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China’s CSI 300 index has climbed 3.6 per cent in 2017.

BOBBY YIP/REUTERS

Optimism over China's economy has driven gains in the world's second-largest equity market this year. But that budding recovery could also be investors' undoing.

Some money managers are turning cautious on Chinese shares on concern the economic rebound will spur the central bank to tighten monetary policy further. While People's Bank of China Governor Zhou Xiaochuan reiterated the bank's neutral course in a rare press conference Friday, and officials have steered clear of boosting benchmark interest rates so far, mainland markets have started to price in a "major hawkish shift" from the PBOC, according to Goldman Sachs Group Inc.

"Where stocks will head will really depend on how fast the government tightens monetary policy and how fast company earnings will recover – it's like a competition between these two things," said Dai Ming, who manages a fund of structured products for investing in Chinese equities at Hengsheng Asset Management Co. in Shanghai. "There could be a further correction in the stock market."

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China's CSI 300 index has climbed 3.6 per cent in 2017, winding back some of last year's 11-per-cent slump as evidence Asia's largest economy is on a stronger footing started to mount. Analysts surveyed by Bloomberg at the end of 2016 were bullish, predicting a strong rally as signs of growth become more embedded.

But the CSI 300 slumped the most in almost three weeks last Thursday after an uptick in producer-price growth boosted the outlook for Chinese, and global, reflation. The economy accelerated for the first time in two years last quarter, manufacturing is gathering pace and China saw its steepest import growth in five years in February.

Main risk

While the market fallout from the PBOC's focus on curbing leverage has so far centred on bonds, the potential for tightening is a "main risk" for mainland shares, said Shi Bo, chief investment officer at China Southern Asset Management Co., the country's fifth-largest mutual-fund manager, overseeing 390 billion yuan ($56-billion U.S.).

When asked whether the Federal Reserve's tightening bias would put pressure on the PBOC, Mr. Zhou said in the medium term interest rates are determined by the domestic economy, jobs and inflation. Still, one-year rate swaps rose the most this week for more than a month.

"Higher lending rates drive up the cost of borrowing for companies, providing a potential hit to earnings," said Chen Li, an A-shares strategist at Credit Suisse Group AG in Hong Kong. Monetary tightening will "definitely" affect Chinese shares, "though the impact will likely be less severe on stocks than on bonds."

Qiu Dongrong, manager of the 2.64 billion yuan HSBC Jintrust Large Cap Equity Securities Investment Fund, said he's turned less aggressive on Chinese stock allocations. "Whether China will maintain a tight stance over monetary policy and for how long will be a key focus for 2017," he said. "Corporate earnings may be put to the test."

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"Equity markets have been roaring along because economic data have been very strong globally and we've had some very loose monetary policy," said Marc Franklin, a fund manager in Hong Kong for the Asian unit of Conning Holdings Ltd., which manages about $109-billion globally. "Policy stimulus needs to normalize."

Though these investors have their concerns, the wider consensus is bullish. Citigroup Inc. reiterated its positive A-shares stance March 5, while UBS Group AG and even Chen at Credit Suisse see the market higher by year-end. Morgan Stanley predicts the Shanghai Composite Index's 2017 gains will be more than double that for Hong Kong-traded Chinese stocks.

Economists, too, see a moderation in Chinese producer-price inflation toward the end of the year as commodity prices come off and curbs on the property market bite.

There's also the China intervention factor. Regulators are said to have supported equities this week amid the National People's Congress and will want to avoid instability in the markets ahead of the twice-a-decade Communist Party conclave later this year, when almost half of China's most senior leaders may be replaced.

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