Stock markets in China and Hong Kong will rally more than 20% next year on the back of Beijing’s ambitious social housing plan and expected stabilisation in money supply following action to curb inflation, forecasts brokerage CLSA.

Only this month, China’s Ministry of Housing and Urban-Rural Development set a target for social housing of 10 million units by the end of next year, which would represent a 72% increase from the 5.8 million units at present.

“The biggest positive theme we see is [China’s] social housing plan with a target of 10 million units next year, which is double our forecast,” says Francis Cheung, head of China/Hong Kong strategy for CLSA.

At a recent media conference in Hong Kong he expressed a bullish view on China’s economic outlook, forecasting GDP growth of 10% for 2011. And he sees the recent correction in the domestic stock markets as an opportunity for reinvestment in anticipation of a rally in the second half of 2011.

On December 10, China’s Central Economic Work Conference stated that monetary policy would shift from loose to prudent next year. The stock market had already priced in tightening measures, with the Shanghai Composite having plunged 13% from mid-November to early December.

At present, China’s consumer price index (CPI) stands at 5.1% – far above the government’s 3% target – and Cheung believes inflation will peak in the second quarter of 2011, after which he expects monetary tightening to ease.

“When the government controls liquidity, the market corrects; when tightening finishes, the market starts to rally,” he notes.

In fact, Cheung sees 2011 as an extended version of 2004, when CPI hit 5.5% and an overheating economy tested Beijing policymakers, but subsequent action then led to a late-year rally.

“The key indication is M2 [money supply, which stood at 19% in November],” says Cheung, “Once M2 stabilises at the target level of 15%, the market can rally.”

Cheung forecasts 25% upside for MSCI China for 2011, based on 16% earnings growth and 8% forward price-earnings expansion. While CLSA’s expectations for the Hang Seng Index and the Hang Seng China Enterprises Index are for rallies of 24% and 20%, respectively, to 29,000 and 15,500.

This tallies with the firm’s recent investor survey, which found 61% of respondents expect more than 20% upside in China’s stock market next year, while 51% said they planned to add weightings to China equities.

For his part, Cheung urges investors to overweight stocks in such sectors as technology, media and telecommunications (TMT), consumer discretionary, gold, insurance, transport, industrials and energy.

He notes that firms such as Baidu will benefit from a doubling of broadband users, strong online advertising demand from multinational companies entering China and increased e-commerce business. He is also bullish about insurance firms, which would benefit from likely interest-rate rises.

CLSA’s top China stock picks for 2011 are Ping An, Baidu, Sands China, GCL-Poly Energy and Great Wall Motor.

In terms of near-term China risks, Cheung lists a potential property bubble and rising inflation, the latter driven by a weak US dollar, bad weather hampering crop yields, and excessive liquidity being pumped into the system by central banks.

He forecasts that the consumer price index for food will peak at a 13-15% year-on-year increase, while inflation could persist for between seven and 15 months, based on historical data. He cautions investors to underweight banks, consumer staples and property until inflation has peaked.

Cheung also expects China to accelerate its efforts to internationalise the renminbi, with QE2 epitomising policymakers’ fears about the US dollar as a global reserve currency.

RMB internationalisation requires about Rmb2 trillion circulating offshore, equivalent to 3% of China’s M2 supply, or 60% of Hong Kong’s, according to a study by the Development Research Center of the State Council.

“If Hong Kong is not fast enough to develop investment products, such as RMB bonds and IPOs, to absorb surging RMB deposits, its [deposits] will leak [to sectors such as property],” Cheung points out.

He also raises concerns that a large amount of RMB circulating offshore could overwhelm Hong Kong, which is already battling its own asset-inflation issues.

“The more quantitative easing the US does, the faster the RMB will come to Hong Kong,” he suggests, driving up property prices at a time when housing supply is forecast to remain tight until 2014.