Investors' interpretation of July's manufacturing data will be key to determining the direction of the Chinese stock market in the coming quarters, analysts said.
China's manufacturing sector grew at the slowest pace in 17 months in July as the official Purchasing Managers' Index fell to 51.2 from 52.1 in June, according to the China Federation of Logistics and Purchasing.
Investors' reading of the key economic indicator will test the resistance of the recent rebound in the A-share market, which has been the world's worst performer this year after Greece, said investment bank China International Capital Corp (CICC) in a report.
"The market will face the risk of correction if investors started to worry about the deceleration of the economic growth and shift focus to the deteriorating fundamentals," the CICC said. "The rebound may continue if investors are still betting that the government will relax the tightening measures if necessary to sustain the pace of economic growth."
The Chinese stock market has started to rebound after hitting a 15-month low by plunging nearly 30 percent this year. The benchmark Shanghai Composite Index rallied 11 percent in July, set for the best monthly performance in a year, on expectation that the government would relax property tightening measures and maintain policy stability.
Chinese mutual funds have raised their suggested weighting for stocks within a balanced portfolio to 80 percent from 74.4 percent in June, the first increase since February, according to a recent poll of nine China-based fund companies by Reuters.
Most of the fund managers polled were turning more optimistic as they are betting Beijing would not tighten policies further, especially regarding the real estate market, given the consensus view that China's economic growth is already slowing.
In the meantime, capital inflow from insurance funds will also help shore up market liquidity as about 400 billion yuan is expected to enter the market soon after the Chinese insurance regulator loosens the limits on investments by insurance companies in stocks.
But China's stock-index futures fell last Friday, signaling a trend of decline for the benchmark index. Market watchers said the recent rebound of the A-share market may face downward pressure as the inflow of hot money will add to China's inflationary pressure and the recent gains were excessive relative to earnings prospects.
The rebound is also likely to be much more subdued since the market will continue to embrace an influx of new share offerings in the second half of the year, analysts said.
Initial public offerings, rights and other share issues have totaled about 450 billion yuan so far this year and some 350 billion yuan more are expected for the rest of the year.