How big is China’s rally likely to be and what is the best way to play it? Via Investing.com

Investing.com — Last week’s rally in Chinese stocks marked the benchmark’s strongest weekly performance since 2008 as the country’s central bank and regulators introduced a slew of stimulus measures.

The combination of monetary, fiscal and direct market support almost guarantees that Chinese stocks will continue their upward trajectory, however, investors are now questioning the sustainability of the rally and how best to capitalize on it.

According to Gavekal Dragonomics, while the market’s initial gains have been impressive, the scale of the increase will depend on whether policymakers can deliver on their recent promises of fiscal and monetary support.

Historically, China’s stock markets have oscillated between feast and famine. In the past 20 years, there have been five major rallies, three of which were fueled by government stimulus.

“Stimulus-driven recoveries have had minimal gains to the top of 50-100%, so if Chinese stocks now start another such rally, then there should still be plenty of upside even after the recent bounce,” he said Gavekal in a statement on Monday. note.

However, this optimistic scenario depends on swift and decisive policy implementation. The note warns that China’s economy faces major challenges, with weak labor markets, sluggish consumption and declining export growth, all of which could hamper growth if not addressed.

The scale of stimulus announced so far is relatively modest, with the People’s Bank of China (PBOC) cutting policy rates by just 20 basis points last week. Still, expectations of a bigger fiscal package, potentially RMB 2 trillion in new debt, raise hopes for stronger support.

In addition, new mechanisms were introduced, such as a RMB 500 billion swap facility for institutional investors and a RMB 300 billion refinancing facility to support share buybacks. These moves could create a more aggressive and explicit version of the so-called “China put” in the market.

Gavekal argues that much of the rally is being driven by a shift in expectations rather than actual stimulus measures, at least for now.

“The early days of this rally are driven more by expectations as well as direct central bank support for the market.” The PBOC’s buyback facility could quintuple the pace of corporate buybacks in China, which would significantly boost market liquidity.

In terms of investment strategy, Gavekal recommends focusing on onshore stocks. In two out of three previous stimulus driven ADs, onshore stocks have outperformed their offshore counterparts by 20-40%.

“In the past week, onshore and offshore stocks have responded largely identically, but as the rally progresses, onshore likely has the edge, especially as the PBOC’s funding to support markets is directly targeting onshore stocks,” the note said.

“In the onshore universe, Shenzhen-listed stocks have outperformed Shanghai-listed stocks by 5-20% in the past three stimulus rallies and are likely to do so again,” the report said.

Sectorally, cyclicals such as industrials, materials and consumer discretionary have historically outperformed by about 10% during previous rallies. Struggling property developers will also gain the most from a potential change in housing policy, provided the government follows through on its recent promises.