Reevaluating China's manufacturing sector

Since the surge in artificial intelligence agents, particularly the maturity of coding agents, it became evident that the economic benefits of AI investment are currently limited, but that AI could have a significant impact on the traditional enterprise service sector and cause structural damage to employment. According to tech sector data portal The Information, when ChatGPT internally displayed a list of purchasable products, the proportion of users clicking the buy button was less than 1 percent, significantly lower than the average conversion rate of 3-4 percent on e-commerce websites. The asymmetrical impact of AI development on the production side and the demand side is a reality that must be confronted.

As investors grapple with the long-term structural shifts of the AI revolution, we are seeing an immediate impact on capital flows in the US stock market: a defensive surge into HALO (heavy assets, low obsolescence) assets contrasted by a significant valuation reset for SaaS (software as a service) providers. The strategy behind HALO trades is to identify defensive stocks that can avoid damage to free cashflow or pressure on declining capital return rates in the face of AI's disruptive innovation — essentially serving as a passive defensive switch.

The disruptive impact of AI innovation on China is somewhat less than that on the US and Europe. The proportion of the services sector, which is most vulnerable to the impact, in the total employed population in China, the US and Europe is 48.8 percent (65 percent in urban areas), 79.0 percent and 73.5 percent, respectively. China's economic reliance on services is significantly lower than the US and Europe. Moreover, the three sectors with the highest employment in China's production-oriented services (internet, finance and real estate) have already undergone deep adjustments.

With its abundance of competitive manufacturers and attractive valuations, the A-share market offers a different investment narrative shaped by AI's influence. In fact, if we apply the HALO framework to A-shares, HALO portfolios have not shown significant outperformance. The logic of HALO cannot be simply applied to A-shares, which differs from the US. The core focus is on resource and manufacturing companies with existing market share advantages, which actively manage the pace of future capital expenditure and convert current competitive edges into profit margin recovery. This process aims to restart the expansion of free cashflow after a period of low-return capex peaks. Essentially, this is about identifying those sectors and companies whose production capacity is difficult to simply replicate globally, and whose significant market share advantages are gradually being transformed into stronger profit and cashflow under the backdrop of intentional government capacity control.

Profit recovery of manufacturing companies is also guaranteed by the policy. The 15th Five-Year Plan's industrial policy displayed a radical change from "big" to "strong", transitioning from scale expansion to stabilizing supply chains, protecting profits and preventing risks. The focus is on improving the quality and efficiency of advantageous manufacturing to generate profits, which in turn strengthen the weak points in the industrial chain, ultimately achieving sustainable improvements in living standards and social security levels for households. Profitable sectors can generate profits, rather than being continuously trapped in vicious competition, which is in line with the entire policy logic.

This policy shift is rooted in a fundamental change in the fiscal landscape. The growth of value-added taxes, driven by production expansion and the growth of land-related revenues, has inevitably slowed. The combined annualized growth rate of VAT and business taxes fell to 1.7 percent, both of which are lower than the growth rates of nominal GDP and fiscal expenditure. From 2019 to 2025, China's fixed-asset investment saw an annualized growth rate of 2.4 percent, with the growth rate of fixed-asset investment dropping below zero in 2025 for the first time in history. To ensure the sustainability of the fiscal situation and maintain a controllable debt level, it is necessary to promote a moderate expansion in prices, increase corporate profits and boost household incomes to enhance the growth of direct taxes. We see and believe that the alignment between future fiscal interests and shareholder interests will be bolstered.

The recent rise in oil prices presents an opportunity to test the pricing power of China's advantageous manufacturing sectors. Rather than price changes in the stock market, we need concrete fundamental evidence to support the logic of China's manufacturing re-evaluation. The energy cost shock brought about by the current Middle East conflict provides us with an opportunity to observe and verify: if China's advantageous manufacturing sector can truly demonstrate pricing power, or China's high dependence on crude oil imports and intense competition diminish manufacturing profit margins. These two narratives may offer more concrete evidence in the second quarter.

While the risk of extreme oil price spikes has receded, the market is increasingly factoring in a sustained, long-term rise in energy costs. After the US and Iran reached a temporary cease fire, the CBOE Crude Oil Volatility Index declined to 78 percent on April 10, marking the first time since March 5 that it had fallen below 80 percent. The market has clearly reduced its pricing of the tail risk of war. However, the market is now pricing in the possibility of long-term disruptions to passage through the Strait of Hormuz. At the beginning of the conflict, the backwardation in Brent crude oil widened rapidly, indicating that the market priced in short-term supply shocks but remained relatively optimistic about long-term supply damage. Since April, as the conflict has eased, the current-month contract has dropped significantly, but the far-month contract has not shown a noticeable decline, leading to a substantial compression of backwardation. The longer the crude oil supply disruption lasts, the more time it will take to restore balance, requiring a larger amount of restocking, and the higher the oil price will rise.

In terms of allocation opportunities under the reevaluation of China's manufacturing pricing power, we recommend focusing on chemicals, nonferrous metals, power equipment and alternative energy. Chemicals could be most significantly benefited by supply disruptions in the Middle East and subsequent price increases, while the nonferrous metals sector may also gradually restore resource-based pricing after liquidity shocks subside. Recently, the State Council — the nation's Cabinet — unveiled a set of regulations on industrial and supply chain security. The most significant marginal change in the alternative energy sector is the discussion around export controls on photovoltaic equipment. We believe that, like lithium battery equipment, from the perspective of ensuring industrial chain security and capacity advantages, key equipment exports may undergo technical reviews rather than blanket restrictions. While this may present headwinds in the short term, it is crucial for maintaining long-term relative competitiveness, eliminating excess supply in the industrial chain and restoring the pricing power of leading enterprises.

The writer is chief A-share strategist at CITIC Securities.

The views do not necessarily reflect those of China Daily.