Chinese equity markets are likely to be range bound in the coming months, with performance reflecting the positive domestic outlook on one end and the concern over potential credit tightening and a global economic slowdown on the other end, according to a report from HSBC Investments.

ôWhile ChinaÆs economic fundamentals remain strong, its equity markets are not always able to decouple from external volatility,ö the report says. ôUntil there is clarity in the global picture, Chinese equity markets may experience periodic bouts of volatility and profit taking.ö

Investor sentiment is more likely to be supportive in the second half of this year, HSBC Investments says. Once global uncertainty has cleared and inflation has eased, the risk of government policy action will diminish and investors can then start to focus on the positive fundamentals for the equity market, such as strong earnings growth of around 30% in 2008 and reasonable valuations, especially for H-shares, the firm adds.

Global equity markets stabilised in April, and Chinese equity markets managed to rebound during the month. Shanghai A-shares rose 11%, while H-shares and red-chips were up around 16% and 12% respectively, supported by easing global volatility.

The government cut the stamp duty on shares from 0.3% to 0.1% last month. They also announced new regulations to restrict the direct sale of non-tradable A-shares to the secondary market, once they become floatable. This eased fears of a supply overhang in the A-share market, and both measures boosted investor sentiment in April. The market was also buoyed by strong economic and earnings data; GDP growth was 10.6% in the first quarter of 2008. Inflation stayed high at 8.5% and concerns led the PeopleÆs Bank of China to raise the reserve ratio requirement for banks by 100 basis points to 16.5%, in order to limit bank lending and reduce liquidity in the financial system.

Inflation may be exacerbated in the short term by the recent earthquake that hit Sichuan province on May 12, according to HSBC Investments. The affected region is a key producer of grain within China, and this has ignited worries of a potential disruption in food supply, which may cause food prices to spiral. Any potential distortion in food prices is unlikely to last very long. The government has previously taken steps to increase food supply, and is likely to step up these efforts if necessary.

News reports have also cited damage to energy and mining companies, raising fears that production may be affected and that commodity prices may rise even further. The government has allayed some of these fears by confirming that less than 1% of the countryÆs coal mining capacity was affected by the recent earthquake. They also indicated that production would not be significantly reduced. However, the full extent of disruption to power and commodity supplies is not yet known.

ôWe believe that the earthquake, though tragic, has not dented ChinaÆs economic fundamentals and should not have a lasting impact on the equity market,ö the report says. ôThe government has already responded swiftly to the issue, by mobilising the military in the rescue effort and announcing relief for earthquake victims.ö

Though it may take time to assess the economic damage to the region as well as the cost of reconstruction, HSBC Investments believes it is unlikely to curtail ChinaÆs GDP growth, which is forecast at 9.7% for 2008.

Economic growth will continue to be driven by domestic consumption, which remains strong despite higher inflation. Retail sales rose 22% year-on-year in April, despite a CPI reading of 8.5% for the month.

Over the medium-term, inflation remains the biggest risk to equity markets. The consecutive increase in the reserve ratio requirement signals that the government is still worried about inflation. But this measure is probably intended to maintain stability in the domestic financial market, rather than to tighten credit in China, HSBC Investments notes.

ôInflation should moderate in the second half of this year, and the governmentÆs attention should shift from trying to control overheating to maintaining stable growth,ö the report says. ôThis should lead to more benign economic policies by the government in the coming months.ö