What China's Battered Stock Market Is Telling Us

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China's battered stock market has taken another tumble this week – a sign perhaps that the country's investors are bracing for a faster-than-anticipated slowdown in the world's second largest economy.

The Shanghai Composite stock index tumbled more than 2 percent on Monday and extended that fall on Tuesday to its lowest level in more than a week before recovering a touch. Chinese shares are down almost 14 percent so far this year, making Shanghai Asia's worst performing major equity market.

"If you look purely at the Shanghai Composite, it has a massive retail component so it's very much driven by sentiment rather than the earnings growth that professional traders look at," said Chris Weston, chief market strategist at trading firm IG.

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"So I would look at the Shanghai Composite as a good gauge of sentiment in China. And what we're looking at in China right now are clear risks to growth - whether that turns into a hard landing or a more manageable slowdown remains to be seen," he added.

Weak data in recent months have prompted economists to cut their gross domestic product (GDP) growth forecasts for China, while Beijing's tolerance of a credit squeeze last month and its determination to push ahead with structural reforms have added to the jitters about China's growth outlook.

The Chinese government said on Friday that it would cut off credit to those industries beset by overcapacity as it tries to end the economy's dependence on investment funded by cheap debt. The statement fueled the sell-off in Chinese shares on Monday.

Helen Zhu, chief China equity strategist at Goldman Sachs, said that while the reforms had long-term benefits for the economy, investors were likely to remain nervous about the short-term consequences for growth.

"I haven't found any investors who have been very bullish on Chinese stocks in the next few quarters," she told CNBC Asia's "Cash Flow."

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"Generally there are worries about the direction of reforms, which people think is a good thing. But there are likely to be cyclical costs and the liquidity crunch last month really scared people into thinking that there could be significant volatility to the cyclical picture during this reform process," she added.

Goldman still sees Chinese shares heading higher this year but has significantly cut the targets it had for stocks at the start of the year.

"We think there could be some gains by the end of the 2013 but over the next few months, people are still waiting to see how much cyclical tightening we have and how much the economy slows down," Zhu said.

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Chi Lo, senior strategist, Greater China at BNP Paribas Investment Partners said he did not expect significant improvement in the outlook for Chinese corporate profits in the months ahead.

"The peak in profits was reached earlier this year and given the slowing growth momentum there's not much pricing power from the CPI [consumer price index] side, so corporate profits are unlikely to see a significant improvement," he told CNBC Asia's "Squawk Box."

Data on Tuesday showed China's CPI rose 2.7 percent in June from a year earlier, higher than a consensus forecast by Reuters of 2.5 percent. China's producer price index fell 2.7 percent in June from a year earlier.

By CNBC's Dhara Ranasinghe; Follow her on Twitter:@DharaCNBC