There are reasons for caution but the longer term outlook for Chinese equities remains positive, the Swiss banking and wealth management house says.

Chinese equities look cheap amid the headwinds from slowing domestic economic growth and worries about protectionism, and policymakers are taking steps to boost markets by injecting liquidity, UBS said in a recent note.

“Amid incrementally challenging sentiment but attractive earnings per share growth and valuations, we refrain from taking beta positions. Instead, we are neutral on [mainland] Chinese A-shares versus bonds,” Adrian Zuercher, head of asset allocation for Asia-Pacific, at UBS Global Wealth Management Chief Investment Office, said.

“That said, the volatile market environment offers excellent alpha opportunities that we try to exploit. We prefer offshore to onshore equities given the former's greater return on equity and relative defensiveness against [Chinese renminbi] CNY depreciation. Within the onshore market, we prefer small caps to large caps, as a liquidity-driven rebound will likely benefit the former the most. Among onshore sectors, we favour healthcare and software and services sectors,” Zuercher said. 

“Chinese financial markets continue to be challenged by slowing domestic economic growth, uncertainty on the CNY and, in particular, the Sino-US trade skirmish. The high-profile earning misses in the Chinese offshore IT sector have also left investors puzzled, and the crisis in Turkey hasn't helped. As a natural reaction, onshore investors have been looking for safety in low volatility assets,” he continued. 

Despite the weak sentiment, not all is lost – equity valuations look cheap, and the second-quarter earnings season has produced an impressive 24 per cent year-on-year growth so far. Next to strong fundamentals, Chinese policymakers are shoring up the country's arsenal of policy tools. Liquidity has been injected – e.g. via reserve requirement ratio cuts – and the deleveraging pace has clearly slowed down. These measures will take time to show results, and more efforts such as tax cuts might be needed. But switching the plug from credit constraints to market-friendly measures may just be enough to lure investors back to China's asset markets. In addition, while unlikely, if the US and China manage to find a compromise on trade, it would most likely prompt a strong market rebound.

In the fixed income area, UBS has added a moderate “risk-on” position via long investment grade enterprise bonds relative to government bonds, because the former asset class offers an attractive yield carry, and because UBS expects yield spreads to tighten.

“We remain overweight long-duration CGBs but trim the position to keep the overall portfolio duration neutral. Slower growth and supportive monetary policy should lead to lower CGB yields, in our view,” he added.