Xingzheng Strategy: External shocks' impact on A-shares is gradually diminishing; focus on opportunities with confirmed economic prospects

1. Overall, the market is pricing in “stagflation” and “escalating conflict intensity,” which may not be the final outcome of this round of conflicts.

This week, with no signs of easing in US-Iran tensions, two core concerns triggered a concentrated market adjustment and rapid sector rotation. On one hand, the market is beginning to price in a prolonged conflict stalemate and high oil prices leading to “stagflation” expectations, as well as the liquidity tightening pressures from the Fed delaying or even reversing rate cuts. These have become the main contradictions in asset pricing recently. On the other hand, the market is also quickly rotating structurally in response to marginal changes in conflict intensity—defensive assets outperform when tensions heat up, while technology stocks lead the recovery when tensions cool.

Regarding the current two core market concerns—economic “stagflation” and “escalating conflict intensity”—and the potential systemic risks to the stock market, we believe this may not be the final outcome of this conflict cycle. Recent market adjustments have already priced in considerable pessimism, and there remains a significant “expectation gap,” which could present opportunities for market recovery after the correction.

First, regarding the transmission of high oil prices to the economy, inflation, and policy orientation, the market currently tends to compare with the pessimistic scenarios of the US two oil crises in 1970 and the Russia-Ukraine conflict in 2022. However, we believe there are clear differences in terms of economic cycle position, sensitivity of inflation and the economy to oil prices, and the demand support for continued price increases:

1. Before the first two oil crises and the Russia-Ukraine conflict, the US was already in an inflationary cycle, directly influencing the Fed’s monetary policy stance after high oil shocks. In contrast, prior to this round, overall inflation pressures are controllable, and the likelihood of rate hikes remains lower. Historically, before those crises, US inflation was already rising above 5%, leading the Fed to prioritize anti-inflation measures and raise rates, which suppressed equities. Currently, US CPI year-over-year remains at a low 2.4%, similar to levels in 2003 during the Iraq War and 2011 during the Libyan civil war, and even during the higher inflation period of the third oil crisis, the Fed viewed inflation as manageable and maintained an easing monetary policy cycle, supporting equities in the medium to long term.

2. The biggest difference from the two previous oil crises is that the sensitivity of the US economy and inflation to oil prices has significantly decreased. The era of oil prices solely dominating economic, policy, and asset prices is over. Since the post-crisis energy transition and the breakthrough of shale oil technology in 2010, the US has shifted from the world’s largest oil importer to a net exporter. The energy component’s weight in CPI has fallen sharply, and the impact of high oil prices on the economy and inflation has become more moderate. The era where oil prices alone dictated economic and policy directions has ended.

3. Unlike during the 2022 Russia-Ukraine conflict, when strong domestic demand and smooth price transmission supported inflation, the current US PPI-to-CPI transmission lacks sufficient demand support, further easing the inflationary pressure from high oil prices. Before 2022, US consumers benefited from large direct cash subsidies, and post-pandemic demand surged, allowing upstream high oil prices to pass through to consumer prices smoothly. In 2011, after the global financial crisis, demand remained weak, and despite high oil prices pushing PPI sharply higher, the transmission to CPI was limited. This cycle, after sustained high interest rates since 2022, has weakened consumer purchasing power, and the PPI-to-CPI transmission lacks demand support. The Fed’s monetary policy focus remains on CPI. Currently, the market only expects inflation to rise significantly following the February PPI increase, reflecting a large “expectation gap.”

Therefore, these three differences suggest that “stagflation” may not be the ultimate baseline scenario. The Fed is likely to remain cautious in the short term, with continued rate cuts in the second half of the year being highly probable. The current overly pessimistic market expectations for policy are likely to gradually correct. According to calculations by the Industrial Securities macro team, if WTI oil prices stay at $70/$80/$90/$100 per barrel through the end of the year, the US CPI year-over-year central tendency would be approximately 2.87%/3.08%/3.30%/3.51%. Considering that 3.5% is the lower bound of the current federal funds rate, inflation remains controllable. The Fed’s short-term cautious approach and potential rate cuts in the second half are highly probable. Currently, the implied first rate cut in CME futures has been pushed back to September next year, with some rate hike expectations embedded. The market’s pessimistic expectations are already priced in, and as rate cut expectations rebound, the space for equity recovery opens up.

For the domestic market, the previous adjustments in A-shares during oil supply shocks mainly stemmed from internal inflation pressures leading to proactive monetary tightening (2003, 2011), or from external factors like significant overseas rate hikes combined with weak domestic demand creating a “domestic and external dilemma” (2022). This cycle, the Fed’s continued easing remains the baseline, and with domestic inflation pressures modest, there is little risk of proactive monetary tightening. Moderate inflation provides positive support for nominal economic recovery and corporate profits, and the fundamental factors supporting this bull market have not changed significantly.

Finally, regarding the future development of this conflict, we maintain the view that “escalation is for better de-escalation.” Short-term escalation of conflict intensity may create opportunities for de-escalation later. With the US threatening to destroy power plants, deploying troops to seize islands, issuing ultimatums, and Iran’s potential retaliations such as blocking the Red Sea or attacking oil facilities, the market may temporarily see increased geopolitical premiums. However, in the medium term, such premiums may face obstacles. The US’s political goal has shifted from regime change in Iran to reopening the Strait of Hormuz, and negotiations are more likely to achieve this than military victory. Therefore, whether it’s troop deployments or island seizures, the core aim is to exert maximum pressure on Iran to facilitate the Strait’s reopening. The ongoing escalation may not be the final outcome; negotiations remain the baseline. If conflict intensity continues to escalate in the short term, high oil prices and tactical setbacks for the US military could catalyze greater willingness from Trump to negotiate, creating an opportunity for both sides to de-escalate at the negotiation table.

In summary, recent market adjustments mainly stem from two concerns: 1) the risk of economic “stagflation,” and 2) the risk of uncontrolled escalation of conflict intensity. Both may not be the final outcome of this cycle. In the short term, escalation may create opportunities for de-escalation, often when market sentiment is most pessimistic. In the medium to long term, “stagflation” could be the most pessimistic scenario for the economy, but it may not be the baseline. The current market’s significant pessimism in pricing provides a foundation for medium- and long-term recovery.

2. Structurally, the market has already chosen the direction for us, with performance periods still focusing on “performance-driven” sectors with high certainty of prosperity.

Structurally, the market has effectively selected a “winning amidst chaos” approach. We analyzed the top-performing sectors in A-shares since the US-Iran conflict began, which can be summarized into three main themes:

• High certainty and strong logic of prosperity: North American computing power chain (communications equipment, components).

• Post-oil-price increase, benefiting from energy substitution and price transmission: New energy industries (batteries, new energy vehicles, photovoltaics, wind power), coal, utilities (electricity, gas), agricultural products.

• Domestic demand and defensive sectors for risk aversion: Banks, food and beverages, home appliances, infrastructure.

Meanwhile, the “price increase chain” sectors closely related to oil prices—such as oil and chemicals—have underperformed or experienced high volatility, with less favorable holding experiences. This is partly due to short-term fluctuations driven by conflict marginal dynamics and sentiment, and partly because some funds have realized gains since the beginning of the year. More importantly, many stocks driven by oil prices reflect cost increases, which can erode industry profits, especially downstream in oil. As earnings disclosures approach and the market shifts focus to “reality,” the trading will not solely be driven by rising oil prices but by sectors with clear prosperity and genuine benefits under high oil prices.

Looking ahead, as external shocks to A-shares diminish and performance focus shifts to prosperity, we see three potential developments:

1. For sectors with prosperity and technology or export chains, after initial devaluation due to geopolitical risk and liquidity tightening, these sectors—having independent industry trends and less sensitivity to oil prices—may become the focus of market attention, with more high-quality sectors performing well.

2. For sectors related to price increases, as the first quarter shows more signs of price hikes, overall prosperity is expected to be validated by earnings reports. This will be an important signal beyond tech growth, with internal differentiation especially among oil-driven sectors.

3. For dividend and domestic demand stocks driven solely by risk aversion, if earnings fail to confirm prosperity during earnings season and conflicts de-escalate, their excess gains are likely to gradually decline.

In terms of allocation, based on upward revisions of profit forecasts since the beginning of the year, sectors expected to perform well in the first quarter include:

• AI: Hardware (consumer electronics, components, computing equipment, communication devices, electronic chemicals), software (gaming, digital media, IT services).

• Advanced manufacturing and export chains: New energy (batteries, photovoltaics, wind power), military industry (marine equipment), machinery (rail transit equipment, specialized machinery, construction machinery), commercial vehicles, auto parts, medical services.

• Cyclical price-increasing chains: Non-ferrous metals, coal, steel, chemicals (rubber), building materials (glass fiber), shipping ports, gas.

Among these, sectors with relatively low gains since the start of the year include: North American computing power chain (communications equipment, components), mid- to downstream AI (gaming, digital media, computing), manufacturing & export chains (consumer electronics, batteries, commercial vehicles, home appliance parts, innovative drugs), cyclical & price-increase chains (non-ferrous metals, steel, agricultural products, gas). From the perspective of benefiting from rising oil prices, the top picks are energy substitution sectors with export prosperity logic, such as new energy, and cyclical sectors like coal, agriculture, and gas with upward revisions. For sectors with high certainty of prosperity, focus on North American and domestic computing power chains (CPO, PCB, domestic semiconductor industry chain), and AI sectors with large expectations under “AI disruption” themes (gaming, digital media, AIGC beneficiaries, cloud service-driven computing). From a low-position perspective, previously adjusted sectors like innovative drugs are also worth attention.

Risk warnings

Fluctuations in economic data, policy easing below expectations, Fed rate cuts below expectations, escalation of geopolitical tensions, etc.

(Source: Industrial Securities)