CICC: How much room is left after the big rise?

During the National Day holiday, the Hong Kong stock market and the Chinese concept stock market continued to soar, extending the strong performance of the last week of September, exceeding the expectations of many market participants. From September 30th to October 7th, among the major indices, the Hang Seng Index rose by 12.0%, the MSCI China Index and the Hang Seng China Enterprises Index rose by 11.5% and 14.1% respectively, and the Hang Seng Tech Index surged by 21.0%.

By the end of these three short weeks since mid-September, the Hang Seng Index had risen by over 30%, and the Hang Seng Tech Index had surged by over 50%, which is quite remarkable compared to any historical period.

In terms of industries, the leaders during the National Day holiday were diversified financials (+26.0%), insurance (+19.4%), real estate (+19.3%), consumer discretionary (14.9%), and healthcare (+13.7%), which are high-elasticity cyclical sectors mainly driven by market sentiment rather than fundamentals. On the contrary, banks (+4.7%), utilities (+5.3%), and energy (+6.8%) lagged behind.

Chart: In terms of industries, the leaders are non-banking financials, insurance, real estate, and other high-elasticity cyclical industries

Source: FactSet, CICC Research Department

In recent discussions, we have generally felt that investors are confused and even worried about the speed and magnitude of this round of rebound, with questions mainly focused on: What drove this rapid rise? Where is the current market positioned? How much room is there for further development? How to participate in the subsequent market movements? Building on the analysis of "Space Under the New Round of Policies," we further quantitatively analyze and estimate in this article.

I. What are the driving factors of this round of market trends? Amplified sentiment and short squeeze assistance

The starting point of this round of market trends comes from the change in policies and expectations, especially the direct encouragement of the three financial ministries for the private sector to leverage up in the stock market and real estate, as well as the core changes in policy signals focusing more on consumption and people's livelihood conveyed at the political bureau meeting. We have elaborated on this in detail in "Space Under the New Round of Policies."

However, the rapid evolution of the market trends may have caught most people off guard, and to achieve this, it is probably difficult without the coordination of sentiment and capital, as vividly demonstrated in the performance of the Hong Kong stock market during the National Day holiday.

1) Firstly, at the industry level, the leaders are non-banking financials, insurance, real estate, and other high-elasticity cyclical industries, which are highly correlated with market trends and not primarily driven by fundamental logic.

2) Secondly, from a technical indicator perspective, the market has already shown signs of being overbought and overextended. For example, the relative strength index (RSI) measuring the degree of overbought conditions reached 90.9 on October 2nd, hitting a new highBreaking down this round of market trends, starting from the policy announcement on September 24th, the Hang Seng Index has seen a 21.6% increase, with profit contribution basically negligible and valuation expansion contributing 21.5%. Further breaking down the valuation, the decline in risk premium contributed 19.8%, while the risk-free rate actually increased.

Chart: On October 2nd, the 14-day RSI reached a high of 90.9

Source: Bloomberg, CICC Research Department

Chart: Almost all of this round of market trends are contributed by risk premium

Source: Bloomberg, CICC Research Department

Chart: The risk premium of the Hang Seng Index quickly dropped from a high of 9.5% on September 11th to 6.0%

Source: Bloomberg, CICC Research Department

3) Thirdly, "short squeeze" boosts the rebound. At the start of this rebound, short selling volume and its proportion of total trading volume in the Hong Kong stock market increased (peaking at 19.9%), indicating that some market participants were skeptical about the sustainability of the rebound and shorted during the process. However, during the National Day holiday, as the market rebounded significantly, short selling volume and proportion both decreased significantly, dropping below 14% during the holiday and recently rising again.

Moreover, the sharp rise in the market forced long-term funds that were previously "underweight" to increase their positions to prevent underperformance. The latest fund flow data from EPFR shows that overseas active funds saw their first inflow in 14 months, which we will further analyze in the following sectionsChart: Short selling transaction ratio once dropped below 14%

Source: Bloomberg, CICC Research Department

Chart: Overseas active funds saw the first inflow in 14 months

Source: Bloomberg, EPFR, CICC Research Department

II. Which funds are the main inflows? Passive and trading funds were the main ones in the early stage, and active foreign funds have recently started to return

The rapid rise in the market naturally requires the support of funds, otherwise it cannot be so "extreme". Therefore, analyzing which funds are the main inflows is crucial for judging the sustainability of inflows and future space.

First of all, it needs to be clarified that unlike passive ETF funds dominating in developed markets, according to MSCI's statistics on the volume of funds tracking its global index, in emerging markets, the scale ratio of passive and active funds is 20:80, with active funds being the absolute majority. Therefore, we recommend focusing on the trend of active funds, which is also why EPFR passive funds have been continuously flowing in for the past three years, but have almost no explanatory power for the market.

Chart: If foreign funds return to the standard allocation of Chinese stocks with improved fundamentals, it is expected to bring about a return of approximately $74 billion, a scale higher than the overall outflow of active foreign funds since 2022 (approximately $50.5 billion)

Note: Data as of October 7, 2024 Source: Wind, CICC Research Department

During the holiday period, the Shanghai-Hong Kong Stock Connect southbound channel was closed, providing us with a good "control variable" window to observe overseas funds. After synthesizing EPFR data from the past two weeks and feedback from various sources, we can tentatively conclude:► In the early stage of rebound, the main force of funds is mostly passive (ETFs, mainly individual investors) and trading (hedge funds), while overseas active funds are still flowing out, which is consistent with the characteristics of these two types of investors who act quickly or are easily influenced by emotions;

► After a continuous rise, passive funds still flowing in indicate excessive excitement, trading funds may be somewhat overdrawn, reflected in short covering, and active funds also show inflows mainly to avoid falling too far behind.

Specifically, 1) Passive foreign funds are accelerating inflows and remain the main inflow. As of this Wednesday (September 26th to October 2nd), passive funds flowed into Hong Kong stocks and ADRs by $2.87 billion, which is 3-4 times the size of last week, reaching a new high since 2016. Regionally, funds investing in China are the main focus, with a small inflow of global funds;

2) There is a certain overdraft of trading funds, judging from the changes in the short selling transaction ratio, we speculate that hedge funds may have forced liquidation, so they may not necessarily be the main force of funds.

3) Active foreign funds have turned into inflows. As analyzed above, active funds are more important for the sustainability of the market in the future, this week overseas active funds turned into inflows of $190 million in A-shares, $120 million in Hong Kong stocks and ADRs, although the scale is not large, it is the first time since the end of June 2023 that there has been a continuous outflow for 65 weeks. Regionally, funds mainly investing in China and the Asian region are the main focus, while funds investing in emerging markets and globally have not yet flowed in, which may be related to some active funds being forced to reduce underweight positions to prevent falling too far behind.

Chart: EPFR statistics on the inflow of foreign funds into Chinese stocks by investment direction

Note: Data as of October 2, 2024 Source: Wind, CICC Research Department

III. How much more room is there for foreign funds to flow in? Active foreign funds are more important, turning into standard allocation will bring in $74 billion

As we have emphasized before, trading and passive funds, due to their flexibility, tend to flow in early in the rebound, but they also face the problem of lack of sustainability. A typical example is the rapid inflow of trading funds during the sharp rise in April-May, but EPFR active foreign funds did not show a clear return flow, and the rebound market eventually did not continue. On the contrary, if the repair of the fundamentals leads to more active long-term funds flowing back, the market space will be larger.

The massive inflow of long-term active foreign funds, especially significantly overweight, still needs to be based on the improvement of fundamentals, we estimate the following based on two different scenarios:1) If all the funds that have flowed out since the beginning of this year return, it would amount to approximately $10.7 billion, equivalent to 39% of the outflow from the peak in 2021 and 49% of the outflow in 2023.

In May this year, amid fluctuations in the external markets, some funds in the "main battlefield" flowed back to the Chinese and Asian markets, but subsequently flowed out again due to a lack of further fundamental support. Roughly speaking, using all the funds that have flowed out since the beginning of this year as a reference, according to EPFR's calculation, it is equivalent to 39% of the outflow from the peak in 2021 and 49% of the outflow in 2023.

2) Long-term foreign capital returns to standard allocation, corresponding to an inflow of $74 billion. The latest data from EPFR shows that as of the end of August, the proportion of active funds of all types globally allocated to Chinese stocks has decreased from 14.6% of their assets under management at the beginning of 2021 to 5.0%, about 1 percentage point lower than passive fund allocations.

However, considering that both A-shares and Hong Kong stocks have rebounded significantly since the end of August, the allocation data as of the end of August is obviously outdated. Therefore, we attempt to fit the current global fund allocation proportions by analyzing the changes in the weight of Chinese stocks in various types of global index components and calculate the potential inflow space in the future.

Chart: If active funds as a whole shift from underweight by 1.9 percentage points to standard allocation, it is expected to bring in approximately $74 billion in the long term.

Data source: Bloomberg, EPFR, CICC Research Department

Taking the MSCI ACWI Index as an example, the weight of Chinese stocks was about 2.75% on August 31, and this proportion has since increased by about 0.8 percentage points to 3.58%. Using the same method, we calculate the changes in the weight of Chinese stocks in the MSCI Emerging Markets, Asia ex-Japan, and Global ex-US indices during the same period, and weight them based on the AUM of various types of funds tracked by EPFR.

Finally, it is estimated that the overall proportion of passive funds globally allocated to China has increased by about 1.7 percentage points from 6.0% at the end of August to 7.7%. Compared to passive funds, the allocation changes in active funds are often limited in the short term and lag behind. Assuming that the increase in the allocation of Chinese stocks in various types of active funds is about half of that in passive funds, i.e., rising from the current 5.0% to about 5.8%.

Based on this assumption, we calculate that if active funds as a whole shift from underweight by 1.9 percentage points to standard allocation, it is expected to bring in approximately $74 billion in the long term.Within the EPFR scope, the scale of active foreign capital outflow from Chinese stocks since 2022 (approximately $50.5 billion) is even higher by nearly 50%. However, based on historical experience, active fund inflows or even overweight positions require improvements in domestic fundamentals and profit expectations.

Chart: Fund sizes tracking the MSCI Index

Source: EPFR, CICC Research Department

IV. What expectations are currently priced into the market? Short-term technical indicators are clearly overbought, with sentiment similar to the early 2023 peak; focus on whether fiscal measures meet expectations

After two consecutive weeks of rapid gains, short-term sentiment has clearly become overbought, similar to the optimistic sentiment at the beginning of 2023: 1) The Hang Seng Index risk premium has rapidly declined from its peak of 9.5% on September 11 to 6.0%, below the historical average since 2010, reaching a new low since January 2023, indicating that the current optimistic sentiment is on par with the early 2023 peak.

2) The dynamic valuation of the MSCI China Index has risen rapidly from its low of 8.6 times on September 11 to 11.7 times, exceeding the historical average of 11 times since 2010. The Hang Seng Index's dynamic P/E ratio has also increased from 7.9 times to 10.5 times, reaching a new high since January 2023.

Chart: Hang Seng Index's dynamic P/E ratio has increased from 7.9 times to 10.5 times, reaching a new high since January 2023

Source: Bloomberg, CICC Research Department

Therefore, after factoring in sufficient optimism, the key going forward is whether subsequent policies can meet or even exceed these expectations. Currently, compared to monetary and real estate-related policies, the key lies in addressing the ongoing credit tightening in China's private sector, namely whether fiscal expansion is fast enough and strong enough. In our report "Market Space Under the New Round of Policies," we estimate that 1) a 45-70bp rate cut could solve the issue of excessively high financing costs2) Fiscal increment of 7-8 trillion yuan may boost investment return expectations. Considering the current market expectations, a fiscal stimulus of 2 trillion yuan is basically in line with expectations. We expect the market to potentially shift to high-level volatility after a rapid rise to digest the previous rapid gains. If the stimulus exceeds this scale, it can bring additional momentum, and vice versa.

Chart: The weighted average interest rate of corporate loans (3.63%, likely to decrease to 3.43% in October) is higher than the ROA of A-share non-financial listed companies (2.87%).

Source: Wind, CICC Research Department

Chart: The growth rate of social financing is expected to recover to 10% within the year (the level at the beginning of 23), requiring an additional issuance scale of 7-8 trillion yuan.

Source: Wind, CICC Research Department

V. How much room does the market have left? If sentiment further recovers to the early 2021 high, corresponding to around 24,000 points for the Hang Seng Index, but from a fundamental perspective, it is somewhat strained

We previously calculated in "Market Space Under the New Round of Policies" that if the risk premium improves to 6.1% corresponding to the high point after the epidemic is lifted in early 2023, the Hang Seng Index is expected to reach around 22,500.

The market has indeed reached this position, but faster than we expected. As the market's upward movement is entirely driven by the risk premium, which is sentiment-driven, in the short term, with risk-free interest rates rising (expectations of a Fed rate cut cooling, pushing U.S. bond yields back above 4%), and profit improvement requiring greater fiscal efforts to achieve, further improvement in sentiment clearly requires stronger policy expectations support, which is also the main method and basis for our index point calculation.

1. Assuming current risk-free rates in China and the U.S. remain unchanged, if sentiment further improves to push the risk premium down to 5.4% in February 2021, the Hang Seng Index would approach 24,000 points; 2) If profits grow by 10% (returning to 2021 levels, with the baseline expectation at 2-3%), combined with a decrease in the risk premium to 5.4% in February 2021, the Hang Seng Index would approach 26,000 pointsHowever, we believe that achieving the situation in 2021 is somewhat difficult. At that time, China's supply chain was recovering the fastest globally, while the real estate market was also at a historical high, making it difficult to compare the balance sheets of various sectors.

Chart: Emotions further recovered to the early 2021 peak, corresponding to the Hang Seng Index at 24,000 points, but it is somewhat challenging from a fundamental perspective.

Source: Bloomberg, CICC Research Department

Chart: The current dynamic valuation of the MSCI China Index has quickly risen from a low of 8.6 times on September 11 to 11.7 times.

Source: Bloomberg, CICC Research Department

VI. Review of Historical Bottom Features: Currently somewhat similar to 2019, while 2015 saw a rapid rebound driven by liquidity

The relatively loose macroeconomic policy environment both internally and externally is one of the conditions that help the Hong Kong stock market bottom out and start an upward trend. In our analysis of "Historical Bottoms and Rebounds in the Hong Kong Stock Market," we pointed out that looking back at several rounds of bottom rebounds, there were different characteristics in terms of economy, policy, and market performance domestically and internationally. Simple averages of historical experiences may lack significance, indicating that finding more similar macro stages for comparison is more critical.

Comparing the internal and external policy environments during previous bottom periods in the Hong Kong stock market, we found that the appearance of bottoms usually coincides with the opening of a loose domestic or overseas policy environment or the pause and termination of a tightening cycle. We also compared the two rapid market rebounds in the first quarter of 2019 and from the end of 2014 to the middle of 2015.

► The Fed's halt to rate hikes in the first quarter of 2019 opened up space for domestic policies: Taking the 2019 Fed rate cut cycle as an example, the significant rebound in A-shares and Hong Kong stocks actually occurred in the first 1-3 months when Powell announced the halt to rate hikes, rather than the formal start of rate cuts in July-September. The main reason for this was that when Powell announced the halt to rate hikes at the beginning of 2019, U.S. bond rates and the USD/CNY exchange rate both weakened, which may have opened up space for domestic policies from the perspectives of the U.S.-China interest rate differential and exchange rateAt this time, the People's Bank of China also decided to significantly cut the reserve requirement ratio, creating resonance internally and externally, igniting the market's bullish sentiment. However, after experiencing the valuation repair brought about by the loose monetary policies of China and the United States in the previous period, along with factors such as the first-quarter monetary policy report of the central bank reiterating the "total gate of monetary policy" and the reverse of the loose policy of the Federal Reserve, this rebound came to a halt after April, and the overall index entered a sideways range.

► From the end of 2014 to the middle of 2015, loose monetary policy drove liquidity expansion, and leverage in the secondary market promoted a general market rise. In comparison, from the end of 2014 to 2015, China cut interest rates 6 times and the reserve requirement ratio 4 times, coupled with the rapid development of margin trading business, driving the market upwards. Loose liquidity drove non-banking, financial, and real estate sectors to lead the gains.

At that time, the growth had not yet improved, the Producer Price Index (PPI) remained negative, and lacking fundamental support, the ChiNext board and growth stocks significantly outperformed, becoming the main theme of this round. However, after this round of market surge, there was a significant pullback due to policy tightening and investor sentiment reversal.

Looking back, the start of this round of rebound also came from the Federal Reserve's interest rate cuts opening up space for domestic policies, and domestic loose policies resonating as a result. Therefore, the overall market situation to some extent is also similar to that of 2019.

Since mid-September, the Federal Reserve's "unconventional" 50 basis points interest rate cut to boost market sentiment in the external environment, corresponding to the restoration of the Hang Seng Index; in the internal environment, the policies of the three financial commissions and the Central Political Bureau meeting ignited market sentiment beyond expectations, with the core being the direct encouragement of the private sector to leverage up (stock market and real estate) through various financial policies, and more emphasis on people's livelihood and consumption, conveying signals and ideas that are not completely the same as before. We believe that the market's future trend will depend more on the strength and speed of subsequent policies, especially the fiscal stimulus.

Article by: Liu Gang, Wu Wei, Zhang Weihan, Wang Muyao, Source: CICC Insight, Original Title: "CICC: How much room is there after the big rise?"