Investor sentiment on China has deteriorated sharply over the past two months, initially due to the spillover of the European crisis but more recently beginning to reflect anecdotes of weakening domestic demand and financial stress in the SME and property sectors. Our view is that there is unlikely to be a blow-up situation in China, but sequential GDP growth will likely decelerate significantly to or slightly below 7% in the coming two quarters, and MSCI China may face further downside risk of 10-15% before a meaningful recovery.

Our specific observations, based on both macro analyses and our recent interviews with a dozen firms in coastal China, are as follows:

• We expect sequential GDP growth (saar) to slow rapidly to or a tad below 7% in 1Q12 (from 9% in 2Q11), but a “crash” to 5% is very unlikely.
• We believe the biggest threat to the economy in coming quarters is still likely further decline in export orders.
• Physical property prices may decline visibly (e.g., by 10%) in next 4-6 months.
• The decline in commodity prices will likely continue to depress earnings and drive another round of inventory destocking for energies and raw materials.
• We believe small business stress is best measured by the recent PMI report, which shows that the PMI of small companies in China stands at 45 (still significantly better than the worst reading of 38 in 2008).
• The extent of informal lending looks to be exaggerated by the press. We think the risk of potential defaults in the informal lending market to the banking system is contained.
• Consumer spending on education, health, insurance, auto and supermarkets will likely remain resilient. However, discretionary spending, such as Macau gaming, travel, eating out, sportswear, and apparel could be vulnerable in an economic downturn.

As for market outlook, we continue to see downside risk to MSCI China even from the current fairly depressed level. We believe the market has priced in a mild recession in the EU/US, but a deeper recession in Europe is increasingly likely. This global outlook, as well as falling China export orders, commodities prices, physical property prices and inventory demand, imply another 10-15% downside to MSCI China in the coming months before we see catalysts (e.g., policy change) for a meaningful recovery. Energy, materials, and consumer discretionary will likely underperform the index in the near future, while banks appear cheap (below crisis valuations) to us.

• [Editor:editor]