CICC recently published a research report analyzing the recent market rebound. The report suggests that in the first half of 2026, the "opposite" of the extreme K-shaped differentiation driven by AI was the weakness in Hong Kong stocks and consumption. Due to its composition, the Hong Kong stock broad-based index can essentially be viewed as a "large-scale proxy for consumption." Conversely, when the tech sector began to fluctuate in July, Hong Kong stocks and the Hang Seng Tech Index rebounded, acting like two ends of a "seesaw."
Was there any indication of this recent rebound? Beyond assessing whether the AI rally was a bubble and evaluating its crowdedness, the Hong Kong market also showed some bottom signals at the end of June. The firm observed left-side signals from valuation, sentiment, and allocation in Hong Kong stocks, explicitly indicating attractive "odds" and left-side allocation value, especially for absolute return investors.
Key Drivers of the Rebound
Since the bottom in late June, the Hang Seng Index has rebounded by 13.2%, and the Hang Seng Tech Index has recovered 14.2%. The leading sectors include the previously lagging consumer discretionary (26.2%), healthcare (25.2%), materials (17.9%), transportation (14.8%), and media & entertainment (14.7%). Low valuations (the Hang Seng Tech's dynamic P/E was one standard deviation below its historical mean before the rebound) and low positioning (the allocation to Hong Kong stocks by active equity public funds in Q2 fell to 2022 levels) provided the conditions for a rebound, essentially offering "odds." However, the primary catalyst for the rebound was the forced rebalancing of overcrowded positions following the tech sector's sharp decline.
The rebound was characterized by a clear "rotation from high to low," with low-beta sectors leading the recovery. The internet sector, holding the largest weight in Hong Kong stocks, was the main storyline. The Hang Seng Internet & Technology Index rebounded nearly 25% from its low, with consumption-related e-commerce giants like Alibaba, Meituan, and JD.com showing stronger gains, rising over 40% from their lows. In comparison, media & entertainment stocks like Tencent also rebounded but with less momentum. Additionally, innovative drugs and non-ferrous metals were key drivers, each gaining around 20%. Conversely, sectors that led the first-half rally, such as optical fiber, copper foil, and large models, saw corrections exceeding 60%.
This rebound was almost entirely valuation-driven, contributing 11% of the 13% gain in the Hang Seng Index and 11% of the 14% gain in the Hang Seng Tech, with minimal earnings contribution. Further decomposition shows that the valuation recovery was primarily due to a risk premium decline, reflecting improved sentiment. This occurred despite the weighted risk-free rate for Hong Kong stocks (based on US and Chinese bond yields) rising from 3.6% to 3.9%.
The rebalancing was driven by both Southbound and active foreign capital flows. Previously, global and domestic fund allocations were heavily skewed towards tech. For instance, the Hong Kong stock allocation of active equity public funds dropped from 22.5% in Q1 to 15.1% in Q2, the lowest since Q3 2022, with internet sector holdings at historic lows. During the rebound, Southbound inflows reached HK$62.9 billion in July, with a daily average of HK$28.6 billion, matching levels from March and April and significantly higher than June's HK$12.9 billion and May's -HK$2.1 billion. Foreign capital also flowed in for two consecutive weeks starting in late July, the first time in nearly three months. Conversely, capital outflow from the Korean and Taiwanese markets reflected the "seesaw" effect of fund movements.
Are the Pressures on Hong Kong Stocks Resolved?
The firm notes that the root causes of Hong Kong stocks' weakness in the first half were threefold: 1) weakening domestic demand impacting consumption, including Hong Kong stocks as a "large-scale proxy for consumption"; 2) Hong Kong's market structure lacking AI hardware, with internet leaders lagging in the AI trend; 3) tight liquidity due to heavy IPOs, high US bond yields, and capital outflows from Southbound and foreign sources.
The review of the recent rebound shows that only the third constraint has significantly eased, while the first two, especially the first, remain largely unchanged. The first constraint has not changed, and consumption is not a major driver of the rebound. The second constraint, while helping avoid the severe tech hardware sell-off, remains unresolved. The third constraint has improved, with tech volatility prompting some capital to return, and the weaker-than-expected July non-farm payrolls easing pressure on the Fed to raise rates.
Domestic demand fundamentals remain weak, and the Politburo meeting offered limited incremental policies, leading to a need for a "924 moment." The K-shaped divergence between tech and consumption stems from a divergence in corporate and household credit cycles, driven by fiscal policy tilt towards tech without increasing total spending, alongside slow recovery in household income and confidence. This requires fiscal policy to increase and shift towards consumption, replicating the "924 moment." However, the July Politburo meeting focused on implementing existing policies, with policy signals weaker than those from the September 2024 and April 2025 meetings. While Q3 may see acceleration, it won't change the full-year range-bound pattern or drive a broad-based recovery.
The recent structural mismatch in tech has ironically become an "advantage," but Hong Kong's tech internet sector still needs to "prove itself," requiring a "DeepSeek moment." The lack of hardware exposure helped Hong Kong stocks avoid the recent tech sell-off, but to align with the AI industry trend, Hong Kong's tech internet companies need to demonstrate AI commercialization breakthroughs through increased investment and model optimization, replicating a "DeepSeek moment" to drive index-level performance via heavyweight stocks. Focus should be on investment progress and earnings catalysts from leading companies.
Tech volatility and position crowding are driving capital rebalancing, and easing Fed rate hike pressure will also help. Beyond IPOs and lock-up expiries, tech stock volatility and crowded positions are prompting domestic and foreign capital to partially rebalance, benefiting Hong Kong stocks. Additionally, the weak July non-farm payrolls eased Fed rate hike pressure, and a potential reopening of the Strait of Hormuz could lower oil prices and help suppress US bond yields.
When Can Hong Kong Stocks Outperform?
The K-shaped divergence between tech and consumption, and between A-shares and Hong Kong stocks, essentially reflects a divergence in corporate and household credit impulses. The firm observes that over the past decade, Hong Kong stocks significantly outperforming A-shares has consistently corresponded to a strengthening of the household sector's credit impulse, especially since 2018. This phenomenon is linked to Hong Kong's market structure. The Hang Seng Index and Hang Seng Tech Index have over 70% exposure to domestic demand, including internet platforms, e-commerce, new energy vehicles, and consumer electronics, making index earnings highly correlated with domestic consumption. The ongoing decline in the household credit cycle explains Hong Kong's underperformance and weakness. To sustain a rebound from the bottom, the market needs either a "924 moment" (fiscal stimulus) or a "DeepSeek moment" (tech breakthrough), given Hong Kong's high exposure to the consumption cycle and heavy weighting of internet leaders.
How to Position?
Compared to the Hang Seng Index, the Hang Seng Tech Index still offers attractive "odds." Given that the Hong Kong rebound is driven more by "relative appeal" due to tech's high valuation, crowding, and volatility, rather than "absolute appeal" from earnings growth, the "odds" naturally decline as valuations and sentiment return to mean without earnings improvement. In this sense, the Hang Seng Index's "odds" are significantly lower than the Hang Seng Tech Index. After the recent recovery, the Hang Seng Index's valuation has returned to its historical average, with the previously anticipated valuation odds mostly realized. The firm maintains its short-term target range for the Hang Seng Index at 26,000-27,000 points. In contrast, the Hang Seng Tech Index had a deeper correction, and its current valuation remains at a historically low percentile, with odds not fully exhausted. It will show greater elasticity in the event of lower US bond yields, catalysts from internet leaders, and capital rebalancing, as also indicated by the firm's updated cross-asset and market odds/win-rate framework.
However, the firm emphasizes that capital rebalancing and low valuations can only support a phased rebound, still based on "odds" thinking. For a sustained, comprehensive rally, either a "924 moment" with fiscal stimulus towards household consumption or a "DeepSeek moment" with breakthroughs from internet leaders is required. In terms of sector selection, tech remains the main theme. The firm's proprietary AI stress index last week approached levels seen during the peak of bubble concerns in April and November 2025, indicating extreme pressure, which historically suggests it's unlikely to worsen. Recent data has indeed eased, which is beneficial. Moreover, two of the three AI pressures (high crowding, Fed, and industry bottlenecks) have been partially resolved, suggesting the most volatile phase of tech may be passing. However, for a significant upward move, new catalysts are needed to break through the current demand ceiling, similar to the coding breakthrough by Anthropic in Q1. Therefore, beyond tech, moderate diversification into other sectors can balance odds and win rates, preventing excessive portfolio volatility. The experience of the recent tech turmoil suggests that over-concentrating on win rates can lead to high volatility risk, making a balanced approach more prudent. Specific diversification can target sectors with low fundamental resistance, such as innovative drugs, select internet stocks, and gold and non-ferrous metals benefiting from lower US bond yields. In other words, cyclical and export-oriented sectors offer higher certainty compared to domestic consumption. Finally, the firm's updated odds/win-rate framework shows that sectors like insurance, materials, electrical equipment, pharmaceuticals & biotech, and energy currently have high composite scores.