Analysts argue A-share market will rise if inflation is controlled

BEIJING - While investors are concerned that rising inflation could lead to tightened market liquidity, some analysts are bullish about China's A-share market, saying that it is likely to rebound when speculators are convinced that inflation is well under the government's control.

"We believe that Chinese equities are likely to start outperforming when there is a genuine conviction that the government is getting ahead of the curve in fighting inflation," Viktor Shvets, a stock strategist at Samsung Securities, said in a recent report.

Shvets predicted that investors are likely to turn positive on Chinese equities in the second or third quarter of 2011 and the benchmark Shanghai Composite Index is likely to gain 18 percent to reach 3,400 points.

Researchers at Standard & Poor's had similar views toward Chinese stocks and said that the market is set to gain in 2011 because concerns over interest rate increases have been discounted and valuations are attractive.

"A fair bit of interest-rate-hike concern has been discounted in the valuation, and that's why there is room for upside," Lorraine Tan, director of equity research for Asia at S&P, was quoted by Bloomberg as saying.

Henry Wu, head of China equity research at Nomura Securities, said that even if inflation stays high the stock market can still rise because what matters more is the expectation of inflation.

"China's consumer price index is likely to stay in the 4 percent range in 2011 and as long as the situation does not get worse than expected, the market is unlikely to overreact," Wu said.

But some analysts said that significant policy headwinds facing China are likely to continue to retard the country's equities market, which may continue to deliver higher-than-normal volatility in 2011.

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Experts say tackling inflation will be the overarching priority of Chinese policymakers in 2011 and the central bank is very likely to get tougher on credit control in 2011 by expanding the use of differentiated reserve requirements and adjusting the required level of reserves for each bank on a monthly basis.

It is also expected that the central government may not set a clear target for new loan growth in 2011 as it did in 2010.

Although the average price-to-earnings ratio of the A-share market is as low as 20 times, Wang Qing, an economist at Morgan Stanley, said a re-rating in valuations is unlikely to happen at least in the next three to six months as the expectation of lower liquidity may continue to depress the market.

"About 70 percent of overseas institutional investors that I've talked with are bearish on the emerging markets including China at least for the next three to six months due to the concern over tightened liquidity," Wang said.

"They are taking a long position on the upstream industries such as the energy sector and are short on the downstream sectors such as the consumer sector," he said.

The Shanghai Composite Index fell 14 percent in 2010, making it the worst performer among benchmark indexes in the world's 10 biggest markets.

Wang said that the primary risk of the Chinese economy stems from policy uncertainties and potential policy missteps.

"The risk of a policy-induced boom-and-bust cycle would be on the rise if the Chinese authorities were to mainly rely on administrative controls instead of price-based policy instruments such as rate hikes and appreciation of the yuan to control inflation," he said.

Guotai Junan Securities is also bearish on the Chinese stock market, predicting the market would slump for a second year with inflation remaining the biggest risk.