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China Stocks: Why Goldman Likes This Market Laggard

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Chinese equities, together with the country's economic performance, have repeatedly disappointed investors in recent months, but U.S. investment bank Goldman Sachs remains optimistic that the laggard will deliver solid returns this year.

Investors, according to Goldman Sachs, are now focusing more on the pace of reforms than on government stimulus in the world's second largest economy, which is trying to rebalance away from an over dependence on exports and investments to being more consumption-led.

The bank wrote in a report on Monday that its expects economic reforms to accelerate further in the second-half of the year that will boost investor sentiment and in turn provide a fillip to stocks.

(Read More: HSBC: Why We Are Still Bullish on China)

"The market's response to progress on reforms has been more pronounced, whereas reactions to cyclical stimulus have held less and less conviction," wrote Helen Zhu, chief China equity strategist at the bank.

"Over the coming months we expect reform news flow to intensify and still see opportunity for reform progress to support valuations towards our year-end target," she said. The bank expects the MSCI China to rise 14 percent from current levels.

The MSCI China is down 3.7 percent year to date, underperforming the benchmark Shanghai Composite, which is up 1.2 percent over the same period. The Shanghai market is still a laggard relative to regional peers like Japan and Australia.

(Read More: Outlook for China's Economy Just Keeps Getting Worse)

Reform Minded

There are a number of signs that the new leadership intends to be progressive, she said, pointing to their greater tolerance for slower more balanced growth and increased focus on tackling corruption.

(Read More: China President Takes Charge of Sweeping Economic Reform Plans)

The most important reform milestones in the coming months include the government's urbanization blueprint – expected to be unveiled in June or July – as well as the third plenary session of Congress scheduled for October where the government will present its medium to longer term objectives for the country.

"More specific policy priorities are likely to be clarified and we hope to see some easy-to-achieve objectives reiterated while new goals are also likely to be introduced," she said, referring to the third plenary session of the 18th National Congress of the Communist Party of China which has historically been a meeting when decisions on major economic reforms are made. The last such session was held in 2008.

(Read More: China Profit Growth Quickens, No Harbinger of Recovery)

"Some investors have expressed impatience to wait until the fall for full clarity on the reform agenda, but we think this timeline is customary and within reason," Zhu said.

Investors Overlook Stimulus

According to the bank, investors are reacting less to the prospect of fresh stimulus or even positive money supply data that reflect the impact of an accommodative monetary policy.

"More recently, accommodative monetary policy has been met with skepticism. Whereas 12-24 months ago, a large money supply print was generally embraced by the market and quickly rewarded, recent reaction has been more muted," she said.

(Read More: Is China Really Mulling a Lower Growth Forecast?)

Zhu added that robust money supply growth is currently being met with significant concern among investors who are questioning whether policymakers are losing control of the shadow banking system, and how the government intends to control such leverage.

"In an informal poll of several hundred investors taken at our February 2013 macro conference in Hong Kong, 87 percent of respondents indicated a preference to see China reform, even at the cost of GDP [gross domestic product] and thus earnings growth," she said, highlighting investors' desire for reforms.

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