Two weeks ago, our view was to go long on the Shanghai Composite while anticipating volatility in the Nasdaq. Looking back now, our judgment proved correct. Reducing exposure to cope with Nasdaq volatility, while going long on Chinese equities related to artificial intelligence and robotics, has both reduced portfolio volatility and enhanced excess returns. These strategies have aligned well with recent market momentum. We believe that in the near term, the Nasdaq is likely to stage a modest rebound, while the extreme rally in A-shares will likely persist for a short period.
Economic cycle theory underscores an important point: small changes in industrial policy can trigger large shifts in output and capital markets, with these impulses amplifying over time. Since the Central Financial and Economic Affairs Commission meeting, asset prices—from futures to equities, and now bonds—have undergone significant adjustments. Yet, from a technical standpoint, the correction is not complete.
This week, expectations of a concentrated rally in the government bond market began to unravel. The 10-year government bond yield climbed to 1.78%, while benchmark bond futures contracts (2512 and 2603) plunged. Across futures, equities, and bonds, the influence of capital flows on asset price movements is becoming increasingly profound. The bond market, being the cornerstone of the capital system, is particularly critical. Since last year, the central bank has repeatedly warned smaller institutions about the risks of going long in government bonds. Yet bond futures continued their strong rally, with 10-year yields once falling to 1.6%. Now, yields have risen by 18 basis points. If small and mid-sized financial institutions failed to stop losses in time, it will be difficult for 10-year yields to return to 1.6%. With this shift in expectations, selling pressure in the bond market is set to intensify.
The changes in the government bond market highlight not only shifts in retail and speculative flows, but also potential adjustments in institutional positioning. Technically, bond futures contract 2512 remains some distance from key support levels, while 2603 has already reached its support platform. Whether buying momentum will emerge here remains to be seen. If this support breaks, the bond market could face a wave of forced liquidations, threatening the balance sheets of smaller financial institutions and undermining overall financial stability. Regulators may be forced to intervene.
Two weeks ago, we argued that regulators were unlikely to issue strong guidance to rein in this bull cycle, and this has indeed played out. The key question now is: what are the appropriate levels for the Shanghai Composite and government bond futures? Our views are as follows:
Bond Market Stability as Priority:
If a choice must be made between stabilizing equities and bonds, bond market stability will likely take precedence. A rapid rise in yields can trigger institutional bankruptcies, as illustrated by Silicon Valley Bank’s collapse in the U.S. Given the high leverage in bond markets, sharp short-term fluctuations could set off chain reactions. At such moments, regulatory intervention to stabilize bonds is necessary. During the previous bond rally, the PBoC intervened—pausing purchases and issuing window guidance—to prevent yields from falling further. At that time, yields hovered around 2.0%. We believe yields may once again approach 2.0%, and as that level nears, the PBoC could resume bond purchases. The timing of such purchases may prove pivotal in future market dynamics.
Yield Trajectory and Equity Support:
The move from 1.78% toward 2.0% in 10-year yields may take some time. Meanwhile, large-scale capital flows will continue to support A-shares. If the PBoC restarts bond purchases, this may temper A-share momentum, presenting a regulatory challenge. That said, with the Shanghai Composite breaking above 3,800, daily turnover exceeding RMB 2 trillion, and total market capitalization surpassing RMB 100 trillion, the foundation of a bull market is in place. Cooling excess liquidity at this stage is unlikely to trigger systemic collapse. Furthermore, resuming bond purchases represents a softer, market-based form of intervention, leaving ample room for communication with markets.
The “Liquidity-Driven” Bull Market:
While many view this as a liquidity-driven bull run, we believe the balance point—10-year yields returning toward 2% alongside A-shares advancing deeper into a bull market—remains some distance away. This reflects the long-tail effect of China’s regulatory adjustments materializing in asset prices. Valuations in innovative sectors are driving this cycle, with robotics (sensors, mechanical transmission) and AI-related plays (optical modules, chip manufacturing) forming the bull market’s core. In comparison, large-cap indices such as the SSE 50 and Hang Seng have not deviated significantly from fundamentals. Thus, the risk concentration lies in technology valuations, though not yet severely divorced from underlying fundamentals.
Technology Valuations and Geopolitical Context:
The recovery in Chinese tech valuations traces back to the SME Entrepreneurs’ Symposium earlier this year, extending from internet platform reforms to today’s semiconductor push. This reflects both genuine technological progress and the ongoing U.S.-China tech rivalry. China is undoubtedly poised to be a vast semiconductor market, spanning chip manufacturing, optical modules, foundational software, and large-model AI training. This underpins the lofty valuations of companies like Cambricon and Foxconn Industrial Internet. Following news that Nvidia would sell its H20 chips to China, Besant argued in an interview that H20 is a low-end product, posing no threat to U.S. chip dominance, and that he opposed the emergence of an independent Chinese chip standard system. This stance underscores U.S. intentions to contain China’s standards-setting ambitions. In response, both regulators and industry in China are pushing back. The fact that Cambricon and Foxconn Industrial Internet now rival the market capitalizations of China Mobile and China Unicom reflects this structural shift. Beyond semiconductors, rare earths have also become strategic. On Friday, regulators mandated traceability systems for rare earth producers—clearly targeting U.S. chip sanctions. From refining to final distribution, China aims to secure control. The rare earth sector could, in time, rival PetroChina and Sinopec in market value.
Macro Backdrop and Policy Outlook:
July’s macroeconomic data suggests the previous round of stimulus-induced growth pulses is fading, with a broad decline in activity. Weakness in liquor and automotive consumption confirms that rate cuts and bond issuance alone may not be sufficient to counter structural contraction. Some argue that policy rates remain too high, but this conflicts with the PBoC’s stance on preserving deposit pricing power. We see limited room for rate cuts. Moreover, China’s approach to debt resolution—largely via extensions—has raised the effective cost of debt as inflation remains subdued, further restraining demand recovery. Structural monetary policies have proven insufficient to reduce borrowing costs, while fiscal subsidies for production and household fertility remain negligible in effect. In our view, macro policy can tolerate one to two more months of weak demand data before shifting into a full-scale fiscal expansion. At that stage, markets may once again begin discussing the prospect of a RMB 10 trillion stimulus plan.
