Shenwan Hongyuan Group Co., Ltd. believes the current market rally is being driven by initial capital from ETFs, allocation funds, fixed-income plus strategies, and quantitative funds. Subsequent inflows are primarily fueled by the accumulation of profitable effects, initiating a virtuous cycle of incremental capital. Conditions for sustaining this positive fund flow cycle are expected to improve further. Following a short-term index uptick, a phase of sideways consolidation is likely, which may represent only the lower bound of the market's potential. The upper bound is defined by incremental fund inflows expanding the upside probability, suggesting a second phase of the rally may be commencing.
1. Small-cap revenue and profit growth rates continue to show relative improvement compared to the broader market, with the expansion pace of smaller enterprises accelerating. This trend, validated by Q1 2026 reports, represents a key fundamental shift. The recent diffusion of the tech growth rally has some fundamental support.
Post the Q1 earnings season, the small-cap growth style has recovered as anticipated. Beyond the support from the earnings season conclusion and a stalemate in overseas conflicts boosting risk appetite, fundamental evidence for small-cap outperformance remains clear. Q1 2026 reports show that small-cap stocks' revenue and profit growth rates relative to the overall A-share market (excluding financials and petroleum) have continued their upward trend. Concurrently, the expansion speed of smaller enterprises—measured by the marginal change in revenue share of companies in the bottom 40% by income within each sector—continues to rise. This serves as the most direct fundamental concurrent indicator for small-cap dominance. This aligns with the deepening trends in new economic industries and the broadening reach of AI-related inflation. It also matches the trend of venture capital and primary market financing bottoming out and rebounding since 2025, alongside increasing hotspots in the new economy. The current diffusion of the tech growth rally thus rests on a solid fundamental base, with a reasonably high probability of short-term continuation.
2. The accumulation of profitable effects in the A-share market is undergoing a qualitative shift. Conditions for initiating a subsequent virtuous cycle of incremental capital are improving. After a short-term index rise, a phase of sideways consolidation is likely, potentially representing only the market's lower bound. The upper bound is set by incremental fund inflows expanding the upside probability, indicating a second phase of the rally may be starting.
During an uptrend cycle, incremental capital can be categorized as "first-in money" and "follow-on money." The composition of first-in money varies each cycle, depending on capital market reforms and the development stage of the asset management industry. In this cycle, first-in money primarily comes from ETFs, allocation funds, fixed-income plus strategies, and quantitative funds. Follow-on money is mainly driven by the accumulation of profitable effects, creating a virtuous cycle of incremental inflows. Historical patterns based on the last peak in mutual fund issuance suggest that a new round of scale expansion typically begins when the net asset value (NAV) of products from the previous issuance peak rises to between 1.1 and 1.2. Expansion may accelerate once the NAV exceeds 1.2. Following this week's structural market performance, the average mutual fund NAV has surpassed 1.3, indicating the profitability effect has qualitatively shifted. Even considering the learning effect within the mutual fund channel, subsequent investment opportunities are increasingly likely to evolve into a positive feedback loop of incremental capital. This is evidenced by sector ETFs regaining strong momentum and actively managed tech-focused products leading the scale expansion, thereby opening up further upside potential.
For a rally validated by new economic sector vitality, the baseline scenario typically involves a price increase followed by a new phase of high-level volatility. However, considering medium-term capital supply and demand dynamics, this consolidation may only represent the lower bound of the market move. The upper bound is defined by incremental fund inflows expanding the upside probability, suggesting the second phase of the uptrend is now underway. For the short-term market, we do not recommend prematurely taking profits.
Potential downside risks to monitor in Q2: The U.S.-Iran conflict remains deadlocked. The navigability of the Strait of Hormuz may face prolonged and repeated disruptions. More impactful than high crude oil prices could be an outright supply shortage. Overseas economic shocks may become more concentrated in Q2 2026, and the effects of cost pressures may begin to surface. Additionally, vigilance is needed against the risk of inventories falling below safe levels, potentially triggering significant volatility in commodity and capital markets. While endogenous market forces are strengthening, external risks have not been fully eliminated. At this stage, moderate measures to curb excessive market heat appear reasonable.
3. Structural investment preferences remain unchanged; continue seeking opportunities within core themes. Maintain focus on optical communication, energy storage, memory storage, and gas turbines. Conditions are favorable for the diffusion of the rally; monitor investment opportunities in commercial aerospace and humanoid robotics. For emerging high-growth directions, focus on new energy, new energy vehicles, and export/overseas expansion alpha.
Structural selection remains consistent: continue emphasizing core thematic assets. Sectors where earnings can justify valuations offer a higher short-term floor. After a short-term rise, a new range of sideways consolidation is possible. Building on this, one can also watch for opportunities where fundamentals and incremental capital resonate, and valuation re-anchoring opens up upside potential. We remain positive on the core themes of optical communication, memory storage, energy storage, and gas turbines. Furthermore, conditions are ripe for the profitable effect to diffuse to other sectors in the short term. Focus particularly on recovery opportunities in relatively low-positioned tech sectors like commercial aerospace and humanoid robotics. In the next phase, for identifying new inflection points in sector vitality, focus on beneficiaries of the global industrial realignment following the U.S.-Iran conflict. Key structural focuses are the alpha opportunities within new energy, new energy vehicles, and the export/overseas expansion chain.