Will China reforms rejuvenate Hong Kong stocks?

Why Chinese shares are back in favor

As Hong Kong stocks powered to their highest level in nearly seven months this week, some analysts expect the downtrodden market to gain a new lease of life as mainland reforms boost sentiment.

The climbed 1 percent by midday on Wednesday to 23,414, after touching its highest level since December 10 in early trading. The rally was driven by upbeat Chinese manufacturing data, positive U.S. data and a strong performance in Hong Kong's property sector.

Analysts told CNBC they are bullish on the equity market's prospects for the rest of the year.

"The market we expect to rise the most is Hong Kong," said John Vail, chief global strategist at Nikko Asset Management.

"Though we are not really positive on the Chinese economy we expect a lot of reforms to occur there that are going to excite foreigners and locals about the future of the region," he added.

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Chinese authorities unveiled their 60-point reform agenda at their Third Plenum meeting in November, paving the way for sweeping changes in the world's second largest economy. Furthermore, in May China's State Council said it would push ahead with a broad range of capital market reforms, including developing a system for direct bond issuance by local governments, streamlining the approval process for initial public offerings (IPOs) and removing some restrictions on the use of financial derivatives.

"A broad array of reforms, both economic and financial will loosen state control and provide more prospects for profitability in the private sector," said Vail. He also expects additional targeted stimulus measures to a boost the economy.

Vail told CNBC he expects stocks on the Hang Seng, which include exposure to mainland stocks through H-shares index, to rally 7 percent from current levels to 25,084 by year end. The surge would mark a stark turnaround after the index ended the first half down 0.5 percent.

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Other economists told CNBC they expect the Hang Seng's fortunes to turn upwards over the coming months but don't expect gains to be as strong as Nikko's Vail has forecast.

"Valuations are quite reasonable. Consensus expectations for Chinese growth are finally beginning to turn up and there is quite a bit of bad news in the price," said Manpreet Gill, senior investment strategist at Standard Chartered Bank.

"Having said that, we think it may be too early to expect spectacular performance for the Hang Seng. In China, we expect policy makers to continue striking the balance between cutting back on excessive growth without slowing growth too much. In Hong Kong, real estate remains a downside risk," he added, referring to the nation's frothy property sector - where prices have more than doubled since 2008.

Crowd walking in a street, Hong Kong Island, Hong Kong, China
RedChopsticks | Getty Images

Meanwhile Alexis Garatti, an economist at Haitong International Securities, is cautious about taking a bullish view on Hong Kong stocks amid concerns about China's economy, where annual gross domestic product growth weakened to 7.4 percent in the first quarter of this year, down from 7.7 percent in the final quarter of 2013.

"[The Hang Seng index] depends on the progress of the Chinese economy and there are still high uncertainties...if you had a choice between Europe, U.S. and China I would definitely prefer European and American stocks," said Garatti.

Garatti also doubts that reform will be enough to spur strong equity market gains.

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"They will definitely play a supportive role for the markets, but structural reform is not the most important factor for the stock market in the short term," he said. He advises investors to stay away from cyclical stocks, such as materials and energy stocks, which are most exposed to Chinese growth.

"Two major risks to Hong Kong stocks are: a significant correction to China real estate market which could endanger the stability of financial institutions; and also political risk, the Occupy Central movement worries me because there is strong determination from both local people and Beijing," he added.

Last week, the "Occupy Central" movement launched an informal referendum on how Hong Kong should pick its chief executive, but authorities in Beijing said the poll did not have any legal standing.

Read MoreWill 'Occupy Central' hurt Hong Kong?