China at a Crossroads: Three Scenarios for Investors
- After Chinese stocks declined considerably in the past months, Chinese authorities' COVID-19 lockdowns have added another headwind to the world's second-largest economy.
- Given China's importance in the global supply chain, investors may wish to look out for potential spillover effects to the global economy and another source of upward pressure on inflation.
- In our stress test's most dire scenario, which assumes economic decoupling and a growth slowdown, a diversified portfolio of global equities and U.S. bonds and real estate could lose 9%.
China's recent dramatic underperformance
The downturn in China's USD 55 trillion real estate market2 and the crackdown across its tech sector3 may have contributed to the MSCI China Index's underperforming the MSCI World Index by 49% between January 2021 and March 2022. The MSCI China Index, which is a combination of onshore and offshore stocks, has significantly underperformed the MSCI China A Index, which contains onshore stocks only. In a recent blog post, we dissected what drove the sell-off in Chinese equities and identified the most pressing issues going forward: the new COVID-19 wave and lockdowns, the impact of the Russia-Ukraine war and concerns about economic decoupling.
Global equity-market performance since January 2020
For market-illustrative purposes, during this period only. May not represent long-term index performance.
What could lie ahead for Chinese markets?
China's demographic situation, high debt levels4 and zero-COVID policy, resulting in recent and potential future lockdowns, may spell further trouble for global supply chains and China's 5.5% target for GDP growth. On the other hand, recent sell-offs may present opportunities for investors if geopolitical tensions and supply-chain concerns fade.5 Amid this uncertainty, investors might wonder how their portfolios could be impacted. We propose three hypothetical scenarios:6
- New and sustainable growth: China prevents spreading of the current headwinds in the real estate and tech sectors to other sectors, while it steers the economy toward an alternative, more sustainable high-growth model. Regulatory easing lifts investor confidence, allowing Chinese equities to rebound significantly after their recent underperformance. The resolution of supply-chain concerns exerts downward pressure on global inflation and allows global growth to remain robust.
- Decoupling and growth concerns: Global East/West polarization accelerates deglobalization, while investor confidence deteriorates amid potential regulatory risk. Demographics and economic decoupling act as a drag on Chinese growth, preventing China from hitting its growth targets. Chinese equities continue to slide, while the global economy faces heightened inflationary forces and headwinds to growth.
- Continuing COVID lockdowns: China's zero-COVD policy could cause further large-scale lockdowns in economic centers, production facilities and shipping hubs. The resulting slowdown in economic activity and consumption, and the elevated uncertainty across producers and investors, may cause Chinese equities to drop. The global economy could face a supply-driven economic shock like in the previous scenario, although its impact is likely shorter-term.
What we assume in our scenarios
None | New and sustainable growth | New and sustainable growth | Decoupling and growth concerns | Decoupling and growth concerns | Continuing COVID lockdowns | Continuing COVID lockdowns |
Inflation | U.S. BEI 2Y: -40bps | U.S. BEI 10Y: -20bps | U.S. BEI 2Y: +50bps | U.S. BEI 10Y: +50bps | U.S. BEI 2Y: +25bps | U.S. BEI 10Y: +15bps |
Nominal yields | China Govt 2Y: -20bps U.S. Govt 2Y: -40bps | China Govt 10Y: +50bps U.S. Govt 10Y: -20bps | China Govt 2Y: -50bps U.S. Govt 2Y: +20bps | China Govt 10Y: -50bps U.S. Govt 10Y: +40bps | China Govt 2Y: -20bps U.S. Govt 2Y: +20bps | China Govt 10Y: -10bps U.S. Govt 10Y: +20bps |
Equity | U.S. Country +10% China Country (offshore): +30% | U.S. Country +10% China Country (offshore): +30% | U.S. Country -14% China Country (offshore): -25% | U.S. Country -14% China Country (offshore): -25% | U.S. Country -5% China Country (offshore): -7.5% | U.S. Country -5% China Country (offshore): -7.5% |
Credit spreads | U.S. IG: -15bps | U.S. HY: -50bps | U.S. IG: +40bps | U.S. HY: +130bps | U.S. IG: +15bps | U.S. HY: +50bps |
CNY/USD | +5% | +5% | -7.5% | -7.5% | -2.5% | -2.5% |
Scenario assumptions for U.S. equities and two- and 10-year breakeven inflation (BEI) and government rates (in basis points, or bps) are based on the MSCI Macro-Finance Model with a combination of hypothetical macroeconomic shocks. The additional shocks are informed by a combination of our analysis of historical market data and valuation ratios, external market commentary and subjective judgment. These are not forecasts but hypothetical narratives of how the various scenarios could affect portfolios. It may take time (up to several months) for the shocks in these scenarios to materialize.
Potential implications for financial portfolios
We assessed the scenarios' impact on multi-asset-class portfolios applying MSCI's predictive stress-testing framework to a hypothetical global diversified portfolio. For a diversified portfolio consisting of global equities and U.S. bonds and real estate, the impact ranged from -9% to +6% for the "Decoupling and growth concerns" and "New and sustainable growth" scenarios, respectively, while the "Continuing COVID lockdowns" scenario registered a -4% return. Our decoupling scenario may be particularly concerning as it hits Chinese equities heavily, while in the U.S. both bonds and equities would sustain losses. The exhibit below shows more detailed results, by asset class and region and for various base currencies.
Potential impact across asset classes
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Portfolio impact of the scenarios based on market data as of April 29, 2022. U.S. Treasurys and Treasury inflation-protected securities are represented by Markit iBoxx indexes. Equity markets and corporate bonds are represented by MSCI indexes. Private equity is represented by model portfolios. U.S. real estate is represented by the MSCI/PREA U.S. AFOE Quarterly Property Fund Index. The composite portfolio is represented by the following weights: 50% global equities (35% public and 15% private), 10% U.S. Treasurys, 10% U.S. Treasury inflation-protected securities, 10% U.S. investment-grade bonds, 10% U.S. high-yield bonds and 10% U.S. real estate. The China onshore composite portfolio is represented by the following weights: 60% onshore equities, represented by the MSCI China A Index, and 40% onshore Chinese bonds, represented by an adjusted version of the CCDC Chinabond Composite Bond Index. Source: IHS Markit, ChinaBond Pricing Center, MSCI.
China's 'landing' could have a global impact
In addition to the uncertainty around the Russia-Ukraine war, global investors may wish to closely monitor developments in China. Potential macroeconomic headwinds in the world's second-largest economy, which is heavily intertwined with the global economy, could have a significant impact on global multi-asset-class portfolios.
The authors thank Jeffrey Ho for his contribution to this blog post
Further Reading
1Harding, Robin. “The rest of the world should watch what is happening in Shanghai.” , April 12, 2022.2Yu, Sun, and Mitchell, Tom. “China’s economy: the fallout from the Evergrande crisis?” , Jan. 6, 2021.3Armstrong, Robert. “Is China uninvestable?” , Sept. 8, 2021.4Tooze, Adam. “Chartbook-Unhedged Exchange: China under pressure, a debate.” Chartbook, March 24, 2022.5Armstrong, Robert and Wu, Ethan. “China under pressure, a debate.” , March 24, 2022.6The results are generated based on this methodology, using MSCI's BarraOne®, whereby we used current correlations to propagate the shocks to a hypothetical multi-asset-class portfolio. MSCI clients can access BarraOne® and RiskMetrics® RiskManager® files for these scenarios on the client-support site. Note that China has two country equity factors in the MSCI Multi-Asset Class (MAC) factor model: CX Market Equity and CN Country for its offshore and onshore markets, respectively. To account for the impact of regulatory changes, we shock the offshore factor in the “New and sustainable growth” and “Decoupling and growth concerns” scenarios, while we shock the onshore equity factor in the “Continuing COVID lockdowns” scenario.
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