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Investment Strategy

The China equity rally: artificial or intelligent?

Chinese equities have recently been among the best-performing major markets, with offshore stocks rising nearly 20% year-to-date and almost 40% since bottoming last September, just before the government's comprehensive stimulus announcements. Despite this, the market is only now retesting previous peaks. The year-to-date gains have largely been driven by valuation expansion fueled by positive sentiment around DeepSeek and recent AI developments, rather than a fundamentally improved macro outlook. This raises the question: is the rally merely 'artificial,' or are there 'intelligent' reasons for the optimism surrounding China?

VALUATION EXPANSION HAS DRIVEN MOST OF THE YEAR-TO-DATE RALLY IN CHINESE EQUITIES

Total return % (local currency)

Source: Bloomberg Finance L.P., J.P. Morgan Private Bank. Data as of February 20, 2025. *J.P. Morgan Private Bank EPS estimates.
In this Asia Strategy Weekly, we explore the macro impact of China's AI development, identify the sectors and industries poised to benefit, assess the equity rally, and highlight areas where investors can find opportunities.

What we think

The rapid adoption of AI models like DeepSeek's R1 is expected to drive increased investment, particularly in industry-specific applications. China's cost-effective implementation could foster innovation in sectors like autonomous driving, robotics, and cloud services. However, challenges like weak household consumption and external risks remain, necessitating supportive government policies. 

Investment implications

These local AI developments offer a fresh perspective on Chinese equities, and could potentially lead to productivity gains and earnings upgrades. However, skepticism persists among onshore investors, and the path to AI-driven earnings growth is unclear or may take longer than anticipated. The current rally presents an opportunity to reduce China exposure, as markets approach average valuations. That said, there are selective opportunities in AI beneficiaries, autonomous driving, and robotics. Structured products with buffers and downside protection are recommended to enhance portfolio resilience. While AI adoption may boost corporate efficiency, potential risks include labor demand reductions and geopolitical challenges.

Is the China AI opportunity real?

Artificial intelligence (AI) is emerging as a significant investment theme in China. The release of DeepSeek's R1 model has prompted both Chinese and global companies to adopt existing or develop new open-source models. The reduction in costs and the proliferation of large language models (LLMs) are likely to accelerate AI adoption. We anticipate increased AI-related investments and applications in China. While the U.S. leads in hardware and research, China's cost-effective implementation allows for experimentation in industry-specific applications. We think various Chinese industries and companies can leverage data and scaling advantages to enhance consumer and business engagement.

Is the equity rally sustainable or short-lived?

AI developments in China offer investors a fresh perspective on Chinese equities, with the potential for productivity gains and earnings upgrades. However, the onshore China A-share market, dominated by traditional cyclical sectors like banks and consumption, remains unenthusiastic, reflecting skepticism about China's economic recovery. This is further evidenced by the offshore market's rally being concentrated in a few AI stocks, while non-AI stocks have underperformed year-to-date.

NOTABLE PERFORMANCE DISPERSION BETWEEN AI BENEFICIARIES AND NON-AI BENEFICIARIES IN CHINA

Performance since DeepSeek R1 model launch on 20 Jan 2025

Source: Bloomberg Finance L.P., J.P. Morgan Private Bank. Data as of February 26, 2025. 

We believe AI-driven earnings-per-share (EPS) upgrades may take longer than anticipated by markets. While consensus expects AI adoption in China to modestly boost corporate earnings growth by mid-single digits in 2025, company guidance could disappoint due to elevated expectations. Significant capital expenditures, such as Alibaba's $52 billion AI capex plan (more than the last 10 years combined), may not yield immediate returns, as monetization of AI may take time. The key for investors is to be selective within the AI value chain to identify genuine beneficiaries with strong adaptation and execution capabilities, like BYD with its recent enhancements in autonomous driving.

While AI can enhance corporate efficiency and margins, it may potentially reduce labor demand, risking an increase in unemployment and social instability – potentially leading to more regulation aimed at ensuring AI adoption aligns with socio-political needs for employment. Furthermore, a combination of higher tariffs and the tightening of chip exports curbs implemented by the U.S. could also jeopardize China’s AI progress. There are risks that the buoyant equity market currently overlooks.

What are investor flows and positioning telling us?

Have international investors returned to China? Many view AI adoption as a more predictable driver for a structural re-rating of Chinese equities, similar to the impact of AI on the U.S. equity market over recent years, leading them to reduce their underweight positions by adding high-beta growth AI stocks. The strong momentum following DeepSeek's launch is largely attributed to these previously underweight positions. Positive guidance and robust AI product launches from leaders like Alibaba have also encouraged local investors to increase their stakes in Chinese AI stocks.

CAPITAL FLOWS FROM MAINLAND CHINESE INVESTORS TO HONG KONG STOCKS HAVE PICKED UP EVEN AS GLOBAL FLOWS REMAIN NEGATIVE

USD million

Source: Haver Analytics, Hong Kong Exchanges & Clearing. Data as of February 21, 2025. 

Overall, regional hedge funds and retail investors are still trading on momentum, but it is important to note that they are generally very tactical and could exit quickly. Long-only funds remain relatively cautious and have held an underweight or neutral position at most for China, although the degree of underweight has decreased over the past month. Up until now there have been some interesting trends in flows: we’ve seen strong flows from mainland China into individual HK-listed stocks, which have been driving the rally, while overall flows into China funds and ETFs have been negative, perhaps reflecting an outflow out of index-related strategies into specific AI-related names.

What to do in Chinese equities?

We view this rally as an opportunity to reduce China exposure as the Hang Seng Index approaches 24,000 and the MSCI China Index nears 75. We have no preference between the onshore and offshore markets, given both markets are trading at average valuations (MSCI China at 11.5x, CSI 300 at 13x). While AI adoption may provide a new angle for the Chinese markets to trade in a higher range, the risk-reward ratio for chasing the rally from current levels looks less attractive, with a lot of optimism already in the price. A more quantifiable earnings upgrade from wider AI adoption could also lead us to further upgrade our outlook. But we may only get more evidence of these improvements in the second half of the year. We would feel more comfortable with a structural China upgrade if it’s accompanied by a broader economic recovery, especially in the consumption and property sectors, as well as signs that companies will generate sustainable earnings-per-share growth, which has been notably absent over the past ten years. In 2025, investors could focus on AI adoption, autonomous driving and robotics as key themes. In this volatile market, structured products with buffers and downside protection can enhance portfolio resilience.

Selectivity is key for investors: which sectors and industries are poised to benefit?

Certain sectors stand to benefit significantly from AI adoption, and investors are keen to identify leaders in AI implementation. Although we are in the early stages, initial responses from business leaders suggest that a few industries will likely lead the way. Autonomous driving and robotics are two rapidly emerging areas that could experience much faster product development cycles, as open-sourced AI models cost significantly less. These sectors also have high export potential, barring trade restrictions, given that Chinese manufacturers already have competitive advantages over their international peers.

China’s broader digital economy encompasses product manufacturing (such as robotics and semiconductors), product services (such as gaming), technology applications (such as software, the Internet of Things (IoT) and data centers), plus factors of production (such as platforms and smart logistics). With industry revenues of RMB48 trillion, this digital ecosystem is equivalent to 38% of GDP. Both in terms of size and the multiplier effect on economic growth, it is likely larger than the real estate and related construction sectors. The high degree of digitalization in China underscores the potential for AI implementation across these sectors.

THE DIGITAL ECONOMY IN CHINA HAS REACHED A SIGNIFICANT SCALE

2023 industry revenue, RMB trillions

Source: The National Bureau of Statistics of China, J.P. Morgan Private Bank. Data as of February 28, 2025. *Digital Economy core sectors includes digital product manufacturing (such as robotics, semiconductors), digital product service (such as gaming), digital technology application (such as software, IoT), digital as factors of production (such as platforms, smart logistics). 

The electric vehicle (EV) sector stands out, with adoption rates already rising quickly in China, accounting for just over half of all new car sales last year. The enhancement of autonomous driving functions will likely further boost EV adoption. Corporates and governments can also tap into this technology to upgrade their management of fleets and public transportation networks.

Automation robotics have ready applications for AI, particularly as China remains the world’s largest manufacturing economy. As with any capital expenditure cycle, infrastructure providers such as data centers and upstream supply chains that service them may benefit. Cloud service providers could also be early beneficiaries, followed by AI applications that could see significant upgrades in their AI-driven product features. Large internet companies can deepen user engagement by providing more differentiated services with AI agents.

SOME INDUSTRIES COULD LEAD THE WAY FOR AI ADOPTION IN CHINA

Potential beneficiaries of AI adoption

Source: J.P. Morgan Private Bank. Data as of February 28, 2025.

Macro implications of China’s AI development

AI’s broader implementation in China will likely positively impact the economy. In the near term, the AI buildout will likely require increased capital spending. We estimate that capital expenditures by large internet companies and other industries could reach RMB1 trillion in the next two to three years. This may catalyze an improvement in business sentiment and a recovery in the investment cycle, which has been tepid in the private sector in recent years. It will likely take time for the results of these investments to be seen, so the real benefit of AI from a productivity perspective is likely still a few years away.

Another important question is how consumer sentiment responds to the newfound confidence from DeepSeek’s development and the equity rally. Weak confidence and consumption have been key factors holding back China’s economy. If recent developments are enough to spark a broader turnaround, the impact could be felt more immediately.

Meanwhile, there are also problems that AI does not solve. The property sector has shown some signs of stabilization since late 2024, but the negative wealth effect has not dissipated, given high inventory levels. As part of the ongoing economic transition away from the housing sector, the government will likely need to boost support for household consumption. The household goods ‘trade-in’ program in late 2024 has achieved some success. We estimate the government’s RMB170 billion support program has generated an additional RMB300 billion in retail sales, beyond the goods already covered by the program. An expansion of this scheme in 2025 to include more goods and potentially even services may help give retail sales an extra lift. The upcoming National People’s Congress (NPC) might confirm a more supportive policy environment for domestic demand.

Another risk may be on the external front. So far this year the tariff headwind has been much less than feared. But given how quickly things can shift on that front, a strong export environment may not be something we can take for granted. External uncertainties necessitate policies to bolster domestic demand.

DOMESTIC DEMAND IS AT AN ALL TIME LOW (OUTSIDE OF COVID)

Contribution to real GDP, %

Source: The National Bureau of Statistics of China, J.P. Morgan Private Bank. Data as of December 31, 2024.

Currency outlook

From a currency perspective, positive sentiment from equities has spilled over to the foreign exchange market, though this equity-FX correlation may be short-lived. Equity inflows are expected to target AI beneficiaries in the offshore market, while the yuan's movement depends on potential onshore equity market flows, which are expected to be limited.

US-CHINA INTEREST RATE DIFFERENTIALS RECENTLY COMPRESSED FROM BOTH SIDES, BUT IT MIGHT BE SHORT-LIVED

Source: Bloomberg Finance L.P., J.P. Morgan Private Bank. Data as of February 24, 2025.

Recent CNH strengthening can also be attributed to compressing interest rate differentials between the U.S. and China. CNH's sensitivity to interest rate movements has increased in this cycle, as it has become a low-yielding funding currency. While long-term U.S. Treasury yields have retreated from January highs, Chinese government bond yields have rebounded from the historically low levels seen late last year, driven by technical corrections and slight inflation improvements. However, this compression may not last, with rate differentials expected to remain wide as the PBoC eases monetary policy while the Fed takes a cautious approach.

This does not alter our bearish outlook on the CNH. Since President Trump's election, the USDCNH has remained relatively stable, largely due to increased PBoC intervention efforts. Nevertheless, the ongoing overhang from tariff risks and wide negative carry are likely to continue exerting pressure on the currency. Investors might consider leveraging the recent movement to hedge long CNH exposure or utilize it as a funding currency.

All market and economic data as of February 28, 2025 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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