In the ever-shifting landscape of global stock markets, the recent surge in Hong Kong stocks has sparked optimism regarding the potential for a rebound in the A-shares of ChinaGoldman Sachs has recognized this momentum and suggests that A-shares may soon follow suit, experiencing what could be described as a long-awaited catch-up rally.

Since the advent of the DeepSeek-R1 report, there has been a noticeable uptick in investor optimism surrounding China's economic growth and stock market performanceGoldman Sachs highlighted that, since the lows observed in January, the MSCI China Index has recorded an impressive 26% increaseMeanwhile, the Hang Seng Tech Index, representative of Chinese internet stocks, has soared by 31%. In stark contrast, A-shares have seen a more modest rise of only 7%. This disparity has led to discussions about the potential for a significant reversal in trends.

In a report issued on February 23, Goldman Sachs pointed out a historical trend: whenever the earnings gap between A-shares and H-shares exceeds 15%, there is a 95% probability that market leadership may flipBased on this pattern, the firm is optimistic that A-shares might witness a catching-up rebound in the next three months, projecting an excess return of around 2% as a result.

Importantly, the valuation premium of A-shares relative to H-shares has contracted considerably, shrinking from 34% just three months ago to 14% todayShould this metric recover to its average level over the past year, it would imply an enticing 10% increase in A-share valuationsThis narrowing valuation gap exemplifies the competitive landscape between the markets.

The evolution of the A-H market dynamics is illustrated by Goldman Sachs' market rotation modelThe analysis suggests that there is a strong likelihood of a shift in market leadership within the next three months, with A-shares positioned to deliver enhanced returnsIn recent months, the return differential between A-shares and H-shares has widened to 15%, reaching the 99th percentile of historical ranges

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This represents the second-largest return gap since 2018, surpassed only by the period from November 2022 to February 2023 when the MSCI China Index outperformed the CSI 300 Index by an impressive 30%.

Goldman Sachs' historical data indicates that the relative three-month returns between A-shares and H-shares typically fluctuate within a range of ±10%. Notably, when the relative return exceeds this envelope, the odds of a reversal become significantly heightenedAs empirically observed, a divergence of over 15% in returns generally signals an impending change in leadership; thus, market participants are advised to remain vigilant for any signs of such a transition.

Examining the various macroeconomic factors that Goldman Sachs evaluated—such as economic growth, policy responses, regulatory conditions, fundamental corporate performance, valuations, and liquidity—two primary drivers are underscored for the anticipated rise of A-shares: their attractive valuations and the prospect of supportive macroeconomic policiesThe MSCI China Index and CSI 300's respective price-to-earnings (P/E) ratios of 11.5 and 13.1 accentuate this pointThe diminishing A-H valuation premium, from 34% to 14%, implies that A-shares are ripe for a significant revaluation, potentially yielding a 10% upside.

Moreover, Goldman Sachs believes that favorable Chinese policies will further bolster A-share performanceTheir economists anticipate that the upcoming Two Sessions, China’s annual political summit, will reaffirm a stance towards expansionary fiscal policy while offering a plethora of implementation specificsSuch affirmations could encourage A-shares to outperform their H-share counterparts, primarily due to the latter's heightened sensitivity to policy announcements and the diversified nature of industries represented within the A-share market.

From a capital flow standpoint, global hedge funds currently allocate approximately 8.2% of their investments to Chinese equities

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Though this figure marks a 1-percentage-point increase from the previous month, it still falls short of the 10% peak level observed in OctoberActive global funds maintain a relatively low allocation to the Chinese market, hovering around 6%. This indicates that there is substantial room for overseas capital to further bolster H-share performance.

The A-share market, however, tends to be less influenced by global capital flowsIncreased participation from domestic retail investors could provide a crucial boost to the A-share market’s rebound prospectsThe strong inflow of southbound capital and financing purchases of stocks associated with software and artificial intelligence (AI) suggest that confidence among onshore investors may be gaining traction, driven by the recent advancements in AI technologies.

Given this comprehensive analysis, Goldman Sachs continues to assign an overweight rating to both Chinese A-shares and H-shares, while specifically anticipating a catch-up rally in the former, potentially reducing the earnings gap with their H-share counterpartsNotably, small-cap stocks are expected to outperform; indices like the STAR50, ChiNext Index, and CSI 1000 are particularly well-positioned due to their significant exposure to AI-related industries and a higher percentage of holdings by retail investors, thus standing to benefit from any improvement in market sentiment.

Within the large-cap sector, the newly introduced CSI 500 Index may outperform the CSI 300 Index, as it has greater exposure to technology and innovation sectorsDespite the overall preference for A-shares, Goldman Sachs also acknowledges that stocks within the Hang Seng Tech Index may continue to benefit from upward adjustments in earnings forecasts attributed to advancements in AI technologies.

Industry-wise, it is worth noting that hardware and software technology companies involved with AI have seen substantial gains of 20% to 40% in offshore markets over the past month, while their A-share counterparts have lagged relatively

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