China's bull market risks running out of gas

China's onshore equity markets have significantly outperformed global peers, with the Shanghai Composite and CSI 300 up 9-12% since mid-July, driven by domestic investors reallocating from property and fixed income into a narrow set of high-growth technology sectors. However, the rally faces vulnerabilities including rising margin financing surpassing 2015 peaks, prominent sectors appearing fully valued despite high P/E multiples, and a persistent decline in corporate return on equity due to margin compression. For the bull market to be sustainable, improved corporate fundamentals, earnings growth, more effective government stimulus to boost domestic demand, and greater corporate discipline are crucial, as current policy efforts have shown limited impact.

Analysis

China's onshore equity markets are exhibiting strong outperformance, with the CSI 300 and Shanghai Composite indices gaining 12% and 9% respectively since mid-July, surpassing the S&P 500's 6% rise. This rally is primarily fueled by domestic capital flows, as households reallocate from a weakening property market and low-yield deposits, where equities still represent only 5% of wealth. Institutional support is also growing, evidenced by insurers investing $90 billion in the first half of 2025 after the government raised equity allocation caps. However, significant vulnerabilities temper the bullish outlook. The rally's breadth is exceptionally narrow, concentrated in sectors like technology services and electronic technology, which have surged 98% and 81% respectively. Valuations in these leading sectors appear stretched, with price-to-earnings multiples significantly exceeding forecast EPS growth. A major technical red flag is the level of outstanding margin financing, which has now surpassed its 2015 peak of 2.27 trillion yuan, evoking memories of the subsequent market crash. This speculative fervor is not supported by improving fundamentals, as the return on equity for Chinese corporations has been in a 15-year decline due to intense margin compression. The sustainability of the current market momentum is therefore contingent on a material improvement in corporate earnings and discipline, alongside more effective government stimulus to boost domestic demand, as recent measures have yielded only limited impact.

Key Decisions for Investors

• Given the rally's narrowness and stretched valuations in leading technology sectors, investors should exercise caution and consider trimming exposure to names with P/E multiples that significantly outpace their earnings growth forecasts.
• The market's structural risk has increased, with margin financing surpassing the 2015 peak; it is critical to monitor regulatory announcements regarding lending controls and the actions of China's 'National Team' for signs of intervention.
• For the bull market to broaden and sustain, a fundamental uplift is required; investors should closely watch for inflection points in corporate Return on Equity (ROE) and evidence that government stimulus is successfully translating into stronger domestic consumption.
• The significant undeployed capital from households and insurers represents potential future inflows, but investors should look for signs of this capital rotating into undervalued sectors rather than concentrating further into the already crowded technology theme.