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China stocks take one step back, but still going forward

Signs of weakness in China's economy have cast a shadow over a stock market that was just enjoying a run of strength.

The benchmark Shanghai Composite Index fell from a two-month peak on Thursday after the HSBC China flash purchasing managers' index (PMI), a gauge of manufacturing activity, fell to seven-month low.

It extended those falls on Friday, declining almost 1.5 percent to 2,106.

(Read more: China factory activity slows to a 7-month low)

"We need to be careful about extrapolating from the PMI data to earnings; what will be more important is the upcoming earnings season," Sam Le Cornu, senior portfolio manager, Asia Listed Equities at Macquarie Funds Group, told CNBC Asia's "Squawk Box."

"What we're trying to do is put companies under a magnifying glass and really focus on the corporate earnings. I still expect fairly solid corporate earnings from China companies," he added.

China's stock market started 2014 on a weak note but easing worries about tight liquidity conditions and some signs of strength in the economy have helped the Shanghai Composite recover some ground. Even after two days of selling, the Shanghai Composite is up more than 6 percent from six-month lows hit it January.

(Read more: Can China protect its prized 7% growth level)

Anthony Wallace | AFP | Getty Images

Overnight cash rates in China fell to their lowest level since May earlier this week, suggesting that liquidity remains ample for the time being – a good sign for stocks.

"It all depends on SHIBOR (Shanghai Interbank Offered Rate)…If it remains low overall that's good for the A-share market," Dickie Wong, executive director at Kingston Securities in Hong Kong told CNBC Asia's "Cash Flow."

And while Thursday's PMI number was disappointing, China last week released data showing its exports jumped 10.6 percent in January from a year earlier.

(Read more: China posts blowout trade data, exports jump 10.6%)

The mixed data means the jury is still out on the outlook for growth in China, the world's second biggest economy.

"China at this point is in a bit of a muddle-through state. Basically they [the government] don't want to stimulate the economy too much because there are structural issues that need to be solved," said Bin Shi, a portfolio manager at UBS Global Asset Management. "On the other hand they don't want a significant slowdown that could lead to higher unemployment and social issues. "

"So it is a difficult phase. Personally, I don't think the China economy is either booming or collapsing," he added.

Le Cornu at Macquarie said inflation and gross domestic product (GDP) data were the numbers he would be looking at to assess the outlook.

"I'm still an advocate that this is no hard landing that China is facing," he said. "I expect a slowdown, but a gradual one."

Beijing, which set a growth target of 7.5 percent last year, has yet to announce its 2014 target.

— Writing by CNBC's Dhara Ranasinghe. Follow her on Twitter at @DharaCNBC

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