HSBC cuts outlook for China stocks

An investor observes stock market prices on January 7, 2016 in Huaibei, China.
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An investor observes stock market prices on January 7, 2016 in Huaibei, China.

HSBC has cut its end-year targets for China stock index by 14-18 percent as earnings forecasts fell. The good news? Stock may still finish higher from current levels.

Among its estimates for index levels by year-end, HSBC expects the MSCI China index at 60, the Shanghai Composite at 3,200, the Hong Kong China Enterprises Index (HSCEI) at 10,000 and the Hang Sang Index at 21,000 by year-end. That compares with current levels around 51 for the MSCI China, 19,422 for the Hang Seng Index, 8,183 for the HSCEI and 2,893 for the Shanghai Composite.

HSBC noted that implies potential gains of around 8-22 percent by the end of the year.

HSBC had set the previous targets in early December, but it noted that since then, consensus earnings forecasts for the MSCI China index and the H-share index have fallen 5-8 percent, with energy company forecasts cut as much as 40 percent for this year and 24 percent for the next.

That accounts for around 60 percent of the cuts to the MSCI China index earnings-per-share (EPS) forecast cut.

In addition, HSBC also expects financial company earnings forecasts will also come under the knife, noting that so far, the 10 H-share banks - or Hong Kong-listed banks incorporated on the mainland - in the MSCI China index have only seen their aggregate EPS cut by 2-3 percent over the past three months. Those banks have a more than 40 percent weighting in the index, it noted.

A-shares are listed on the mainland, while H-shares are Hong Kong-listed shares of mainland-incorporated companies.

"Banks' earnings are hardly defensive in a deflationary environment where net interest margin (NIM) will continue to be compressed and non-performing loan (NPL) provisions will rise," HSBC said. "We believe the analysts are lagging behind the curve and waiting for more macro data and management guidance, say after annual results, to cut their numbers."

But even with earnings headwinds, HSBC still expects China shares to overcome a choppy start to the year. The Shanghai Composite had dropped as much as 25 percent in January, before recovering around 9 percent from last month's lows.

"We expect the market rebound to continue in coming months," HSBC said in a note Tuesday. Among the positives, the bank noted that the currency market has stabilized amid lower expectations for U.S. interest rate increases.

Additionally, share buybacks in China surged in January, something that historically has proved to be an accurate indicator of valuations bottoming, HSBC noted.

HSBC also puts the chances that MSCI will include A-shares in its Emerging Markets index at higher than 50 percent. It estimates conservatively that inclusion in the MSCI Emerging Markets index would result in around $15-20 billion in fund inflows into China's A-share market.

"Given the strong correlation between A- and H-share markets, a potential MSCI A-share inclusion would also be positive for the H-share market," HSBC said.

In November, MSCI added 14 tech-oriented China companies which are listed outside the mainland to its emerging markets index. That raised the weighting of Chinese stocks in the EM Index to 26 percent from 23 percent previously. At the time, it was estimated that move might see around $7 billion move into those American Depositary Receipts (ADRs) by funds passively tracking the index.

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—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1