42 p.m. local time as a gauge of Chinese companies listed in the city tumbled 2%.

While valuations are becoming more attractive, they’re still too high given the worsening outlook for earnings, Leung said. Hong Kong company profits will tumble 31% in 2016 from a year earlier under the black-sky scenario, he wrote. He also reduced his estimate for the MSCI Hong Kong Index by 27% to 10,443.

The Hang Seng Index trades at 9.9 times projected 12-month earnings, compared with its five-year average of 10.8. The MSCI Hong Kong is valued at 13.4 times, its lowest level in three years.

Forward earnings-per-share estimates for Hong Kong jewelers fell 27% year-to-date as less Chinese shoppers came to the city, according to Bloomberg Intelligence. Visitor arrivals plunged 8.4% in July from a year earlier, despite efforts to attract tourists by loosening visa restrictions.

Hong Kong also faces the risk of importing higher interest rates from the US because of its currency peg to the dollar. Traders see a 56.5% chance that the Federal Reserve will raise borrowing costs by December, a move that would translate into higher mortgage costs in a city where property companies make up about a quarter of the MSCI Hong Kong measure.

Companies including Cathay Pacific Airways, Chow Tai Fook Jewellery Group, Wharf Holdings and Galaxy Entertainment Group are the least preferred at UBS, according to the report. Cheung Kong Property Holdings, Sun Hung Kai Properties and Swire Pacific are among the brokerage’s top picks.