Four factors that can sustain a bull rally

The recent bull market has caught investors and regulators off guard. The ChiNext Price Index, SZSE SME Price Index and SZSE Component Index rose sharply in the first half and popular counters changed from technology and consumer stocks into brokerages, banks and real estate firms.

In my view, the rapid surge in the A-share market was mainly driven by four factors, and how these factors evolve will decide how long the bull market will last.

First of all, China will hopefully continue to ease its monetary policy to deal with the impact of the novel coronavirus outbreak on the economy and to coordinate with large-scale issuance of government bonds and local government special bonds in the second half.

China's gross domestic product shrank 6.8 percent year-on-year in the first quarter. Although GDP achieved a 3.2 percent growth in the second quarter, it may still be difficult for full-year growth to be higher than 3 percent. Currently, insufficient aggregate demand is the principal challenge facing the Chinese economy.

During the annual meetings of China's top legislative body and top political advisory body at the end of May this year, the country set the basic tone of loose macroeconomic policies.

The People's Bank of China, the central bank, has cut the reserve requirement ratio three times since the beginning of the year. It also lowered the one-year medium-term lending facility rate and re-lending and rediscount rates several times, in addition to establishing new mechanisms for monetary policy instruments to directly stimulate the real economy－the part of the economy that produces actual goods and services.

At the end of June, China's M2－a broad measure of money supply that covers cash in circulation and all deposits－rose 11.1 percent year-on-year to 213.49 trillion yuan ($30.5 trillion). The growth rate was 2.6 percentage points higher than that in the same period last year, said the PBOC.

Preliminary statistics from the central bank also show that China's newly added social financing, a measure of funds the real economy receives from the financial system, came in at 20.83 trillion yuan in the first half, up 6.22 trillion yuan from the same period last year.

To prevent large-scale issuance of government bonds and local government special bonds from crowding out private sector financing in the second half, the country's monetary policy will remain moderately loose. We will hopefully see further cuts in banks' reserve requirement ratio and interest rates.

Market expectations for continuous implementation of a moderately loose monetary policy will undoubtedly promote the development of the current bull market.

However, I expect China's GDP to grow by 6 percent year-on-year in the third quarter and 7 percent in the fourth quarter. With the waning of the pandemic and China's economic rebound, we are not very likely to see marginal relaxation of the monetary policy in the second half, unless a massive second wave of COVID-19 takes place.

Second, with the deepening of financial regulation and the rise of financial risk in traditional areas, banks and trust companies are forced to reduce their holdings of nonstandard assets via a large amount of wealth management funds and trust funds and increase asset allocation to A shares through various channels.

On the one hand, financial regulators have kept pressurizing banks and trust companies since 2017, requiring these financial institutions to reduce the proportion of their off-balance sheet assets to total assets and the proportion of their on-balance sheet assets allocated to nonstandard assets.

On the other hand, with the slowing down of China's economic growth and the continuity of macroeconomic regulation, financial risks associated with loans to local government financing vehicles and real estate developers－key asset classes to which wealth management funds and trust funds are allocated－have begun to be gradually exposed.

As a result, trust funds and banks' wealth management funds are more inclined to largely increase their holdings of A shares via channels including mutual funds, private equity funds and exchange-traded funds. The transition of fund allocations by institutional investors is favorable to the formation of the current bull market.

Whether or not wealth management funds and trust funds continue to flow massively into the stock market depends on the judgment of regulators regarding potential risks. If regulators believe that an ongoing overly rapid stock market surge may trigger relatively high risks, they may tighten regulation of the size and the proportion of wealth management funds and trust funds allocated to the stock market.

Third, as the impact of the novel coronavirus outbreak on global financial markets gradually comes to an end, the risk sentiment of global institutional investors is beginning to rise again.

Compared with other major markets, the fundamentals of China's stock market are more stable, and the valuations of its stock market are more attractive than that of the US stock market. Recently, massive inflows of northbound funds－mainly consisting of foreign capital and money by offshore Chinese firms flowing back to the Chinese mainland through Hong Kong－have driven a rapid increase in blue chip stock prices since the last 10 days of June.

However Sino-US economic and trade relations may continue to have difficulties. Geopolitical tensions in the Middle East may also intensify. Considering all these factors, we cannot rule out the possibility that global financial markets may become turbulent in the second half and China may see capital outflows once again.

Finally, policies that regulators have launched or will launch have boosted investor confidence in the stock market. For instance, regulators are considering whether or not to grant securities licenses to some commercial banks, and rumors say that regulators will encourage mergers between large brokerages. These policy measures stimulated rises in stock indexes, China concepts stocks and stocks in the banking and securities sectors.

But the market may have over-interpreted these reform measures, some of which may not be launched. Therefore, enthusiasm ignited by financial reforms may face the risk of a correction.

It is not hard to see that the first three factors driving hikes in the A-share market are all related to liquidity, rather than economic fundamentals.

In summary, China's stock market may be in the middle of the current bull rally, which will continue for a while, but market volatility and financial risks will increase.

We may see performance divergence among stocks once again, and the market will pay high attention to marginal changes in various types of liquidity.

Under current circumstances, retail investors should pay particular attention to risks that may exist in individual stocks and sectors whose valuations are high despite their weak business performance.

The writer is director of the department of international investment at the Institute of World Economics and Politics, the Chinese Academy of Social Sciences.