China outlook darkens but investors look on the bright side

China's worsening economic outlook is hard to ignore, but strategists remain confident about the country's equity market that has racked up solid gains this year.

A sharp slowdown in economic activity in August has reignited talks of a hard landing in the world's second largest economy. Nevertheless, Catherine Yeung, investment director, Fidelity Worldwide Investment, who maintains her overweight rating for mainland equities, says the government's reform momentum is keeping her optimistic.

Read MoreWeak China factory data raise prospect of stimulus

"The macro economy is likely to continue to be bumpy, and we've said that going into the beginning of the year. [But] think of the reforms agenda as the new stimulus for China," she told CNBC, noting that investors are underestimating the government's resolve to usher in economic and financial reforms.

"There are amazing stocks opportunities, valuations are very attractive, sentiment up until recent has been very negative. So it's a stock picker's paradise," she said.

Reform momentum has gathered pace since November's Third Plenum, a key meeting of the country's top leaders, especially with respect to financial liberalization, state-owned enterprise (SOE) reforms and fiscal policy, according to economists.

Read MoreChina reforms to start dragging on growth in 2015

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The release of the National Development and Reform Commission's (NDRC) economic priorities in mid-May was a key reform announcement. In the release, the NDRC announced targets to reduce administrative approval items to encourage private capital investment, accelerate the opening up of the service sector industry and push ahead with steps to open up the capital account.

An encouraging step in liberalizing the capital account has been the Shanghai-Hong Kong Stock Connect, which will come into effect in October. The "through train" scheme will allow foreign investors to place buy or sell orders on Shanghai's A-share market through brokers in Hong Kong. Chinese investors meanwhile will be able to use mainland brokers to invest in Hong Kong's H-share market.

Read MoreShanghai-HK stock connect: What you should know

"It's a step in terms of opening up the capital markets so it's very important: Foreign investors accessing mainland stocks and likewise mainland investors accessing Hong Kong stocks," she said.

Ting Lu, chief China economist at Bank of America Merrill Lunch agrees that investors have underappreciated reforms.

"We believe it's time for investors to shift focus from short-term economic cycles to the new leaders' initiative on reforms, especially the judicial reform which will be the major theme for the coming 4th Plenum in October and the Hukou reform, which so far has been under-appreciated by markets," Lu said.

China's government is in the process of reforming its rigid residence registration, or hukou, system that denies basic services to those who relocate without permission – a source of social unrest.

Stimulus boost for China stocks?

Aside from reforms, strategists point to the prospect of further stimulus measures as a market catalyst following the weak economic data.

Economists expect the government to roll out targeted stimulus measures in the coming weeks to prop up the economy, including steps to boost infrastructure investment, relax property market curbs and ease monetary conditions.

Read MoreIs fresh China stimulus a done deal?

"At this point, we reiterate our call: China should and likely will cut policy rates in the near term. Either that or monetary easing by other means such as RRR (reserve requirement ratio) cuts, increased policy bank lending etc. is very much indicated by latest economic data," said Uwe Parpart, chief strategist and head of research at Reorient Global, referring to the sharp fall in industrial production and fixed asset investment growth in August.

"With the easing we forecast, Shanghai stocks will continue to outperform," he said.

The benchmark Shanghai Composite has rallied over 12 percent in the past three months on the back of stronger economic data, easy monetary conditions and supportive policies from Beijing.