AFTER lagging global markets for several years, China’s stock market surprised investors with a solid rally in 2014, despite tempered growth in the world’s second-largest economy.

The benchmark Shanghai Composite Index ended up 53 percent on the year, its biggest 12-month advance in five years. It was the top performer among major global equity markets.

The rally was triggered by an interest rate cut in November and ample liquidity in the system. In addition, the new landmark trading link between Shanghai and Hong Kong stock exchanges also raised expectations of increasing foreign capital flowing into Chinese markets.

However, as with all rallies, doubts about its sustainability linger.

Chen Li, chief China equity strategist at UBS, sat down with Shanghai Daily and shared his views on where we go from here.

Q: What do you think are major drivers of the current rally in the A-share market?

A: On one hand, there has been industrial capital reallocation as funds withdraw from property and commodity markets and invest in the stock market. On the other hand, the lucrative stock market has attracted a large number of retail investors as indicated by the increasing number of newly opened accounts related to A-share trading.

There have been catalysts in recent two months. The interest rate cut in November confirmed a loose monetary policy and inspired expectations that there will be more monetary easing. In addition, the Ministry of Finance granted 1.6 trillion yuan (US$258 billion) of fiscal funding to enterprises in December, increasing by up to 30 percent from the amount granted in previous years. Moreover, credit supply also increased in the last two months of the year. There was more than 800 billion yuan of new credit in November and an estimated 700 billion yuan in December. That was much more than amounts in the last five years.

Q: Is the market buoyed more by abundant liquidity rather than by fundamentals?

A: I have never seen a bull market without the support of fundamentals. Some people have said the continuous rise of the stock market is driven by reforms because economic growth is likely to slow further in 2015. I don’t agree with that. I think the market rise to some extent reflects expectations that economic growth will bottom out and rebound this year.

There are some signs. First, the increasing credit supply indicates more investment in the future. Second, the National Development and Reform Commission approved 1.2 trillion yuan of projects in the past two months, including a new airport in Beijing and railway projects. Third, the interest rate cut encourages enterprise investment. Thus, I think the market is not bolstered only by liquidity but also by expectations that economic fundamentals will recover soon.

Q: How long do you expect this bull market in China will last?

A: I think March and April will be an important time for the market. If economic data for new project starts, investment and the real estate sector improve significantly and provide evidence that the economy bottomed out in the first quarter, I think the bull market will last until the end of this year or even longer. But if data were to be disappointing, the market will go through a sharp correction and fall back to around 3,000 points.

Q: What are the potential downside risks for the A-share market?

A: The supply of new shares will increase as the market revives. That would weigh on the market. Currently, about 650 companies are waiting for regulatory approval to go public. We expect there will be 300 new listings this year. The launch of a registration system for initial public offerings will further accelerate the pace of new share sales.

We expect draft rules of the registration system to be unveiled around the annual sessions of China’s top legislature and top political advisory body in March. It will lead to a 5 percent to 10 percent downward correction, especially among small-cap shares.

Another risk would be depreciation of the yuan against the US dollar. It’s widely believed that yuan has entered a cycle of interest rate cuts since the last cut in November, while the US dollar is in a rate hike cycle.

That indicates the weakening of yuan against the US dollar is not short-lived but could last for a relatively long time, maybe six months or even one year.

That could lead to capital outflows and undermine liquidity in the money market and interbank market. It will deliver a blow to the market in the short term even though the central bank can cut the reserve requirement ratio to cope with capital flight.

Q: Should we worry about overvaluation?

A: In fact, the A-share market has been very split. Small-cap stocks have been very expensive after gaining more than 300 percent in the past three years.

However, the valuation of large-cap shares is reasonable, even after the 53 percent rise this year. The price-to-earning ratio of the CSI 300 Index is at around 15, almost equal with levels in the US and European markets.

Q: Domestic retail investors are fueling this round of market rally. Why are international investors still holding back?

A: Some investors are far-sighted and may not care about short-term profits. They believe the opening-up process of China’s capital market, such as the trading link between Shanghai and Hong Kong exchanges, will eventually bring opportunities in the long run.

Most international investors are cautious. They tend to wait for data to show the Chinese economy is bottoming and will recover before they decide to buy Chinese shares.

Q: What sectors do you think are most promising in 2015?

A: I am optimistic about the short-term performance of the real-estate sector. Property companies are increasing their supply of new houses. Meanwhile, increasing mortgage loans indicate rising demand. These will form an ideal situation. As supply and demand increase at the same time, home sales will increase, while home prices won’t go up. But from a long-term perspective, investment in the property sector is unappealing.

I also prefer high-dividend stocks and stocks that will be included in the MSCI global indexes in the future. They include two kinds of stocks. One are blue chips. The other are financial shares of lenders and brokerages that list only on the A-share market because dual-listed shares already have weightings in MSCI indexes.

Export companies related to sectors such as high-speed trains, power grids, electrical equipment, nuclear power, communications and agriculture will benefit from China’s “go out” strategy and the efforts to build the Silk Road Economic Belt and the Maritime Silk Road of the 21st Century.

I don’t recommend consumer staple stocks because deflation is expected to last over the next six months.

I would also avoid stocks of energy and materials companies, which are sectors with overcapacity.