Xingzheng Strategy Zhang Qiyao Team: When Will the Counterattack Signal Be Sounded?

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Source: Yao Wang Hou Shi

1. The overall trend, the market’s current pricing of “stagflation” and “escalating conflict intensity,” may not be the final outcome of this round of conflicts

This week, with no signs of easing in the US-Iran situation, two core concerns triggered a market-wide adjustment and rapid sector rotation. On one hand, the market is beginning to price in a prolonged conflict stalemate, high oil prices maintaining a high level, and the resulting “stagflation” expectations, as well as the liquidity tightening pressures caused by the Federal Reserve delaying or even reversing rate cuts. These have become the main contradictions in asset pricing recently; on the other hand, the market structure is also rapidly rotating following marginal changes in conflict intensity—defensive assets outperform when conflict heats up, while technology stocks lead the recovery when it cools down.

Regarding the two core concerns—economic “stagflation” and “escalating conflict intensity”—and the systemic risks they may trigger in the stock market, we believe this may not be the final outcome of this conflict cycle. Recent market adjustments have already priced in considerable pessimism, and there remains a significant “expectation gap,” which could present an opportunity for market recovery after the correction.

First, concerning the transmission of high oil prices to the economy, inflation, and policy orientation, the market currently tends to compare with the pessimistic scenarios of the US two oil crises in 1970 and the Russia-Ukraine conflict in 2022. However, we believe there are clear differences in terms of economic cycle position, sensitivity of inflation and economy to oil prices, and the demand support for rising prices:

1. Before the first two oil crises and the Russia-Ukraine conflict, the US was already in an economic cycle with significant inflationary pressure, directly influencing the Federal Reserve’s monetary policy stance after high oil shocks. In contrast, before this cycle, overall inflationary pressure was controllable, and the likelihood of further rate hikes was decreasing. In the previous crises, US inflation (CPI YoY) had already risen above 5%, prompting the Fed to prioritize inflation control and adopt rate hikes, which suppressed equities. Currently, US CPI YoY remains at a low 2.4%, similar to levels in 2003 (Iraq war), 2011 (Libyan civil war), and even during the third oil crisis with higher inflation, when the Fed maintained an easy monetary policy, supporting long-term equity growth.

2. The biggest difference from previous crises is that the sensitivity of the US economy and inflation to oil prices has greatly diminished. The era of oil prices solely dominating economic, policy, and asset prices is over. Since the post-crisis energy transformation and the breakthrough in shale oil technology around 2010, the US has shifted from the world’s largest oil importer to a net exporter. The energy component in CPI has significantly decreased, and the impact of high oil prices on the economy and inflation has become more moderate. The era of oil prices as the sole driver of macroeconomic and asset price movements has ended.

3. Unlike in 2022, when strong domestic demand and smooth price transmission occurred during the Russia-Ukraine conflict, the current US PPI-to-CPI transmission lacks sufficient demand support, further slowing the inflationary impact of high oil prices. Before 2022, US consumers benefited from large direct cash subsidies, and post-pandemic demand surged, allowing upstream high oil prices to pass through to consumer prices smoothly. In contrast, after 2022, with sustained high interest rates, consumer purchasing power remains weak, and the PPI-to-CPI transmission lacks demand support. The Fed’s monetary policy focus remains on CPI. Currently, the market only expects inflation to rise significantly following the February PPI increase, reflecting a large “expectation gap.”

Therefore, these differences suggest that “stagflation” may not be the ultimate baseline scenario this cycle. The Fed is likely to adopt a “wait-and-see” approach in the short term, with continued rate cuts in the second half of the year being highly probable. The current overly pessimistic policy expectations may gradually correct. According to estimates by the Xingzheng Macro Team, if WTI oil prices stay at $70/$80/$90/$100 per barrel through the end of the year, the US CPI YoY central tendency would be approximately 2.87%/3.08%/3.30%/3.51%. Considering that 3.5% is the lower bound of the current federal funds rate, inflation remains controllable, and the Fed is likely to continue with a “wait-and-see” stance and rate cuts in the second half. Currently, the implied first rate cut in CME futures has been pushed back to September next year, with some rate hike expectations embedded, reflecting a pessimistic outlook. As expectations for rate cuts rebound, the space for equity market recovery will open.

For China, the previous adjustments in A-shares during oil supply shocks mainly stemmed from internal inflation pressures leading to proactive monetary tightening (2003, 2011), or from external rate hikes combined with weak domestic demand creating a “domestic and foreign dilemma” (2022). This cycle, the Fed’s continued easing remains the baseline, and with limited domestic inflation pressures, there is no significant risk of proactive monetary tightening. Moderate inflation provides positive support for nominal economic recovery and corporate profits, and the fundamental factors supporting this bull market have not changed significantly.

Finally, regarding the future development of this conflict, we maintain the view that “escalation is for better de-escalation.” Short-term escalation of conflict intensity may create opportunities for de-escalation later. With the US threatening to destroy power plants, deploying troops for island seizures, issuing ultimatums, and Iran blocking the Red Sea and retaliating against oil facilities, the market may initially see increased geopolitical premiums. However, in the medium term, such premiums may not be smooth sailing. The US’s political goal has shifted from regime change in Iran to reopening the Strait of Hormuz, and negotiations are more likely to achieve this goal than military victory. Therefore, whether it’s troop deployments or island seizures, the core aim is to exert maximum pressure on Iran to facilitate the Strait’s reopening. If conflict escalation continues unchecked, high oil prices and tactical setbacks for the US military could increase Trump’s willingness to negotiate, creating a de-escalation opportunity at the negotiation table.

In summary, recent market adjustments mainly stem from two concerns: 1) the risk of economic “stagflation,” and 2) the risk of “out-of-control escalation” of conflict. Both may not be the final outcome of this cycle. In the short term, escalation may create opportunities for de-escalation, and the market’s rally often occurs quietly when sentiment is most pessimistic. In the medium to long term, “stagflation” might be the most pessimistic scenario for the economy this cycle, but it may not be the baseline. The current market’s pessimistic expectations are substantial and could lay the foundation for medium- and long-term recovery.

2. Structurally, the market has already chosen the direction for us—performance-driven sectors remain the focus of “certainty in prosperity”

Structurally, the market has essentially selected a “winning in chaos” approach. We analyzed the top-performing sectors in A-shares since the US-Iran conflict began, summarized into three main themes:

• Sectors with strong earnings certainty and solid growth logic: represented by North American computing power chains (communications equipment, components);

• Beneficiaries of rising oil prices and price transmission: new energy (batteries, new energy vehicles, photovoltaics, wind power), coal, utilities (electricity, gas), agricultural products;

• Domestic demand and defensive sectors for risk aversion: banks, food and beverages, home appliances, infrastructure.

Meanwhile, the “price increase chain” closely related to oil prices (represented by oil and chemicals) has underperformed or experienced high volatility, with poor holding experience. This is partly due to short-term fluctuations driven by conflict marginal changes and sentiment, and partly because some funds have taken profits from gains since the beginning of the year. More importantly, many stocks driven by oil prices reflect cost increases, which can erode industry profits (especially downstream oil sectors). As earnings disclosures approach and the market shifts focus to “real” fundamentals, the trading will not only be driven by rising oil prices but also by sectors with clear growth prospects and genuine beneficiaries under high oil prices.

Looking ahead, as external shocks to A-shares gradually diminish and earnings season approaches, we see three possible developments: 1) For growth-oriented tech and export-linked sectors, after initial valuation discounts caused by geopolitical risks and liquidity tightening, these sectors may benefit from independent industry trends and less sensitivity to oil prices, becoming more attractive as the earnings season progresses; 2) For the “price increase chain,” with more signs of price hikes in Q1, overall prosperity is expected to be validated by earnings, becoming an important growth signal alongside tech growth, though internal differentiation is likely, especially for oil-driven price hikes; 3) For some dividend and domestic demand stocks driven solely by risk sentiment, if earnings do not confirm growth during earnings season and conflicts de-escalate, their excess gains are likely to gradually decline.

In terms of allocation, based on upward revisions of profit forecasts since the beginning of the year through 2026, sectors expected to perform well in Q1 include:

• AI: hardware (consumer electronics, components, computing equipment, communication devices, electronic chemicals), software (gaming, digital media, IT services);

• Advanced manufacturing and export chains: new energy (batteries, photovoltaics, wind power), military industry (marine equipment), machinery (rail transit equipment, specialized machinery, construction machinery), commercial vehicles, home appliance parts, medical services;

• Cyclical price increase chains: non-ferrous metals, coal, steel, chemicals (rubber), building materials (glass fiber), shipping ports, gas;

• Consumer & financial sectors: agriculture, retail, jewelry, brokerage firms.

Among these, sectors with relatively low gains since the start of the year include: North American computing power chain (communications equipment, components), mid-to-lower segments of AI (gaming, digital media, computing), manufacturing & export chains (consumer electronics, batteries, commercial vehicles, home appliance parts, innovative drugs), cyclical & price increase chains (non-ferrous metals, steel, agricultural products, gas). From the perspective of benefiting from rising oil prices, the top pick is new energy, which combines export prosperity and energy substitution logic. For cyclical & price increase chains, coal, agricultural products, and gas with upward revisions are also worth attention. For sectors with high certainty of growth, focus on North American & domestic computing power chains (CPO, PCB, domestic semiconductor industry) and AI sectors with large expectations for “AI disruption” (gaming, digital media, AIGC beneficiaries, cloud service-driven segments). From a low-position perspective, previously adjusted sectors like innovative drugs are also worth considering.