Fund managers are still upbeat about China's stock market in the third quarter but most are shunning bonds and bills on expectations that market interest rates will rise, a Reuters survey of eight China-based funds showed.

Most of the funds polled late last week and on Monday said the Shanghai Composite Index had entered a consolidation phase, although it still had a chance to rebound above 4,000 points over the next three months.

They cited positive factors such as strong corporate earnings growth, restructuring of listed companies' assets and a strengthening Chinese currency.

The index, which ended up 0.41 percent at 3,836.294 on Monday, slipped 7 percent in June as investors worried that the government would absorb large amounts of funds from the financial markets by issuing $200 billion worth of special yuan bonds to fund China's new overseas investment agency.

Chinese money market rates and most bond yields also rose on Monday on worries about the impact of the special bond issue.

Another key factor worrying fund managers is that China's parliament on Friday authorised the cabinet to cut or cancel the 20 percent tax on interest earned from bank deposits, which could lure funds away from the capital markets. ADVERTISEMENT

Managers generally expect the uptrend in market interest rates to continue, due to monetary tightening by the central bank and a rise in consumer price inflation.

"In the third quarter, the CPI will continue to stay at high levels and the market is generally expecting more rate hikes," said HSBC Jintrust Fund Management Co., Ltd.

"With the issuance of the special yuan bonds, the total bond issue volume (in the second half) should be much larger than in the first half, increasing the bond market risks," it said.

Six funds predicted the yield of the one-year central bank bill in the secondary market would rise to at least 3.3 percent three months from now, against 3.2670 percent at present. One expects the yield to surge to 3.50 percent.

INDEX FORECAST

Four funds forecast that the Shanghai composite index would rise through the 4,000 point level over the next three months. One expected the index would fall to around 3,500 by the end of September. Two declined to make specific forecasts.

The index's decline in June was its biggest monthly loss since May 2005, although it was still up 43 percent from the end of last year.

Funds on average suggested keeping domestic equity allocations at 72.9 percent of a balanced portfolio, which would also include bonds, bills and cash, in the third quarter.

Of the eight funds that were asked for recommendations based on a three-month investment horizon, four recommended reducing domestic equity allocations to 60-85 percent of a balanced portfolio. They did not disclose their current allocations.

Three funds recommended keeping equity allocations unchanged, while one proposed increasing it.

Interest in bonds and bills remained low, with three saying they would completely shun them and the rest suggesting putting 15-20 percent of funds in fixed-income products.

Four funds recommended increasing cash holdings, while three recommended keeping their cash portion unchanged.

Funds saw opportunities in selected stocks, especially those that would post stronger-than-expected first-half earnings and those which would receive asset injections from their parent companies.

"The biggest risks faced by stock investors are regulators' policy moves and the arrival of large numbers of stock offers," said Fortis Haitong Investment Management Co., Ltd., the Chinese fund venture with Fortis.

Fund managers generally focused their equity investments on the financial services, property and consumer sectors. They recommended putting 14-25 percent of equity funds in financials, 8-20 percent in property stocks and 5-30 percent in the consumer sector.

NOTE: Funds polled were:

-- Fortis Haitong Investment Management Co., Ltd. (www.hftfund.com)

-- Fortune SGAM Fund Management Co., Ltd. (www.fsfund.com)

-- SYWG BNP Paribas Asset Management Co. Ltd. (www.swbnpp.com)

-- Franklin Templeton Sealand Fund Management Co. Ltd. (www.ftsfund.com)

-- GF Fund Management Co., Ltd. (www.gffunds.com.cn)

--and bill yield performances.)