The A-share market displayed a pattern of volatility and divergence in the first quarter. In early March, the Shanghai Composite Index experienced a significant breakdown from its high of 4182 points. The primary driver behind this substantial adjustment was the escalation of tensions in the Middle East. The US and Israel launched an attack on Iran, including a targeted strike against Iran's Supreme Leader Ayatollah Khamenei and senior military commanders, which provoked retaliation from Iran. Iran's subsequent blockade of the Strait of Hormuz, a critical global chokepoint for oil transportation controlling 20% of global oil and gas shipments, caused international oil prices to surge from $73 per barrel before the conflict to $120 per barrel. This sparked investor concerns that the global economy could slide into stagflation. Concurrently, the Federal Reserve, in response to potential inflation, was forced to delay its interest rate cut schedule, with the possibility of no cuts occurring within the year, which also contributed to a significant decline in the A-share market.
Comparing this market adjustment to the one in March 2025, the core driving factors are substantially different. The sharp decline at that time was triggered by Trump's announcement of imposing tariffs globally, initiating a trade war. However, following the steep drop, the market experienced a strong rebound fueled by institutional capital inflows and interventions by state-backed funds. Technically, the Shanghai Composite Index has breached the 4000-point level and fallen below the 60-day moving average, often viewed as a bull-bear demarcation line. A key question for many investors is whether this Middle East conflict will terminate the A-share market's slow and long-term bull run. My view is unequivocal: the core logic underpinning this long-term bull market has not fundamentally changed. While this conflict has disrupted the bull market's rhythm, it has not altered its underlying trend. The current market decline presents an opportunity to position in high-quality stocks or funds. As a policy bottom gradually emerges, the market may experience repeated fluctuations before eventually establishing a genuine market bottom.
From April to June of last year, the market underwent a V-shaped recovery following a sharp decline, driven by a confluence of supportive policies and improving fundamentals that pushed indices higher in a volatile ascent. In the second quarter of this year, the A-share market might replicate the recovery pattern seen in the same period of 2025, potentially staging a significant rebound or even an independent rally that could set new yearly highs. This is because the second quarter coincides with the disclosure of annual reports, where sectors and individual stocks reporting better-than-expected earnings may witness valuation repairs. Additionally, Trump now faces substantial domestic anti-war pressure in the US and is seeking a dignified exit from the conflict. Should the Middle East situation de-escalate and normal navigation resume through the Strait of Hormuz, the A-share market could also see a substantial upward opportunity.
Currently, persistent volatility in external markets, the Fed's continually moderating expectations for interest rate cuts, and recurring geopolitical tensions in the Middle East are external factors disrupting the A-share market's inherent operational rhythm, but they have not changed its long-term trajectory. For the second-quarter A-share market performance, the most significant marginal influencing factor remains when the war will conclude. It is anticipated that by April, the three warring parties might resolve major differences through negotiations, leading to a temporary ceasefire or even a potential end to the war within the month, which would significantly impact the market and likely catalyze a bottoming-out rebound.
Towards the end of the first quarter, market margin debt balances saw a phased decline, with some capital temporarily exiting the market, primarily due to the market adjustment and the uncertain outlook for the war. This exited capital is likely to flow back into the market once conditions improve in the second quarter. Sources of incremental funds for A-shares in Q2 will include increased holdings by institutional investors following market stabilization, as well as inflows from external capital, including the shift of household savings into the capital markets. The core trigger for large-scale entry of incremental funds is the conclusion of the Middle East war. Currently, institutions continue to maintain high portfolio allocations. In the second quarter, institutions are generally expected to buy on dips, appropriately increasing their holdings of core assets. The focus for these additions is concentrated in two main areas: technology sectors and heavy-asset, low-volatility HALO assets. The former encompasses AI-enabled industries poised for significant development in the AI era; the latter represents industries not easily replaced by AI, serving as essential infrastructure during this period.
Should the market experience unexpected volatility risks in the second quarter, such as a further escalation of the war into a prolonged conflict leading to a significant market decline, it is possible that capital could enter the market to stabilize it, similar to April of last year, potentially through entities like Central Huijin purchasing ETFs or blue-chip stocks. Simultaneously, insurance funds and public mutual funds might increase their allocations. Such operations would significantly boost market sentiment, attract more external capital, stabilize market trends, and guide the market back onto its slow and long-term bull track.
The market widely anticipates that A-shares will transition from being liquidity-driven to earnings-driven in the second quarter. This shift is expected to gradually materialize following the preliminary release of annual report results and the intensive disclosure period for Q1 earnings reports in mid-to-late April. Sectors and stocks demonstrating strong earnings growth are likely to attract capital inflows, while companies failing to meet earnings expectations could face substantial adjustments. Sectors that exceeded Q1 earnings expectations remain concentrated in technology, including high-growth areas like chips/semiconductors, computing power/algorithms, and power grid equipment.
The main themes driving the current market cycle are the 'price increase' concept and the major AI technology trend, both navigating through the volatility. The core logic behind these two themes is expected to gradually materialize in the second quarter. The price increase concept focuses on industries like lithium batteries, chemicals, and sectors related to new productive forces. Sub-sectors within the AI technology theme might perform more prominently, potentially becoming the core investment focus for Q2, such as previously strong but recently adjusted areas like chips/semiconductors, humanoid robots, and computing power/algorithms. Investors can capture these opportunities by positioning in related high-quality leading stocks or thematic funds.
During the adjustment period in March 2025, small-cap stocks significantly outperformed large-cap weighted stocks. In the first quarter of 2026, AI and growth sectors led the gains, while defensive sectors like banks and coal underperformed. A shift in market style is possible in the second quarter, with potential rotation between large/small caps and tech stocks. The recent frequent outperformance of traditional white-chip stocks also reflects this style rotation. Regarding asset allocation, investors should aim for balance, adopting a diversified approach—allocating half to growth stocks and half to value stocks.
The core risks requiring heightened vigilance in the Q2 2026 A-share market primarily concern the potential for the Middle East war to spiral out of control; this represents the most significant risk. Another key risk involves companies that might report unexpectedly poor earnings. Recently, some ST (Special Treatment) stocks have experienced sharp declines. Investors must maintain caution towards fundamentally weak stocks with potential for continued deterioration or earnings disappointments, steering clear of such underperformers and being particularly wary of ST stocks. ST status is typically assigned after two consecutive years of losses; if performance does not improve, these stocks face delisting risks. In the current context of overall slowing economic growth, it is difficult for ST stocks to stage a recovery, as many are driven by speculative themes and concepts rather than fundamentals.
The second quarter is highly likely to be characterized by volatile markets. For position management, investors could maintain a moderate allocation of around 50-60%. In terms of portfolio structure, a balanced mix—half allocated to leading technology stocks and half to blue-chip stocks with solid earnings—creates a defensive yet opportunistic portfolio, avoiding excessive bias towards any single style. Amid the current ambiguous international situation, adhering to value investment principles is crucial.
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