Overseas shocks may trigger a style change in A-shares

Abstract

Global capital markets experienced a sharp decline on Monday, with a reoccurrence of "Black Monday 1987". The Japanese stock market led the global decline, triggering circuit breakers at one point, erasing most of the gains since the beginning of the year, and almost no Asia-Pacific stock indices were spared.

Our analysis:

1. There has been intense volatility in overseas markets recently, with the unwinding of carry trades and more significantly, deleveraging.

2. Due to the narrowing of the interest rate differential between Japan and the United States, the Japanese yen has appreciated, leading to continued carry trade unwinding, which involves selling off dollar assets and repatriating funds to Japan.

3. The carry trade unwinding has resulted in short-term U.S. Treasury rates not decreasing and has also impacted the earnings per share (EPS) of Japanese stocks priced in yen, affecting the performance of the Japanese stock market.

4. The suppressed performance of the Japanese stock market may prompt some Asia-Pacific funds to selectively opt for Chinese assets in the short term.

5. If these Asia-Pacific funds choose Chinese assets, they are likely to focus on industries with long-term growth potential rather than traditional industries with high valuations.

6. Inflow of funds into specific industries would further drive changes in the style of the A-share market.

Risk warning: 1) Economic recovery falls short of expectations; 2) Federal Reserve's interest rate cuts are slower than expected; 3) Geopolitical "black swan" events affecting foreign capital flows.

I. Intense Overseas Volatility Resulting from Deleveraging

One aspect is the deleveraging surrounding NVIDIA. This year, NVIDIA rapidly rose to become a member of the "3 trillion dollar club". It became a major holding for many institutions, with many family offices stating, "If you only buy one stock, it should be NVIDIA". This has led to a significant amount of NVIDIA derivatives in the market. As NVIDIA's stock price falls from its highs, it inevitably triggers a large number of derivative unwinds. In a sense, this is a deleveraging process.

Another aspect is the deleveraging in the Japanese stock market. We believe that the sharp fluctuations in Japanese stocks are not solely due to the appreciation of the yen, but rather the result of rising Japanese interest rates. In fact, including foreign investors like Warren Buffett, the mainstream approach for investing in Japanese stocks is to borrow yen to buy Japanese stocks. Two months ago, the yield on Japan's 10-year government bonds surpassed 1%, reaching a nearly 10-year high. After the Bank of Japan announced a 15 basis point rate hike, the 10-year bond yield continued to rise to 1.07%. This led investors who previously borrowed yen to buy Japanese stocks to sell off their holdings, triggering a significant amount of quantitative trading strategies and causing market volatility.

![](https://wpimg-wscn.awtmt.com/a7f5f2dc-2447-4f35-b187-0f7c72469e56.png? If the market fluctuations in the past were only explained by carry trade unwinding, there are two phenomena that cannot be explained:

1. The typical operation of carry trade unwinding is selling off USD assets for JPY. However, the current decline in US stocks is more due to recession trading, and we have not seen abnormal declines in US stocks caused by carry trade unwinding. In other words, the current US stocks do not reflect a crash-like decline caused by unwinding trades. The market is concerned that US employment data may trigger the Sam Law, leading to panic about a US economic recession, which can also be seen from the significant fluctuations in the VIX index.

2. The main entities involved in carry trade unwinding should be short-term US bonds, but we have not seen large-scale selling of one-year or two-year US bonds.

Carry trade unwinding involves more trading between USD assets and JPY, which cannot explain the significant drop in Japanese stocks, even digesting nearly a year's worth of gains in a single day. Therefore, we believe that there has been carry trade unwinding in the past period, but it is not the main cause of the recent market turmoil.

The Spread between JPY and USD is Narrowing, There Will Be Carry Trade Unwind in the Future

Carry trade unwind has already occurred in the past, and in the future, we believe it will continue, mainly due to the appreciation of the Japanese yen. Considering that the Federal Reserve will start cutting interest rates in the second half of the year, while the Bank of Japan will raise interest rates, the spread between JPY and USD will narrow. The trend of narrowing the spread between USD and JPY implies that the Japanese yen will further appreciate. During the yen appreciation process, Japanese financial institutions will continue to sell off USD assets and repatriate funds to Japan.

If carry trade unwinding continues, what potential impacts will it have?

1. The short-term U.S. Treasury bond interest rates may remain high, further reinforcing the recession logic. Arbitrage traders borrow low-interest yen to purchase high-interest assets, with 1-year and 2-year U.S. Treasury bonds being the main investment targets. If the arbitrage trading continues in reverse, short-term U.S. Treasury bonds will become the main selling targets, leading to high or even rising short-term U.S. Treasury bond interest rates, exacerbating the yield curve inversion.

2. The rise of Japanese stocks is hindered. The main profits of Japanese listed companies come from overseas, and the appreciation of the yen will dilute Japanese corporate profits. The growth rate of profits denominated in yen may be flattened, with EPS growth rate likely to be 0, and the performance of Japanese stocks will be disrupted.

4. If the rise of Japanese stocks is hindered, what does it mean for the Chinese stock market?

If the short-term rise of Japanese stocks is hindered, some global Asia-Pacific funds may temporarily shift into Chinese assets.

From the perspective of fund behavior, some global Asia-Pacific funds can only allocate within the Asia-Pacific region. Apart from the Japanese market, there is no other market in the Asia-Pacific region with sufficient fund capacity. Therefore, in the case of "rebalancing," these funds will temporarily choose the Chinese market.

From the perspective of economic fundamentals, in the second half of the year, China's nominal GDP is expected to rise, which will also be a reason for the temporary inflow of foreign funds. We believe that nominal GDP is expected to rise on a quarter-on-quarter basis, mainly based on the likely increase in fiscal expenditure in the second half of the year. Drawing a parallel to the pace of fiscal efforts in 2023, the fiscal efforts in the second half of the year will be more pronounced compared to the first half. Fiscal efforts in the first half of this year were also lower than historical levels, so fiscal expenditure in the second half of the year will accelerate. Against this backdrop, this will help improve nominal GDP.

If the Japanese stock market declines and the nominal GDP in China increases on a month-on-month basis, we believe that overseas funds will flow into Chinese assets in stages.

V. What to Buy If Foreign Capital Flows Back into China in Stages?

In terms of industry selection, preferences will still lean towards the "old favorites" of the past 20 years: 1) globally competitive new energy and automotive industries; 2) irreplaceable general consumption, such as baijiu in the food and beverage sector; 3) technology and internet companies supported by the world's largest middle class.

VI. How Will Industry Styles Evolve If Foreign Capital Flows into Chinese Assets in Stages?

If foreign capital flows into China in stages, will the extreme large-cap style in the first half of the year converge? Value stocks may not necessarily continue to outperform growth stocks, and the CSI 100 Index may not necessarily continue to outperform the CSI 500 Index. Over the past two years, the cumulative return of the CSI 100 Index relative to the CSI 1000 Index has exceeded 120%, indicating a very clear extreme style performance. In the second half of the year, this extreme interpretation may converge, and the CSI 500 and CSI 1000 may no longer underperform the CSI 100.

Authors: Chen Li, Chen Meng; Source: Chen Li lichen; Original Title: "Overseas Shock May Trigger Changes in A-Share Style"