Currently, three critical questions confront the market: First, as Middle East geopolitical conflicts gradually evolve into persistent and significant global supply chain disruptions, and with the A-share market having experienced a year-and-a-half-long bull run now at a critical juncture, what will propel it further upward? Second, with global financial conditions beginning to weaken, could there be a major shift in market style? Third, as the disruptive innovation from AI and code inflation continue to accelerate, what impact will they have on economic structure and asset allocation direction? The answers to these three questions will determine our strategic response.
From an index perspective, we believe the room for further valuation repair is limited. A recovery in corporate profit margins is the key for the A-share market to sustain its bull run in the next phase. Global supply chain disruptions once again present an opportunity to validate the pricing power of China's advantaged manufacturing sector. Regarding market style, the Middle East conflict acts as a catalyst for style rotation this year. Against a backdrop of rising global costs and weakening financial conditions, low valuations and pricing power are the two most crucial factors. From an industry trend standpoint, the phenomena of code inflation and physical scarcity manifest in China as an enhancement in the pricing power of its advantaged manufacturing. Both the accelerated disruptive innovation from AI and disruptions in the global energy and chemical supply chains are reinforcing this trend.
In terms of allocation, we firmly advocate positioning around the re-rating of pricing power in China's advantaged manufacturing sectors (chemicals, non-ferrous metals, power equipment, new energy). Price increases remain a core trading theme. Simultaneously, it is advisable to increase exposure to the low valuation factor (insurance, securities, utilities).
Geopolitical turmoil coincides with indices reaching a critical juncture. The spring season represents a period for rebuilding confidence and making decisive moves regarding index direction.
1) The second quarter is a crucial window for rebuilding confidence on the A-share market's path of a slow bull run. Whether considering the index level, valuation level, or macro liquidity level, the A-share market stands at a pivotal point this spring. Firstly, the monthly chart of the Shanghai Composite Index is currently at a resistance line spanning 20 years since October 2007. Whether it holds firm or corrects will significantly impact investor confidence. Secondly, after a year and a half of a bull market, the valuation percentiles of major broad-based indices have moved to a higher tier, with most above the 80th percentile of the past decade, suggesting limited apparent room for re-rating. Thirdly, the Middle East conflict has delivered a significant negative shock to global supply chains and financial conditions, dampening risk appetite. However, having risen for a long time, appearing expensive in valuation, and being at high levels are merely static observations. Profit margins for a large number of industries remain at historical lows—the coexistence of "expensive" valuations and "low" profitability is the most prominent structural characteristic of this market cycle. At the broad index level, the net profit margins for the CSI 300, CSI 500, CSI 800, and CSI 1000 are at the 82.8%, 35.9%, 51.5%, and 14.0 percentiles, respectively, since 2010. If profit margins were to return to their historical median levels, the valuation percentiles would all fall below their historical medians. Further comparing A-share leaders with US stocks also reveals substantial room for profit margin improvement. If we acknowledge that the future profit ceiling for China's leading advantaged manufacturers is the global TAM (Total Addressable Market), then this gap itself implies significant potential upside.
2) The long-term stabilization and recovery of corporate profit margins are the necessary prerequisite for the A-share market to continue its bull run. For indices to advance to the next level, relying on valuation expansion is insufficient. The core determinant is whether China's advantaged manufacturing sector can systematically convert its market share advantages into a long-term recovery in profit margins. If validated, this would reshape the market perception of A-shares' "short bulls and long bears" pattern seen over the past two decades. From the perspective of policy-driven industrial development, the core of the "15th Five-Year Plan" industrial planning is transitioning "from large to strong"—shifting from driving industrialization and urbanization through scale expansion to stabilizing supply chains, preserving profits, and preventing risks. The essence is for advantaged manufacturing to enhance quality and efficiency to generate profits, which can then feed back into bolstering technological industries to address weaknesses, ultimately achieving sustainable improvements in living standards and social security. The ability of advantaged industries to generate profits (rather than continuously engaging in internal competition) is the starting point and prerequisite of this entire policy logic. From a more fundamental fiscal perspective, growth in value-added tax based on production scale expansion and land revenue growth based on accelerated urbanization are inevitably slowing. The annualized growth rate of China's fixed asset investment fell to 2.4% for 2019-2025 (turning negative historically in 2025), and the annualized growth of VAT + business tax dropped to 1.7%, both lower than the nominal GDP growth rate and fiscal expenditure growth. To ensure fiscal sustainability and controllable debt levels, it is necessary to promote a moderate recovery in price levels and encourage corporate profit growth and household income increases to boost direct tax revenue. From these angles, we should believe that the alignment between future fiscal interests and shareholder interests will be stronger. Translated to the market, one of the most important investment themes this year is going long on PPI and CPI.
3) The rapid rise in the oil price center provides an opportunity to test the pricing power of China's advantaged manufacturing sector. Since we first proposed the re-rating of pricing power in China's advantaged manufacturing last year, within sectors like chemicals, non-ferrous metals, power equipment, and new energy—aside from categories directly boosted by North American AI infrastructure—most stock price increases have reflected investor recognition of the narrative and anticipatory market moves. We cannot simply use "rising stock prices" to justify the narrative's logic. For these sectors to genuinely advance to a significantly higher level, sustained earnings validation is required, alongside tangible fundamental evidence of pricing power re-rating for investors to see. The energy and chemical cost shock induced by the current Middle East conflict offers such a window to observe and verify whether China's advantaged manufacturing can indeed structurally demonstrate pricing power. Tracing upstream from basic necessities like clothing, food, shelter, and transportation through the petrochemical chain, one finds that most companies in related sectors have experienced pullbacks over the past two weeks, while corresponding commodity prices, both spot and futures, have risen significantly. This reflects market pessimism regarding the cost-pass-through ability of midstream enterprises, even though these Chinese companies already hold dominant global market shares. The second quarter offers an opportunity to gather more empirical evidence to discern between two narratives: one focusing on China's high crude oil import dependency, intense internal competition, and oil prices compressing manufacturing profit margins; and the other suggesting that industries where China already holds sufficiently high monopolistic global market shares are beginning to consistently pass on cost pressures. The petrochemical chain serves as the prime case study currently, and it is entirely possible to witness a recurrence of the order转移 (order shifting) to China seen after the 2020-2021 global supply chain disruptions.
Against the backdrop of rising global energy/chemical costs and weakening financial conditions, low valuation and pricing power are the two most important factors.
1) Historically, during major Middle East conflicts and oil price spikes, low valuation has proven to be the strongest shield. During past significant geopolitical conflicts and crude oil supply disruptions, the performance of global stock markets has been inconsistent. For instance, during the two oil crises of the 1970s, the US stock market experienced a significant decline and valuation correction (1973-1974) in one instance, but rose 35% (1979-1980) in the other. The Russia-Ukraine conflict in 2022, coupled with Fed monetary tightening that year, saw the S&P 500 fall 11.6% over four months, while the Nikkei 225 edged up 0.68%. Theoretically, Asia-Pacific is a market more dependent on oil and more sensitive to US dollar liquidity. The core difference between the S&P 500 and Nikkei 225 at that time was valuation, with the latter being sufficiently low. The principle of low valuation outperforming high valuation, value outperforming growth, and large caps outperforming small caps constitutes the core strategic response to an environment of rising global energy/chemical costs and weakening financial conditions. Previously recognized and priced-in growth momentum may be a relatively vulnerable factor in such an environment.
2) Inflation pressures and uncertainty in the liquidity environment serve as catalysts for style rotation this year. Given that the Middle East situation has transitioned from short-term intense conflict to persistent supply chain disruption, and Trump's TACO trade is no longer effective, until the crisis is properly resolved and supply chains are factually restored, we must contend with the elevation of inflation pressures and the deterioration of the global liquidity environment as given variables. This necessitates a rotation from small caps to large caps, from thematic stocks to quality performers, and from high valuation to low valuation. Attempting to game the marginal direction of geopolitical events now holds little meaningful value. As of March 13th, the ratio of the closing price (5-week MA) of the SZSE 2000 Index (representing small caps) to the CSI 300 Index (representing large caps) was 2.34, sitting at the 98.8th percentile level over the past three years. The excess return (5-week MA) of profitable stocks relative to loss-making stocks is at the 1.3rd percentile level over the past five years, indicating loss-making stocks have accumulated substantial excess returns over the past three years. The net value of a long-short portfolio based on the low valuation factor is currently at the 17.1st percentile level over the past three years, also nearing a historical extreme. From a major cycle perspective, small caps and thematic stocks have experienced a five-year relative outperformance period, which is接近 an extreme duration for leadership phases in A-share history. The structure of incremental funds in the A-share market has been markedly differentiated in recent years, with ample allocation-oriented and trading-oriented capital, but a scarcity of stock-picking capital focused on individual company pricing. Coupled with减持 restrictions and abundant liquidity, this has led to the accumulation of structural mispricing even as indices experienced a low-volatility slow bull market. These issues may gradually become exposed following the Middle East conflict.
The concepts of code inflation and physical scarcity manifest in China as an enhancement in the pricing power of its advantaged manufacturing sector.
1) Employment structure determines that the direct demand shock from AI's disruptive innovation has a weaker impact on China. Since the emergence of GPT-4, market understanding of AI has roughly gone through three stages. The first stage involved vague expectations for AGI and killer apps (2023-2024). The second stage saw the explosion of inference demand revealing practical application scenarios and the potential for a leap in human productivity (2025). The third stage, with the爆发 of Agents (especially mature Coding Agents), made the market realize that the economic benefits from AI investment are currently limited, but it could significantly impact traditional enterprise service industries and cause structural damage to employment. According to estimates by The Information, when ChatGPT internally displays a list of purchasable products, the user click-to-purchase rate is less than 1%, significantly lower than the average 3%-4% conversion rate on e-commerce websites. The asymmetric impact of AI development on the production side versus actual payment behavior is a reality that must be faced; this factor's influence on the market may be more persistent and profound than the Middle East conflict. However, judging by employment structure, the impact of AI's disruptive innovation is weaker for China compared to the US and Europe. The service sector's share of total employment is 48.8% (65% in urban areas) in China, 79.0% in the US, and 73.5% in Europe. Within the service sector, the employment share of producer services is 16.2%, 34.3%, and 32.0% for China, US, and Europe respectively, significantly lower in China. Meanwhile, the share of employment in services involving physical interaction is 48%, 41.8%, and 26.0% for China, US, and Europe respectively, significantly higher in China. From this perspective, the AI impact on the US and Europe somewhat resembles China's economic adjustment post-2021, where the marginal income and employment prospects for a large segment of the middle class continuously weakened. In China, the three industries with the most employment in producer services (internet, finance, real estate) have already undergone deep adjustments beforehand.
2) Overseas markets seek HALO assets, while China's core focus is the enhancement of pricing power in advantaged manufacturing. The global trading trend of "code inflation, physical scarcity" is still burgeoning, but the emphasis differs between China and the US. The core of the overseas HALO trade is screening for defensive stocks that can avoid impairment of free cash flow or declining capital return rates under the impact of AI's disruptive innovation; it is essentially a passive defensive rotation. China's logic is different. The core of the trade here is that resource and manufacturing enterprises, already possessing market share and competitive advantages, actively manage future capital expenditure rhythms, converting existing competitive advantages into enhanced pricing power and profit margin recovery, thereby initiating a process of free cash flow expansion after a peak period of low-return capital expenditure. Essentially, it involves寻找 those industries and companies where capacity is difficult to replicate simply globally, and where huge market share advantages, against a backdrop of government-conscious capacity control, gradually translate into an ability to pass on price increases externally, thereby improving profit margins and cash flow. This is the core logic behind our continued recommendation of chemicals, non-ferrous metals, power equipment, and new energy. This is a proactive value re-rating logic, whose resilience, sustainability, and certainty could exceed that seen overseas. In fact, applying the HALO framework to A-shares reveals no significant valuation difference between high-HALO and low-HALO score portfolios, and high-HALO portfolios have shown no significant excess returns relative to low-HALO portfolios since 2025. The HALO logic cannot be simply applied to A-shares, unlike in North America.
In terms of allocation, we firmly advocate positioning around the re-rating of pricing power in China's advantaged manufacturing.
The current recommended core holdings remain industries where China has share advantages, overseas capacity reset costs are high and difficult, and supply elasticity is easily influenced by policy, with a foundation in chemicals, non-ferrous metals, power equipment, and new energy. Investors might worry short-term about US dollar strength pressuring the non-ferrous metals sector. However, from a medium-term perspective, instability factors in the Middle East are accumulating, exacerbating the drawbacks of the traditional petrodollar and US dollar financial system, actually accelerating the erosion of the US dollar's long-term competitiveness. Short-term USD strength is inevitable, given the relative weakness of the Euro and Yen, and the Renminbi still has a long way to go in structurally competing for USD份额. After the global RISK OFF sentiment subsides, non-ferrous metals will begin repricing cost pressures, supply-demand gaps under re-industrialization trends, and resource security. On the basis of these core holdings, it is advisable to further increase exposure to the low valuation factor, focusing on insurance, securities, and utilities. Considering a short-term framework driven by景气 signals, price increases remain the "sharpest spear" in the first quarter. The Iran-Israel conflict and potential closure of the Strait of Hormuz could stage-wise elevate the oil price center, pushing cost curves rightward for many cyclical products. Under this narrative, multiple themes and structural opportunities exist: 1) Chemical products with alternative feedstock/process routes under oil price shocks (these products in China often have higher "coal content" than overseas competitors); rising prices of the primary feedstock (crude oil) can lead to wide spreads, e.g., urea, MDI, PVC, spandex, coal chemicals. 2) Products where Middle East/Western Europe capacity holds a relatively large share; supply interruptions could create additional supply-demand gaps fueling涨价 expectations, e.g., methanol, sulfur (indirectly affecting phosphorous chemicals), electrolytic aluminum, oil & gas, tanker shipping, industrial gases. 3) Products where substitutes rise in price due to cost influences, and demand increases widen supply-demand gaps, e.g., coal. 4) Products already in a涨价 channel, where cost increases provide a window for price hikes, in tight supply-demand balance situations, e.g., pesticides (glyphosate, etc.), polyester filament, dyes, oil refining, lithium battery anode materials and separators.
Risk factors include intensified Sino-US friction in technology, trade, and finance; domestic policy intensity, implementation effectiveness, or economic recovery falling short of expectations; unexpected tightening of macro liquidity domestically and overseas; further escalation of regional conflicts like Russia-Ukraine and the Middle East; slower-than-expected digestion of China's real estate inventory.