East Capital China

The first quarter is typically a time when investors look for signals about the health and direction of the economy. In the first quarter of 2025, expectations were high. This was particularly the case for China, where the government had reiterated its commitment to supporting growth through a combination of monetary easing, fiscal stimulus, and targeted sectoral support. While these macro efforts were expected, a surprise boost to investor sentiment came in the form of a major breakthrough in artificial intelligence. This dual force - policy support and technological innovation - helped revive China's stock market.

Over the quarter, the MSCI China All Shares Index returned 8.4%, reflecting a solid recovery in investor confidence. Our China Fund significantly outperformed, returning 15.0% and generating 6.6% of alpha. Our portfolio maintained an active allocation of 62.4%, highlighting our differentiated positioning and focus on high-conviction ideas. Strong relative performance was driven by a combination of sector rotation, stock selection, and early identification of emerging growth drivers such as AI.

A major turning point came in late January, when DeepSeek, a Chinese AI research group, unveiled its latest reasoning model - DeepSeek R1. The model's capabilities impressed both the market and the broader AI community due to its strong performance and efficient development timeline. Notably, the model was trained at a cost of US$5.6 million, far below the estimated billions that US hyperscalers typically spend on similar AI models. This demonstrated China's potential to develop cutting-edge technology at a fraction of the cost, and helped shift the global perception of Chinese innovation from cost driven to capability driven. DeepSeek's emergence symbolised a broader trend of technological catch-up, and sparked optimism that China could become a more competitive player in the global AI race.

Beyond this breakthrough, the groundwork for a market recovery had already been laid. Since late September 2024, the Chinese government had introduced a wide range of policies aimed at stabilising financial markets and reaccelerating economic growth. These included interest rate cuts, increased infrastructure spending, enhanced support for the real estate sector, and consumption stimulus programs such as digital vouchers and tax rebates. Together, these measures helped to restore business confidence and stabilise key economic indicators like industrial production, retail sales and credit growth. While challenges to confidence remain in the real estate sector and private sector, the direction of policy is clearly pro-growth, providing a favourable backdrop for equities.
Investor positioning also played a critical role. Heading into 2025, global investors remained heavily underweight China, reflecting years of poor performance, regulatory concerns, and geopolitical tensions. At the same time, valuations on U.S. markets - particularly in technology - had reached elevated levels. According to Bank of America's Global Fund Manager Survey, more than 80% of fund managers viewed U.S. technology as overvalued, while hedge fund and mutual fund allocations to China were at historic lows - around the 10th percentile. This created an asymmetric situation where even modestly positive developments in China could lead to outsized market reactions as investors began to reassess and reallocate.

Among our holdings, Alibaba stood out as the largest alpha contributor, adding 147 basis points after its share price gained 55% during the quarter. Our positive view on Alibaba is rooted in its strategic positioning in AI. The company's Qwen model is among the most advanced in the industry, and its ecosystem - including e-commerce, logistics, payments, and cloud - provides one of the most complete platforms for deploying and monetising AI capabilities. We believe the cloud business in particular will see a significant uptick in demand, as enterprises increasingly adopt AI-driven solutions. The company's restructuring efforts and cost optimisation have also improved profitability, making its risk-reward profile even more attractive.

Looking ahead, we believe the remainder of 2025 will be shaped by two key dynamics: the pace of China's domestic economic recovery and the evolution of global geopolitical factors. Domestically, we expect continued policy support, as the government remains focused on achieving its 5% GDP growth target. Areas such as green energy, advanced manufacturing and domestic consumption are likely to receive continued attention. Externally, developments around U.S.-China relations - including tariffs, export controls, and technology restrictions - will remain key variables to monitor. Despite these uncertainties, we are optimistic about the outlook for Chinese equities. Valuations remain compelling, investor positioning is light, and the government has demonstrated a clear willingness to act. As confidence gradually returns, we see ample room for a re-rating in both fundamentals and sentiment.