Investors should prepare for the largest stock rally in China in 16 years to potentially reverse, as the country’s economy is significantly weaker than it was before the pandemic, according to a note by Nomura Holdings economists, led by Ting Lu.

In the worst-case scenario, Nomura warns of a stock market bubble followed by a crash, akin to the 2015 market collapse. The brokerage group suggests that this outcome has a “much higher probability” than more optimistic projections.

“Although stock market valuations and leveraging haven’t reached extreme levels yet, the underlying economic fundamentals have deteriorated due to multiple shocks and years of slowed growth,” the report stated.

Nomura outlined three possible scenarios and advised investors to be cautious of the least favorable one, even as they enjoy the current market euphoria.

The Three Scenarios: Good, Bad, and Baseline

In the most favorable scenario, regulators will keep a close eye on the emerging market bubbles and intervene with timely measures to prevent overheating. The government would carefully manage fiscal stimulus while addressing deeper issues like cleaning up the property sector and restructuring the fiscal system.

In the worst-case scenario, the stock market could enter a mania followed by a crash, similar to 2015. Beijing may respond by using the People’s Bank of China (PBoC) to print money and stabilize the market, but this could lead to excessive stock purchases, a liquidity crunch, capital flight, and pressure on the renminbi, limiting the PBoC’s ability to intervene further.

Nomura’s baseline scenario anticipates a smaller-scale bubble and bust. Beijing would likely implement fiscal policies to stabilize demand and ensure local governments can continue basic operations. However, these efforts might not resolve structural issues or address the deep-rooted problems in the property market.

China’s benchmark stock index posted its largest gain since 2008 on Monday, entering bull market territory after the government introduced measures to boost an ailing economy. Since then, the onshore markets have been closed for holidays.

Meanwhile, Hong Kong’s Hang Seng Index surged for 13 straight days before dipping slightly on Thursday. Optimism is running high that this rally will differ from past short-lived rebounds, with global money managers growing increasingly bullish. Yet, Nomura remains skeptical.

While investors may continue to ride the wave of the current rally, Nomura cautions that a more measured outlook is necessary.

With Bloomberg inputs