The recent insights from Goldman Sachs suggest that the A-shares market in China may be on the verge of a substantial catch-up reboundThe optimism among investors regarding China's growth and stock performance has notably surged since the launch of the DeepSeek-R1 modelOver the past few months, the MSCI China Index has witnessed a remarkable rise of 26% from its January lows, while the Hang Seng Tech Index, representing Chinese internet stocks, has soared by 31%. In stark contrast, the A-shares market has only seen a modest increase of 7% during this period.

In a report issued on February 23, Goldman Sachs indicated a strong likelihood of market leadership reversal when the earnings gap between A-shares and H-shares exceeds 15%. Their analysis posits that, bolstered by valuation advantages and favorable policy expectations, the A-shares market is expected to experience a catch-up rebound in the next three months, projecting an additional 2% excess returnThis forecast is critical for investors as it outlines the potential for significant profit in a market that has been underperforming relative to its H-share counterparts.

Additionally, the valuation premium of A-shares over H-shares has contracted from 34% three months ago to 14% currentlyIf this premium were to return to the previous year's average levels, it would indicate a potential 10% upside for A-sharesSuch improvements in valuation speak volumes about the shifting dynamics in the Chinese stock market and signal potential lucrative opportunities for savvy investors.

The Goldman Sachs A-H market rotation model suggests that a shift in market leadership could happen within a three-month time frame, with A-shares poised to deliver an anticipated 2% excess returnNotably, the gap between the returns of A-shares and H-shares has widened to 15% over the last three months, reaching a historic high at the 99th percentile of historical rangesThis marks the second-largest disparity since 2018, trailing only the significant surplus of over 30% from November 2022 to February 2023, when the MSCI China Index significantly outperformed the CSI 300 Index

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Historical trends suggest that relative returns for A-shares and H-shares generally fluctuate within a ±10% range; any deviation beyond this threshold carries a high probability of reversalPast evidence has shown that when A-shares diverge from H-shares by a margin exceeding 15%, there is a 95% chance of reversal in market leadership.

Goldman Sachs identifies key macroeconomic and market factors—such as economic growth, macroeconomic policies, regulations/geopolitics, company fundamentals, valuations, and liquidity/sentiment—that are influencing the stock marketsWithin this framework, the relatively lower valuations of A-shares coupled with anticipated macroeconomic policy stimulus are considered primary catalysts for a potential uptrend in A-shares.

Currently, the price-to-earnings (P/E) ratios for the MSCI China and CSI 300 stand at 11.5 times and 13.1 times, respectivelyThe narrowing premium of A-share valuations compared to H-shares—from 34% to 14% in recent months—indicates that A-shares may be undervaluedIf these valuations were to realign with their average from the past year, investors could see an approximately 10% increase in valuation.

Beyond mere numerical advantages in valuation, supportive Chinese policies are also viewed as crucial contributors to A-share performanceGoldman Sachs’ economists forecast that as global funds increase their allocation to Chinese markets, H-shares may continue to favor investmentSimultaneously, should more retail investors in China become involved, it could significantly bolster the A-share market.

Observing the flow of funds, global hedge funds currently allocate about 8.2% of their portfolios to Chinese stocksThis figure, while notable due to an increase of approximately one percentage point since last month, still falls short of the peak level of 9.8% recorded in October of last yearMeanwhile, global active funds maintain their allocations to China at around 6%, a level considered historically low

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This landscape suggests there remains ample room for overseas investments to increase, potentially continuing to prop up H-shares.

The A-shares market, however, is less susceptible to these global financial flowsA significant increase in participation from domestic retail investors could lead to a revival in A-sharesRecent trends such as robust net capital inflow from southern markets and funding purchases related to software and AI applications suggest a growing confidence among onshore investors, likely spurred by the advancements in AI technology.

In light of the above assessments, Goldman Sachs maintains an overweight rating for both A-shares and H-shares, albeit highlighting the more favorable outlook for A-shares to undergo a catch-up rally that may narrow the earnings disparity with H-sharesHaving analyzed various factors, it’s plausible that small-cap stocks will outperform larger counterpartsIndices such as the STAR 50, ChiNext Index, and the CSI 1000 likely stand to gain from a heightened exposure to AI-related sectors and a higher retail ownership ratio, positioning them well to benefit from improved market sentiment.

In the realm of larger-cap indices, the newly introduced CSI 500 is projected to outperform the CSI 300 due to its heavier exposure to technology and innovation sectorsDespite an overall inclination towards A-shares, Goldman Sachs notes that component stocks within the Hang Seng Technology Index could still benefit from upward revisions in earnings driven by artificial intelligence advancements.

Sector analysis reveals that hardware and software sectors linked to AI have surged by 20-40% in offshore markets over the past month; however, A-share counterparts have lagged behindMeanwhile, telecommunications and healthcare stocks have attracted strong interest from investors in mainland China, with increases of 22% and 10%, respectivelyIt is anticipated that as investors broaden their exposure to underperforming sectors, discrepancies in performance across industries may narrow

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