UBS: If China successfully moves towards "re-inflation," the stock market could potentially rise by 20%, and reduce holdings in the internet sector

UBS published a report stating that global commodity prices are expected to rise by 9% in 2025, continuing to increase this year. For many Chinese companies, higher input costs present a dilemma—either raise prices or endure declining profit margins. The bank's industry analysts conducted a "bottom-up" survey showing that more companies are inclined to raise prices this year, and the vast majority of industries expect a better revenue pricing trend compared to last year. As excess capacity decreases and the Chinese government pays more attention to inflation and "anti-involution," this could evolve into a positive inflation cycle.

On the other hand, if companies raise prices, it may lead to a decline in sales, forcing them to lower prices again and accept lower profit margins. Therefore, the Chinese stock market may face a crossroads as it enters the second half of the year, with the possibility of re-inflation as inflation expectations rise, or renewed deflation as corporate earnings expectations decline. The bank estimates that if companies cannot raise prices this year, the MSCI China Index EBIT could decline by about 7%; however, if China moves towards "re-inflation," the bank sees a 20% upside potential (16% from valuation re-evaluation, 3% to 4% from stronger earnings per share growth).

UBS pointed out that Japan's stock market experience in 2022 showed that the best-performing sectors during re-inflation included materials, finance, and real estate. However, for China, early beneficiaries may also include some consumer sectors, as their expectations and holding levels are relatively low. The bank upgraded real estate and consumer staples from "underweight" to "neutral," while downgrading the software sector to "underweight" due to ongoing concerns about technological disruption and high valuations.

The bank stated that it has adjusted its investment portfolio: (1) The software sector has been downgraded to "underweight" due to ongoing concerns about AI disruption and high valuations (the sector currently has a forward P/E ratio of 65 times); (2) The consumer staples sector has been adjusted to "neutral," but home appliances and consumer electronics have been downgraded to "underweight" due to higher input costs; (3) The real estate sector has been adjusted to "neutral," considering the possibility of further government policies; (4) The internet sector has been "reduced," removing NetEase (NTES.US) due to ongoing uncertainties regarding regulation and AI disruption. However, the bank still believes that Tencent (00700.HK) and Alibaba (BABA.US) are the best ways to capture the commercialization path of AI and large language models in China