Concerns about China’s GDP growth, which hit a 25-year low of 6.9% in 2015, and “draconian actions against international investors” suggests that Chinese equities could get even cheaper in 2016.

“The slowdown of the Chinese economy does not make Chinese equites unattractive per se, as the equity market is still not an accurate reflection of the entire economy,” according to a research note from David Pinkerton, the private bank’s chief investment officer.

The report cautioned on potential depreciation of the RMB. Although it is likely, the expectation is that China will do so in a more controlled manner.

“The central bank of China will not want to jeopardise its international reputation in light of the fact that its currency just got approved reserve currency status with the IMF,” the report said.

Falcon’s base case for China equities this year is a 0% return expectation, with outlying bull and bear expectations of +2.5% and -30%, respectively.

In order for base case expectations to play out, the bank said China needs to continue showing evidence of the gradual transition from a manufacturing- to service-based economy. The government needs to take quick action if bad loans pop up and the RMB needs to undergo a more controlled devaluation than in 2015.

The bull case would only emerge if China had more quantitative easing than expected, economic growth clearly stabilised and a hard landing became a remote possibility.

The bear case, with equities returning around -30%, would develop if central bank actions to counter slowing economic growth were insufficient and if the RMB underwent aggressive devaluation.

Cheap sectors

Strategic asset allocation is crucial and selecting the right sectors is key, the report said.

China equity sectors — except for consumer discretionary and IT — are cheap relative to their own history and to peer sectors in developed markets. But the bank sees it as a value trap, “meaning they are likely to get cheaper before forming a positive and sustainable bullish trend”.

                              Sector Valuation Score

Source: Bloomberg, calculation by CIO Office. The valuation score is an equally-weighted average of four common valuation metrics (forward price/earnings, price/book, price/cash flow, dividend yield). As of December 16, 2015.

The financial sector, for example, is inexpensive but the bank believes there is more pain to come before equities become attractive.

“Although financials appear cheap, the earnings environment is not favorable. We expect further increases in non-performing loans and the sector is not likely to be expanding lending activity.”

The report also noted a huge difference in valuation in China’s consumer staples sector equities and peer sector equities globally.

”Overall, we can conclude that Chinese equities are cheap relative to itself, but also cheap relative to its global counterparts, IT being the exception. But again valuations are all relative and things that are cheap can get cheaper over time.