The U.S. stock market plummeted, will the A-share market break out of its "independent trend"?

Combining recent discussions with market investors, reviewing the market trends and market environment of global and A-shares last week, there are several key features worth noting:

Last week, major U.S. stocks showed mixed performance. The Nasdaq fell by 3.35%, the S&P fell by 2.06%, and the Dow Jones accumulated a 2.10% increase.

We believe that the sharp drop in U.S. stocks last week was mainly influenced by weak economic data on Friday. The U.S. unemployment rate in July exceeded expectations, spreading market panic, with the VIX index surging to 60 at one point. U.S. stocks experienced a sharp decline on Friday, and the short-term market sentiment is expected to continue. On the news front, hedge fund Elliott, in a letter to investors, stated that large-cap tech stocks, especially NVIDIA, are in a bubble. There are doubts about whether large tech companies will continue to purchase NVIDIA's graphics processing units (GPUs) in large quantities, and artificial intelligence "has been overly hyped, with many applications not yet ready for the golden age"; it is worth mentioning that Intel's performance disappointed the market, falling by over 26%, marking the largest decline since at least 1982 and the worst performer among the 30 constituent stocks of the Philadelphia Semiconductor Index. In terms of individual stocks, Tesla fell by 5.52% this week, NVIDIA fell by 5.12%, Apple fell by 0.87%, Microsoft fell by 3.95%, and Google Class A fell by 0.2%. Among Chinese concept stocks, Nio fell by 0.25% and XPeng fell by 0.92%.

Firstly, last week, the SSE Index rose by 0.5%, the CSI 300 fell by 0.73%, the CSI 500 rose by 1.1%, the ChiNext Index fell by 1.28%, and the Hang Seng Index fell by 1.69%. Value style underperformed growth style, with large-cap stocks leading the decline. In terms of industries, satellite navigation and CRO industries led the gains. The average daily trading volume of the entire A-share market this week was 726.1 billion, showing an increase compared to last week.

Secondly, in terms of incremental funds, ETF funds continued to flow into A-shares this week, becoming the most important incremental funds in the current market:

ETF funds once again significantly flowed into the CSI 300 this week, and the trend of flowing into the small-cap styles of the CSI 500 and CSI 1000 continues. Recent incremental funds in the market mainly come from ETF inflows. Looking at the net inflow scale of the CSI 300 ETF, a total net inflow of 34.15 billion yuan was recorded in June, and since July, the CSI 300 ETF has received another net inflow of 132.82 billion yuan, with a net inflow of 30 billion yuan last week and a further net inflow of 17.8 billion yuan this week. This is the first time since March that a concentrated inflow of ETFs has occurred, which has an important positive effect on stabilizing the A-share market and investor sentiment

Thirdly, at the index level, the market has been paying close attention to the historical low of M1 data recently. Before 2014, the overall rhythm of the A-share market was basically consistent with the pace of M1 year-on-year growth, a pattern known as "M1 determines buying and selling". However, after 2014, the correlation between the two has decreased, and the pricing effectiveness in the past 3 years has significantly decreased. The crux lies in the fact that the year-on-year growth rate of M1 is essentially tied to the real estate cycle, a financial phenomenon, and under the background of economic transformation, the financial path of monetary injection-real estate sales-inflation transmission is no longer smooth. In this regard, a more profound observation is that in the past few years, the pricing core of A-share macro strategies may be gradually shifting from a financial perspective to a fiscal perspective. Currently, the emphasis is on "finance is the foundation and important pillar of national governance". According to our previous research conclusion, the difference in expenditure growth between central and local governments (the difference in growth rates between local and central government expenditures) may be a leading indicator that explains the more effective pricing of the Shanghai and Shenzhen 300 Index (leading by 1-2 months). If this value expands, it is beneficial to the index, and vice versa. Behind this is the observation of the process of local debt and the intensity of central transfer payments. This indicator has shown a strong correlation with the index from 2017 to the present. Looking at the latest fiscal data for June released in late July, the trend of decreasing intensity in local fiscal expenditure is further evident. The 6-period moving average of the difference in expenditure growth between central and local governments has expanded from -4.24% in May to -5.92%.

Fourthly, as the index further probes downward, there has been a lot of talk about the public offering funds facing a redemption crisis. However, based on the latest disclosed data from the second quarter reports of funds, we found that the net redemption scale of Q2 active public offering funds (including equity-oriented hybrid, general equity, flexible allocation, and balanced hybrid) was 98.3 billion yuan (calculated by multiplying the net redemption shares disclosed in the fund quarterly report by the average unit net value at the beginning and end of the quarter), the lowest level in nearly five quarters, a 28.2% decrease from 130.7 billion in Q1 2024. It can be seen that the current redemption pressure on public offering funds has not significantly increased. In addition, further observation of the redemption scale of different types of funds reveals:

From the perspective of industry distribution, the active funds with the largest net redemption scale in the second quarter are those heavily invested in electronics, pharmaceuticals, and food and beverages, while the overall active funds heavily invested in coal, banks, and oil and petrochemicals have still received net purchases. 2. From the perspective of yield, active funds in the top 10% (first group) in the second quarter had almost no net redemptions, but as the yield decreased, the net redemption scale rapidly increased. In the bottom 20% of active funds, the net redemption scale began to decrease again, which may reflect that funds with deep losses are not willing to exit easily.

1. Looking at the valuation level of top holdings (average P/E ratio of TOP10), only when the P/E ratio of top holdings is below 15 times, there will be a clear distinction in terms of net redemptions (reflecting that the lower the valuation of top holdings, the smaller the net redemption scale). Below 12 times, there were no net redemptions in Q2, and above 15 times, the net redemption scale is unrelated to the valuation level of top holdings.

2. Recently, the significant fluctuations in overseas markets have attracted high market attention. This week, the Nasdaq fell by 3.35%, the S&P 500 fell by 2.06%, overseas non-U.S. markets also generally declined, with the STOXX50 index in Europe falling by 4.60% this week, the Nikkei index plummeting by 4.67%, the VIX panic index surging by 42%, gold prices hitting a historical high but experiencing increased volatility recently. Looking back at the recent global capital market fluctuations, it can be divided into three distinct stages:

Ø The first stage is from July 11th to July 17th. The core contradiction was that after U.S. inflation data fell more than expected, the market's expectation of a September rate cut by the Federal Reserve soared, triggering a return of risk appetite and a high turnover of funds, essentially a preemptive move regarding the rate cut expectation. Subsequently, the shooting incident involving Trump on July 13th led to a surge in Trump's reelection probability, further strengthening the expectation of interest rate cuts. During this stage, the 10-year U.S. Treasury yield dropped from 4.21% to 4.16%, gold surged by 4.02%, the U.S. small-cap index Russell 2000 soared by 10.36%, while the U.S. large-cap tech stocks fell, with the Nasdaq index dropping by 3.49%. On the day when the market's expectation of a Fed rate cut rose on July 11th, the Japanese authorities signaled a rate hike, causing a sharp appreciation of the yen, triggering a reversal of carry trade positions, with a large number of yen carry trade and short positions being closed out, leading to a 3.35% appreciation of the yen, which also drove the unwinding of short positions in the renminbi and the appreciation of the renminbi, as both currencies are involved in carry trades.

Ø The second stage is from July 18th to July 25th. The core contradiction was that the U.S. GDP data for the second quarter was better than expected, coupled with Trump's remarks on a Fed rate cut, leading the market to experience a violent swing in expectations after overextending the rate cut expectation, with gold plummeting by 4.23%, the 10-year U.S. Treasury yield rising from 4.16% to 4.29%, the Russell 2000 ceasing its rise and slightly falling by 1.8%, and the Nasdaq index further plummeting by 7.17% amid a sell-off of tech stocks.

Ø **The third stage is from July 26th to the present. The core contradiction was that at the end of July, U.S. economic data continued to cool down, with PMI data sliding more than expected, and non-farm payroll and unemployment data seeing a significant decline. The market quickly transitioned from overextending the rate cut expectation to swiftly passing through the soft landing rate cut trade, directly moving into the hard landing recession trade According to the latest calculation of the unemployment rate, the unemployment rate in the United States has surged by 0.6% from its low point earlier this year. After several months of consecutive unexpected increases in the unemployment rate, it has finally triggered the "Sam Rule" based on predicting a recession using the unemployment rate (when the three-month moving average of the U.S. unemployment rate minus the low point of the previous year's unemployment rate exceeds 0.5%). Coupled with the financial reports of technology companies such as Intel going bust, this may indicate that the U.S. economy has begun to enter a recession. During this period, gold surged by 5.63%, the Russell 2000 fell by 5.11% under recession expectations, the Nasdaq dropped by 2.36%, and the 10-year U.S. bond yield plummeted significantly by 50 basis points to 3.79% from 4.29%. Particularly noteworthy is the 5.81% single-day plunge of the Nikkei Index on August 2nd, and the offshore Renminbi exchange rate once surged by over 1000 points to 7.14 within a day.

Overall, the recent significant fluctuations in global capital markets can be summarized by two main factors. On one hand, it is due to the anticipation and trading of rate cuts and recession expectations, and on the other hand, it is caused by the reversal of international capital carry trades leading to drastic fluctuations in the foreign exchange and equity markets. In terms of asset performance, it is reflected as a "high cut low" globally, with high-flying U.S. tech stocks (Nasdaq), the Nikkei Index, the long-term devaluation of the Japanese Yen, and the weakening Renminbi exchange rate all experiencing resonant reversal pricing.

In the A-share market, influenced by the global "high cut low" style, the interest rate-sensitive small and medium-cap CSI 2000 Index has shown temporary excess, while high-flying varieties (such as dividend sectors) have seen pullbacks. In fact, upon review, it is found that near the official rate cut by the Federal Reserve, interest rate-sensitive small and medium-cap stocks have all shown excess performance, which can also be verified in the A-share market during the rate cut process in 2019. The sustainability of this trading opportunity depends on whether a continuous rate cut expectation is formed. If a continuous rate cut expectation is formed after the Federal Reserve's rate cut in September, and interest rates officially enter a downward channel, then the dominance of interest rate-sensitive small and medium-cap stocks will continue. If the Federal Reserve does not continue to cut rates continuously after the rate cut in September, then this dominance process will end. For A-shares, it is worth noting that as we approach the upcoming interim report disclosure period, the market's recent temporary focus on interest rate-sensitive oversold small and medium-cap stocks based on the "high cut low" must have performance support, otherwise they will face challenges. In the medium term, we have not revised our judgment on the "return to large-cap stocks"

Looking ahead, there are mainly two subsequent impacts of the recent global asset class volatility. Firstly, the tail risk on the numerator side, which is the potential upcoming recession in the United States. There is a possibility of the Federal Reserve cutting interest rates, not as a preventive measure like in 2019, but more like recessionary rate cuts seen in 2008 and 2001. The former triggers loose trading + recovery trading, leading to global funds overflowing from the U.S. market and benefiting A-shares; the latter triggers recession trading + safe-haven trading, resulting in a global resonance of risk assets moving downwards, with safe-haven assets like U.S. bonds and gold taking the lead. Which will come first, the recession or the rate cut? It still needs further confirmation based on the U.S. economic data in August. However, based on the Sahm rule recession indicator calculated from the U.S. unemployment rate, proposed by former Federal Reserve economist Claudia Sahm to predict economic recessions, when the 3-month moving average of the U.S. unemployment rate rises by more than 0.5 percentage points relative to the lowest point of the past 12 months, a recession may begin. This rule has had a 100% accuracy since the 1970s. After the July unemployment rate data was released, it has already exceeded the 0.5% threshold, indicating that the U.S. may already be in a recession. Out of the 11 signals issued by the Sahm rule since 1950, only the recession in 1960 occurred 5 months later, while the other 10 signals indicated that the U.S. was already in a recession when they appeared.

Secondly, on the denominator side, in an environment where the U.S. dollar weakens and the Chinese yuan appreciates, foreign capital flows back into RMB assets. On one hand, with the weakening of the U.S. dollar and the narrowing of the U.S.-China interest rate differential, the RMB exchange rate has broken the previous low volatility trend and experienced a significant appreciation. On the other hand, the appreciation of the RMB has a clear signaling effect on the inflow of northbound funds. However, it is important to note that the significance of the numerator-side logic may be stronger than that of the denominator side. Firstly, the main factor driving the current appreciation of the RMB is external, meaning it is primarily passive appreciation rather than driven by domestic economic recovery. Secondly, in the environment of recessionary interest rate cuts, the safe-haven properties of assets such as US Treasuries and gold may be more favorable than equity assets in emerging markets. Emerging markets will only receive USD liquidity overflow in the mid-term of interest rate cuts when the macro narrative shifts from recession to recovery. We reviewed several trading environments of US stock market declines + RMB appreciation since 2016 (such as early 2016, late 2018, and late 2021). A basic rule is that in the early stage of US stock market decline + RMB appreciation, A-shares are unlikely to achieve significant gains, and A-shares generally need to rise after the stabilization of the US stock market.

Fifthly, for positions with high dividend yields, it is obviously a focus of the current market. In fact, what we have repeatedly emphasized recently is: it is expected that the value-oriented group focused on high dividend yields is gradually entering the stage of bubble pricing, similar to the stage where the Maotai index was in after mid-2020. Objectively speaking, from the three major elements of the group: excess returns - incremental funds - logic not being falsified (termination conditions: 1. the end of the narrative of a soft landing in real estate leading to Japanization; 2. the AI productivity explosion marking the consumption revolution), it is expected that the value-oriented group-led pricing will be difficult to disintegrate in the second half of the year. Since the second quarter, what we have repeatedly emphasized is: the pricing in the high dividend yield field by the value-oriented group is not just about grouping, but it may further drive the continuous bubble pricing of core high dividend yield varieties (referring to the experience of high dividend yield stocks in Japan, based on the process of increasing the proportion of cash holdings while continuously increasing the dividend ratio, i.e., those varieties with a stable cash flow and an upward shift in ROE). It is expected that utilities will eventually surpass coal and banks to become the winners in high dividend yields.

1. From the perspective of actively long positions, the pricing of core high dividend yield varieties always depends on the comparison between dividend yield and long-term interest rates. The extreme pricing basis worth referring to is: in the process of high dividend yield pricing in Japan, the excess interpretation of high dividend yield stocks in Japan went through two stages: 1. the continuous decline of the 10-year government bond yield, corresponding to the 1990s; 2. the continuous increase in corporate dividend payout ratio, corresponding to the period of 2000-2008 when the central 10-year government bond yield in Japan did not decline but ushered in a larger wave of pricing. The peak of the bubble in high dividend yields lies in meeting two conditions: 1. the central long-term interest rate no longer declines further; 2. the corporate dividend payout ratio does not increase further.

2. Combining passive equity, from the perspective of fund allocation, it is clear that the pricing power of high dividend yields in the current stage is not controlled by actively long positions. Essentially, the development of passive equity investments centered on equity ETFs is driving the continuous evolution of the high dividend yield market. We believe that the potential for the increase in high dividend yield positions by actively long positions will be largely influenced by the development of equity passive investments centered on equity ETFs. It is worth noting that the weight of high dividend yield in the CSI 300 Index is about 20%, and the high dividend yield allocation of active long positions in the second quarter report is around 14%. In this process, if equity passive investments as the main growth body is an irreversible trend in the long term, then the proportion of high dividend yield allocation by active long positions in public funds will gradually approach the standard allocation position This article is written by Lin Rongxiong and Zou Zhuoqing, sourced from Lin Rongxiong's Strategy Salon, original title: "A-shares: Following the decline? Or independent market?"

Lin Rongxiong S1450520010001

Zou Zhuoqing S1450524060001