CITIC SEC analysts suggest the recent Middle East oil shock represents a second, more severe wave, not a milder repeat of the first, as critical buffers have been exhausted. The most crowded trades differ markedly between the two shocks, meaning the market is unlikely to replicate its Q2 2026 trajectory. With the conflict's direction increasingly unpredictable and the risk of prolonged tensions rising, the market must undergo a short-term risk-reduction phase. However, quantitative and sentiment indicators suggest this process is nearing completion, making a broad market rotation and repair highly probable in August. The firm maintains its view on three convergence themes: 1) AI upstream hardware and price-sensitive stocks underperforming downstream platforms; 2) domestic non-AI industrial stocks closing their valuation discount relative to global peers; and 3) a narrowing gap between technology and non-technology sectors.
The Second Shock: Buffers Exhausted
The first oil supply shock was acute, with Brent crude surging nearly 70% from late February to late April. The subsequent price collapse back to near starting levels was enabled by three buffers: unexpectedly sharp demand contraction, particularly from China; coordinated releases of strategic petroleum reserves; and using existing inventories to buy time. China's role was crucial. In June 2026, its crude oil processing volume fell to 51.24 million tons, down 17.7% year-on-year, while net crude imports in May dropped to 7.72 million barrels per day (bpd), a 29.6% annual decline. Shandong refinery utilization rates sank to 43.0% in early July, the lowest since 2023, before a minor recovery. This demand-side buffer was critical.
The second shock arrives after these buffers have been systematically depleted. By mid-July, the US Strategic Petroleum Reserve (SPR) had fallen to 311 million barrels, a 25% drop from pre-conflict levels and the lowest since March 1983. US commercial crude inventories, at 411 million barrels, are now 10.8% lower than at the end of Q1 and have been trading below the 5-year seasonal range for six consecutive weeks. China's capacity for further demand compression is also limited. July's daily crude arrivals were 0.788 million tons, down 19.1% from the March-June average and still 47.7% below pre-conflict levels. With Chinese utilization and inventories already at historic lows, its ability to cushion supply shocks has diminished. The US SPR is at a 40-year low, and OECD reserve release capacity is significantly reduced. This makes the risk of sustained higher oil prices greater than during the first shock.
Conflict Path Uncertain, Risk-Off Mode Required
For Iran, continued conflict may be acceptable. Having endured initial airstrikes and moved to threaten the Strait of Hormuz, Tehran has developed a new strategic outlook, believing its economic resilience is superior to America's, seeing the conflict as a rare geopolitical opportunity, and viewing control of the Strait as an effective countermeasure. It is unlikely to accept a return to previous agreements without greater US concessions. A US "TACO" (Tactical Approach, Conflict Over) scenario remains possible but is unpredictable. Current probabilities suggest a Republican-controlled Senate and Democratic-controlled House after the midterms, reducing the marginal electoral impact of "TACO." Ten-year US Treasury yields recently broke above the 4.4%-4.5% range without triggering "TACO," although weekend orders against new airstrikes offer a tentative sign. As the Middle East situation risks becoming a quagmire, predicting conflict outcomes grows harder. Reducing risk exposure becomes the primary concern, followed by structural portfolio adjustments.
Crowded Trades Diverge Between Shocks
Before the first oil shock, institutions were overweight in many industrial sectors (non-ferrous metals, energy storage, chemicals), which had outperformed tech from September 2025 to February 2026. The initial logic of the Iran-US conflict favored industrial stocks via higher PPI, while high oil prices and rates were seen as detrimental to expensive tech. However, high oil prices and rates ultimately damaged non-AI demand. Industrial stocks saw temporary profits but were de-rated, while AI, buoyed by strong supply-demand gaps, attracted continuous inflows, creating an unprecedented K-shaped divergence. Before the second shock, institutional concentration in tech had reached historical extremes, making it the most crowded trade. Many industrial valuations had compressed to dividend-stock levels, and marginal reduction in institutional positions was also at extremes. Now, the negative impact of high oil prices and rates on valuations outweighs the influence of sectoral earnings divergence on capital flows. Precious metals illustrate this: they failed as a hedge during the first shock, falling 14.2% in Q2 2026 as real rates rose. But since early July, despite Brent and WTI rising 38% and 36% respectively and real rates hitting new highs, gold has only fallen 3.0%, while gold stock ETFs actually rose 2.1%. This suggests that facing a second shock, while past macro logic offers some reference, positioning and trade congestion are key. As risk appetite declines, all risk assets lacking a strong upward catalyst will suffer. The answer may lie in seeking less crowded areas.
Sentiment at Nadir, August Recovery Likely
Quantitative and price-based sentiment indicators have hit lows not seen since the "9.24" rally in 2024. Survey data from CITIC SEC channels shows sample private equity fund positions at 69.0% as of mid-July, having declined since late June and significantly below the two-year median. This level has only been seen during the April 2022, October 2022, and February 2024 market troughs. Implied volatility (IV) for CSI 300 and CSI 1000 index options spiked to 25% and 33% respectively, historically indicating a concentrated release of panic that rarely persists. Despite negative macro and positioning narratives, these are likely already priced into short-term stock movements. With sentiment indicators near freezing, any subsequent position rebuilding, regardless of sector, should trigger a significant index rebound and rotational repair.
Where Will Flows Go Under High Oil Prices?
Fundamentally, high oil prices and rates could further damage non-AI demand, reinforcing the sectoral divergence that has become a market memory. This logic suggests capital might continue to cluster in tech, particularly leading optical communications, foundries, and semiconductor equipment firms. However, the extreme historical level of institutional concentration in tech implies the market has priced in an unprecedented divergence. Tech positions have zero room for error regarding negative events, while non-AI sectors may become more resilient to oil and rate changes, as recent precious metal performance suggests. Under a shrinking market assumption, the overall direction should be towards style balance, with less crowded areas like non-ferrous metals, dividends, innovative drugs, lithium batteries, and chemicals offering smoother performance. AI would require a new, unpriced catalyst to attract fresh capital and break the current zero-sum game. CITIC SEC reiterates its view on three convergence themes: 1) AI upstream hardware and price-sensitive stocks underperforming downstream platforms; 2) domestic non-AI industrial stocks closing their valuation discount to global peers; and 3) a narrowing performance gap between tech and non-tech sectors.
Risk Factors
Escalation of US-China tensions in technology, trade, and finance; weaker-than-expected domestic policy effects or economic recovery; unexpected tightening of global macro liquidity; further escalation of conflicts in Ukraine/Russia and the Middle East; and slower-than-expected property inventory digestion in China.
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