Deteriorating prospects for global growth and Beijing's reluctance to ease monetary policy amid inflationary pressures pose a double whammy to mainland growth prospects in the coming year. While mainland Chinese equities look attractively valued over the long run, such a backdrop suggests high volatility will persist over the next six months.

Despite attractive valuations, I believe equities will continue to experience heightened volatility and struggle to move sustainably higher in the near term. My cautious view is based on three factors:

1. Deteriorating growth momentum: Recent economic data in the US continues to point to a high risk of recession, while data in the rest of the developed world and China is also likely to disappoint. The euro zone sovereign debt crisis is exacerbating growth problems, amplifying risk aversion among consumers and businesses.

2. Tight liquidity conditions: High inflation has prevented the central government from loosening its tight grip on monetary policy, which in turn has triggered a rapid expansion of the informal lending market - often with prohibitive borrowing rates. Investors are worried about the potential systemic risk of a sharp rise in banks' non-performing loans from informal lending and local government debts. Opaque information and uncertainties on policy directions are also leading investors to assign a higher risk premium to equity markets.

3. Downside risk to corporate earnings: Given high risks of a global recession, current estimates for earnings growth of 16 percent in the MSCI China Index for 2012 seem over-optimistic. While equities have discounted a lot of bad news, markets will likely struggle during the initial stage of downgrades to earnings estimates.

To identify a sustainable rebound in the equity markets, I would look for at least two of the following four signposts: 1) global growth momentum improves; 2) developed-economy governments adopt game-changing monetary and fiscal policy; 3) the Chinese mainland's consumer price index (CPI) falls below 4 percent, allowing room for monetary easing; and 4) a complete capitulation by investors, with equities falling a further 15 percent.

In the near term, defensive sectors, such as consumer staples, utilities and telecoms, are better placed to weather the headwinds and continued volatility in equity markets. Companies with strong balance sheets and financing capability are also preferred.

Nevertheless, over the longer term, equity valuations look historically attractive and provide an opportunity for significant returns over a 12-18 month time horizon for investors who buy at current levels - although they need to be willing to accept potential near-term declines. Indeed, I expect 2012 to prove a good year overall for mainland equities as some negative factors fade, although gains are likely to be concentrated toward the second half of the year.

While equities may continue to have high volatilities in the near term, I would look for attractive entry points in selective domestic sectors, particularly consumer stocks. I see consumption as a share of mainland GDP bottoming soon and then rising steadily in the coming decade, driven by a growing middle class, continued urbanization, robust wage growth and the appreciating yuan. I anticipate that pressure on consumer-related stocks, along with other domestic cyclical sectors, will present attractive opportunities to increase positions in automobile, retail, healthcare and internet stocks over the next six months. High-end consumption is a preferred sub-sector within this theme.

One of the potential positive catalysts for equities in the medium term would be a gradual policy shift from fighting inflation to protecting growth once inflationary pressure moderates. I expect the initial stages of such a shift to focus on fiscal stimulus, targeting consumption, social housing, small and medium enterprises (SMEs) and strategic industries outlined in the government's twelfth Five-Year Plan. Outright cuts in reserve requirement ratios (RRR) are also possible in the event of a US recession.

The author is Senior Investment Strategist for Greater China with the Investment Strategy Team at RBS Coutts Bank Ltd. The views expressed here are entirely his own.

(HK Edition 10/18/2011 page2)