A-Share Sentiment Softens, but Still Overweighting A-Shares for Upside

Overview

This is Morgan Stanley's weekly tracking report on China's equity market strategy, centered around its proprietary A-Share Sentiment Indicator (MSASI). The latest reading shows softer investor sentiment and weaker trading volume in A-shares, while the macroeconomy continues its "K-shaped" divergence. Despite this, the firm maintains a generally positive stance: overweighting A-shares relative to offshore markets, projecting approximately 10-12% upside potential for Chinese equities over the next 6-12 months, while cautioning that near-term volatility may persist until the market stabilizes around mid-summer.

Core views

Sentiment: Weighted MSASI declined 4 percentage points to 62% compared to the previous cutoff date (May 27), while its one-month moving average (1MMA) rose 3 percentage points to 59%. Trading activity softened, with ChiNext's average daily turnover down 9% week-on-week to approximately CNY 779 billion, and total A-shares' average daily turnover down 6% to approximately CNY 3,019 billion, while stock index futures trading volume and margin financing balances remained stable. The 30-day RSI rose slightly by 1%, and the earnings forecast upward revision ratio (breadth of expectation revisions) remained negative, unchanged from last week. Overall, short-term market sentiment has cooled. Capital Flows: Southbound funds recorded net inflows of USD 4.5 billion during May 28-June 3, with year-to-date cumulative inflows reaching USD 35.3 billion and monthly inflows at USD 3.3 billion, indicating sustained southbound capital inflows. Macroeconomy: Data points to intensifying "K-shaped" demand divergence and relatively high oil prices. May manufacturing PMI fell 0.3 percentage points to 50%, in line with market expectations, with weakening consumer-related export orders and high-energy consumption production, while high-end manufacturing maintained resilience. Infrastructure investment still lacks policy catalysts. Inflationary momentum remains contained; with oil price gains moderating, month-on-month PPI slowed to 1% (from 1.7% in April), but year-on-year figures may rise to 4% due to low base effects. The firm's economics team believes that weaker data in April-May indicates rising downward pressure on Q2 GDP, expecting policymakers to accelerate fiscal spending from June onward with targeted infrastructure support to prevent growth from falling significantly below 4.5%. Outlook & Allocation: The firm projects approximately 10-12% moderate upside potential for Chinese equities over the next 6-12 months, supported by stronger exports, AI/energy-related capital expenditures, RMB appreciation, and improved corporate earnings in Q2 driven by easing price competition among internet platforms. Allocation-wise, it prefers A-shares over offshore markets (HK + ADR) due to A-shares' higher exposure to upstream manufacturing/hard tech, IPO catalysts, and "national team" support; at the sector level, it favors upstream materials, industrials, energy, and semiconductors, while maintaining moderate allocations to financials and high-dividend stocks.

Analysis framework

The report follows a dual-track analysis of "sentiment + macro": using quantitative sentiment indicators to gauge market sentiment and capital activity, while macroeconomic data informs fundamental direction, leading to comprehensive allocation conclusions. For sentiment assessment, the firm relies on its proprietary MSASI framework: selecting 12 dimensions of indicators including trading volume, margin financing balances, new account openings, RSI, limit-up stocks, options put/call ratios, passive foreign fund flows, and earnings forecast revision breadth. Each indicator undergoes 100-day rolling min-max normalization to eliminate high-frequency noise and ensure comparability. Indicators are then weighted based on their historical explanatory power (R² from single-factor regression) with the CSI 300, giving higher weights to indicators more correlated with market movements. The weighted sentiment index is rescaled to 0-100 based on 2024 highs/lows, with a one-month moving average (1MMA) smoothing medium-term trends. For fundamental assessment, the firm follows a "demand divergence—inflation—policy response" chain: PMI subcomponents reveal weakening export orders and high-energy production alongside resilient high-end manufacturing, indicating intensifying K-shaped divergence; oil prices and PPI show contained inflationary momentum; this leads to the inference of rising Q2 growth pressure and the need for policy stimulus via accelerated fiscal spending from June, ultimately supporting the conclusion of "maintaining overweight on A-shares, favoring upstream and hard tech sectors."

Methodology notes

• Quantitative/Factor/Portfolio Theory

  Market Sentiment Indicator Synthesis Method (MSASI)

  Combines multiple market activity signals such as trading volume, margin financing, new accounts, RSI, limit-up stocks, options ratios, and foreign capital flows. After standardization, indicators are weighted by their historical correlation (explanatory power) with the CSI 300 to synthesize a 0-100 sentiment score. Higher readings indicate stronger market sentiment, while lower readings suggest caution or risk aversion, providing an intuitive gauge of market temperature.

• Quantitative/Factor/Portfolio Theory

  Weighting by Historical Explanatory Power (R²)

  When synthesizing indicators, the firm uses each indicator's single-factor regression R² with the CSI 300 to determine weights, giving higher weights to more correlated indicators. This approach prioritizes historically more predictive signals. Additionally, indicators with lower frequency (e.g., monthly new accounts) or shorter history (e.g., options data) are deliberately downweighted to prevent distortions in the overall conclusion.

• Macroeconomic framework

  K-Shaped Economic Divergence

  "K-shaped" refers to an economy where different sectors move in divergent directions rather than collectively rising or falling. In this report, resilient high-end manufacturing versus weakening consumer-related exports and high-energy production exemplifies this divergence. Understanding this helps explain why the firm favors upstream/hard tech sectors while remaining cautious on overall demand.

• Macroeconomic framework

  Low Base Effect

  Year-on-year growth rates are influenced by the prior-year base: the report notes that while month-on-month PPI has slowed to 1%, year-on-year figures may still rise to 4% due to low base effects from the previous year. This reminds readers to distinguish between genuine improvement and base-related distortions when interpreting YoY data.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• A-Shares

  The firm prefers A-shares over offshore markets due to higher exposure to upstream manufacturing/hard tech, IPO catalysts, and "national team" support.

  Strengths

  High exposure to upstream manufacturing and hard tech; IPO catalysts and national team support; trackable via sentiment indicator system

  Weaknesses

  Recent softer investor sentiment, weaker trading volume, and negative earnings forecast revision breadth

  Comparison

  Preferred over offshore markets (HK + ADR), receiving overweight allocation

  Risks

  Near-term volatility from potential Q1 earnings misses, cooling Fed rate cut expectations, and other disturbances

• Offshore Markets (HK + ADR)

  Serving as a contrast to A-shares, the firm holds a relatively less favorable view with lower allocation preference.

  Weaknesses

  Relatively lower exposure to upstream manufacturing/hard tech

  Comparison

  Compared to A-shares, the firm expects a more volatile market environment, with stabilization anticipated after mid-summer

  Risks

  July HK IPO lock-up expirations, cooling Fed rate cut expectations, and ongoing Strait of Hormuz geopolitical uncertainties

Key data

• Weighted MSASI62%Down 4 percentage points from previous cutoff date (May 27), indicating softer sentiment
• MSASI One-Month Moving Average (1MMA)59%Up 3 percentage points during the same period
• ChiNext Average Daily TurnoverApproximately CNY 779 billionDown 9% week-on-week from previous period
• A-Shares Average Daily TurnoverApproximately CNY 3,019 billionDown 6% week-on-week from previous period; stock index futures trading volume and margin financing balances remained stable
• 30-Day RSI+1%Slight increase during May 28-June 3
• Southbound Fund Net InflowsUSD 4.5 billionMay 28-June 3; year-to-date USD 35.3 billion, monthly USD 3.3 billion
• May Manufacturing PMI50%Down 0.3 percentage points month-on-month, in line with market expectations
• PPI Month-on-Month1%Down from 1.7% in April, moderating with slower oil price gains
• PPI Year-on-YearMay rise to 4%Due to low base effects
• Chinese Equity Upside PotentialApproximately 10-12%Projected over 6-12 months
• Growth FloorNot significantly below 4.5%The firm expects policymakers to accelerate fiscal spending from June with targeted infrastructure support

Impact & implications

The report suggests that despite short-term sentiment softening, K-shaped macroeconomic divergence, and challenges from oil prices and external uncertainties, Chinese equities have a foundation for moderate medium-term upside, with earnings improvement as a key driver. For asset selection, the firm prefers A-shares over offshore markets (HK + ADR) due to A-shares' higher exposure to upstream manufacturing and hard tech, IPO catalysts, and "national team" support. Offshore markets may experience relatively higher volatility due to factors like HK IPO lock-up expirations, with stabilization expected after mid-summer. At the sector level, the firm favors upstream materials, industrials, energy, and semiconductors, while maintaining moderate allocations to financials and high-dividend stocks.

Risks

• Potential Q1 earnings misses
• Supply pressure from July HK IPO lock-up expirations
• Cooling Fed rate cut expectations
• Ongoing geopolitical uncertainties in the Strait of Hormuz
• Rising downward pressure on Q2 GDP

What to watch

• Whether market trends turn clearer and more stable around mid-summer as projected
• The implementation pace of fiscal spending and targeted infrastructure support starting in June
• Whether Q2 earnings improve with stronger exports, AI/energy capital expenditures, RMB appreciation, and easing platform price competition
• Subsequent changes in sentiment indicators and trading activity