Chinese equities have captured headlines recently, with trading volumes surging in Hong Kong and the MSCI China Index (which tracks the performance of Chinese companies listed in Hong Kong) rising 14% over four trading days (April 8–13). The catalyst was a decision in late March by mainland Chinese regulators to allow domestic mutual funds to invest in HK-listed stocks via the Shanghai–Hong Kong Stock Connect program.

Launched last November, the Stock Connect program allows investors to trade in both markets, albeit with daily and aggregate quotas. However, while “northbound” trading from Hong Kong to Shanghai was open to all investors, “southbound” trading from mainland China to Hong Kong had been limited to only high-net-worth investors, and uptake was minimal, leading to the late March expansion.

With Hong Kong markets closed for three days in early April, April 8 was effectively the first time mainland mutual funds could buy HK-listed stocks, and they did so with a vengeance, maxing out the southbound daily quota of US$1.7 billion on two consecutive days.

Why the sudden interest by mainland investors? Because the massive rally in the mainland A-share market over the past six months has created a large valuation gap between the mainland and offshore (HK-listed) markets.* The A-share market (as measured by the MSCI China A Index) gained 62% between September 30, 2014, and March 31, 2015, compared to only 16% for the offshore market (as measured by the MSCI China Index, which makes up 23% of the MSCI Emerging Markets Index). As a result, the “A-H Premium,” a measure of relative valuations between stocks listed in both markets, rocketed from a mild A-share discount last year to a 35% premium by the end of March. In other words, you can buy the same companies at a sizable discount in Hong Kong.

The A-share market is in the grip of a mini-mania, driven by expectations of continued easing by the People’s Bank of China (PBOC) to combat a slowing economy and prevent stress in the banking system. The explosiveness of the A-share rally is due in part to rising margin trading by retail investors, but also the fact that with the housing market slumping, interest rates falling, and the authorities cracking down on high-yielding “wealth management products,” stocks are the only attractive outlet for domestic savings.

The A-share surge also reflects just how cheap and unloved the market was. A year ago the market was more than 1 standard deviation cheap on an ROE-adjusted P/E basis. Despite prices nearly doubling over the past 12 months, the market is now only slightly above its historical median P/E of roughly 20.

Huge rallies are typical for A-shares, which nearly tripled in 2007 and nearly doubled in 2009, only to both times give back most of the gains. The retail-driven nature of the market makes it prone to overshoots and influenced more by liquidity conditions than valuations.

With the A-share market now overheating, the recent decision to let mainland mutual funds invest in Hong Kong is likely an attempt by Chinese authorities to take some steam out of the A-share market. The announcement on Friday (April 17) that margin lending would be tightened and securities lending and short selling would be expanded are other signs that the authorities want to cool the A-share market, triggering a sell-off in recent days.

Meanwhile, despite the recent rally, HK-listed Chinese equities still look slightly cheap. The MSCI China Index trades slightly below its post-2002 median ROE-adjusted P/E of 13, and while the A-H premium has narrowed to only 20% as of mid-April, this is still a sizable gap.

Thus, the HK-listed market remains attractive, especially if authorities further relax cross-border investment restrictions. A plan to connect the Shenzhen exchange with Hong Kong is expected to launch by year-end, and media reports suggest regulators may expand the existing Stock Connect quotas to allow more southbound flows. If this occurs, then more of China’s trapped domestic liquidity will flow into Hong Kong’s stock market.

For now, continued outperformance of HK-listed Chinese equities bodes well for emerging markets equities as a whole and especially Asia ex Japan or emerging markets value managers, which tend to have China overweights. At the same time, pure-play Hong Kong stocks have also started to benefit from the liquidity spillover, as these stocks are also cheap and a logical “next step” for mainland investors.

Questions remain about how sustainable the current rally will be in the face of an ongoing economic slowdown in China and a weak profit backdrop. But at this juncture, “bad news is good news” for Chinese equities if it results in additional easing by the PBOC. With valuations still reasonable, the rally in Chinese equities probably has more to run. But investors should be prepared for a wild ride.

* By way of background, China effectively has two separate stock markets, the mainland (or onshore) “A-share market,” which has historically been closed to foreign investors, and an offshore market concentrated in Hong Kong that forms the basis of the China exposure in global and emerging markets benchmarks. The Hong Kong share class of a mainland Chinese company is known as an “H-share” and there are a range of other types of offshore Chinese companies, such as Red-chips, P-chips, and B-shares, that are included in the MSCI China Index. Chinese companies listed in New York and elsewhere are not yet included in most indexes.

Aaron Costello is a Managing Director on the Cambridge Associates Global Investment Research team.