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Bird Flu: New Headwind for China Stocks?

Wang Zhao | AFP | Getty Images

Fears over a bird flu outbreak in China sent markets tumbling to multi-month lows on Monday, casting doubt over whether 2013 could still be the breakout year for Chinese equities.

Opening for trade after a two-day holiday last week, the Shanghai Composite fell close to 2 percent on Monday to its lowest level since December 25 while the Shenzhen Composite hit a near 3-month low. Meanwhile, Hong Kong's Hang Seng Index hit its weakest level since November at 2,612 points. All three indices have managed to pare some losses since hitting those lows.

The early falls were triggered by reports over the weekend that confirmed 21 reported cases of bird flu with the death toll rising to six.

Aviation stocks suffered the brunt of the losses with Shanghai-listed Air China falling nearly 4 percent, China Eastern Air losing 3.5 percent and Shanghai International Airport slipping over 4 percent.

But is Monday's sell-off merely a knee-jerk reaction or could it lead to a prolonged downtrend?

"We can all safely say we've seen this movie before. We saw in 2009 with swine flu when stocks were off about 10 percent, rebounded very quickly within a month and then doubled," said Timothy Ross, head of Asia Pacific Transport Research at Credit Suisse on CNBC's "Cash Flow."

Analysts at Citi Equity Strategy wrote in a note Monday that "the avian flu may have limited impact on economic growth and this incident may hurt investment sentiment in the very near-term."

They added that in 2003 when the SARS (Severe Acute Respiratory Syndrome) epidemic broke out, the Shanghai Composite proved to be resilient: "The Chinese equity market held off well at the time when the economy was poised to take off after a few years of adjustment."

(Read More: China: Time of Transition)

The Shanghai Composite notched up gains of over 11 percent in 2003 after SARS was first reported in the spring of that year.

Analysts recommend using the current decline as a buying opportunity, especially for transportation stocks.

"If we go back as far as 2003, basically anyone that bought the airline stocks after their first sell-off made money as long as they held it for two to three months," said Ross.

According to the Citi note, sectors such as airlines and insurance could suffer in the near-term while healthcare will be the obvious gainer.

(Read More: China's "Black Clinics" Flourish as Government Debates Health Reform)

Still Bullish on China

The bird flu threat comes at a time when the Shanghai market is already under pressure, down nearly 3 percent year to date despite forecasts late last year, when the index rallied, that 2013 could be the breakout year for Chinese stocks.

Taking a cue from the mainland markets, Hong Kong listed shares of Chinese companies, or H-shares, are also down 4 percent year to date.

Despite the setbacks so far analysts still remain bullish on China.

(Read More: Will 2013 Be the 'Break-Out' Year for China Stocks?)

"We believe that both A-shares [mainland shares] and H-shares will trade sideways into the second quarter. Chinese equity markets will challenge January's high sometime in May or June," said Stephen Sheung, head of investment strategy at financial services firm SHK Private, referring to the 2,391 level reached in January.

Last week, chartist Daryl Guppy, CEO of guppytraders.com expressed confidence that the benchmark would cross 3,000 by the year-end.

"We're looking for consolidation at the 2,200 level followed by a rebound. We will hit 3,500 by year-end," he told CNBC.

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