China's stock market is the worst performing major bourse in Asia this year, undermined by a flagging economy and weak profit growth. Hopes of fiscal and monetary stimulus in the near term are also fading, but equity analysts tell CNBC they are not giving up yet.
Cheap valuations and the nation's long term commitment to growth are what make Chinese stocks still worth buying, they say.
"The weak market is an opportunity and valuations in China are cheap," said Rob Aspin, Head of Equity Strategy, Wealth Management Group at Standard Chartered.
"Long-term if you look at what policymakers are saying, that is positive. Liquidity is the key driver and when that comes through (from government stimulus) it will be good for the stock market," he added.
China has eased monetary policy by slashing reserve requirement ratios for banks three times since November. The country's central bank has also cut interest rates twice this year to bolster an economy that has slowed for six consecutive quarters. Plus the government has fast tracked investments in infrastructure projects, eased rules on bank lending and cut taxes for businesses.
But so far these measures have had little impact on the stock market. Shanghai's benchmark index is down 2.6 percent year-to-date and has tumbled some 15 percent from a high hit in March. Its performance looks poor against major bourses - the Dow Jones stock index for instance, is up almost 8 percent this year and Japan's Nikkei index has gained about 5.6 percent.
Weaker-than-expected economic data for July further dented investor sentiment, fueling concerns about the outlook for China's economy, which grew at 7.6 percent in the second quarter, its slowest pace in three years.
But equity strategists at Citi say that July's numbers, while coming in below expectations, point towards stabilization in the economy.
"On the one hand, economic activities weakened further as export growth dropped to only 1 percent year-on-year and new loans fell below 600 billion yuan ($94.3 billion); on the other side, industrial output remained above 9 percent year-on-year, alongside a more stable PMI reading," Citi equity strategists Minggao Shen and Ben Wei said in a note, referring to China's July Purchasing Managers Index of 50.1. A reading below 50 implies contraction.
"We recommend positioning for a near-term valuation rebound," they said. "Barring no disruption from the European debt crisis, better economic and policy outlooks when the Communist Party Congress draws near should lift market sentiment," they added. The Congress is expected to take place in October.
Skeptical Local Investors
Philip Chan, MD of Institutional Equity Sales at Shenyin Wanguo Securities in Hong Kong says one of the main reasons for the poor performance of equities is that local investors, who are the dominant investors, have turned more cautious about the economy than foreigners and hence are reluctant to get back into the market.
He adds that because any fiscal stimulus from China is unlikely to be as large as it was four years ago, the Chinese stock market is also likely to edge rather than rocket higher from here.
In 2008-2009, China announced spending worth $586 billion or 14 percent of its GDP, to bolster its economy in the face of a global financial crisis. But that spending is blamed for many of China's economic problems in the years that followed such as local government debt, over investment in housing and higher consumer prices.
"We do expect the Chinese equity market to drift higher but we don't expect a pop higher because of the way the government will handle stimulus - we will not get what we did four years ago, instead stimulus will be incremental," said Chan.
He expects the Shanghai stock market to edge up to 2,500 in coming months from around 2,120 on Thursday.
To get investors back, the Shanghai Stock Exchange announced Thursday that it was introducing new measures to encourage firms listed on China's main bourse to increase dividend payouts.
Stephen Sheung, Vice President and Investment Strategist at SHK Private says there are signs that perhaps Chinese investors are moving off the sidelines.
"If you look at the China A-shares market, volume has picked up in the last two weeks," Sheung told CNBC Asia's "The Call" on Thursday. Chinese A -shares refers to shares denominated in yuan, as opposed to B-shares, which are denominated in foreign currency.
"The (economic) numbers are not improving at a pace we like...But we do think it's a time to accumulate Chinese equities," he said.
Citi recommends buying banks, materials, electronics and auto stocks in China based on cheap valuations and hopes of an economic recovery. Its top pick for a valuation rebound include Air China and Bank of China.
Aspin at Standard Chartered said he favored stocks in the discretionary, consumer staples and energy sectors.
- By CNBC's Dhara Ranasinghe
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