Hao Hong

Risk appetite is running high, yet big caps are outperforming instead of small caps. And cyclical assets such as commodities and US financials have corrected significantly. It is perplexing. The new financial regulation in China alone cannot explain this global phenomenon. The market is increasingly challenging, as big caps are becoming crowded, while smaller caps are fraught with risks.

China’s reflation trade has peaked last summer. At the time, the intensity of upstream commodity restocking also rolled over. For China, the reflation trade has long been over – contrary to consensus. Further, PPI inflation is surging globally, and cannot be explained by the supply-side reform in China.

When Chinese cyclical’s relative performance and upstream commodity inventory cycle peaked historically, it means fading momentum in the upward thrust of commodities, China’s 10-year treasury yield and US cyclical’s relative performance, rising real interest rate, as well as peaking Chinese property cycle. And the cyclical recovery that consensus is raving about will lose steam in the coming months. Indeed, defensive rotation in overseas markets will likely be concurrent with volatility surge, but may or may not correspond to the market’s final peak. Together with buoyant expectation, Chinese markets are vulnerable to a contagion.

It is hard to fathom a raging bull market amid tightening liquidity. China’s real interest rate has fallen to new lows that used to portend interest rate or RRR hike. It has been the real culprit behind the bubble in bond, property and commodities, as well as fast depreciating CNY. While inflation expectation is rising, growth may not eventuate, as investment will likely fall with property curbs. As such, the Chinese economy is stuck between mild cyclical reflation and outright stagflation. It will continue to traverse an L-shaped trajectory, as it has since 2012.