Morgan Stanley's Chief China Economist Xing Ziqiang recently shared updated views during a weekly closed-door meeting, focusing on the impact of escalating Middle East conflicts on global energy markets, inflation trends, and China's economy.
Xing pointed out that the nature of the current energy shock has transformed. It is no longer limited to logistics disruptions in the Strait of Hormuz; the damage has now spread to production capacity. This implies that even if geopolitical tensions were to miraculously ease and shipping capacity through the Strait of Hormuz partially recovers, energy prices may not immediately drop back to pre-conflict levels. Restoring damaged production capacity will take at least several months, meaning the price floor for energy, including oil, has been effectively raised.
He outlined three potential scenarios: - Rapid de-escalation of conflict: Oil prices would remain at $80–90 per barrel by 2026. - Continued constrained situation: Oil prices would stay above $100 per barrel. - Extreme scenario: Oil prices could surge to $150–180 per barrel, where inflation concerns would evolve into demand destruction, with recession risks quickly overshadowing inflation worries.
Asian countries facing oil and gas shortages are already feeling the pressure. India, Vietnam, and the Philippines, among others, are scrambling to respond. Additionally, the reversal of petrodollar liquidity could impact global major asset classes.
Xing emphasized that markets have not fully priced in these risks. In the early stages of an energy shock, inflation fears often lead to simultaneous declines in both stocks and bonds, with gold also moving in the same direction, rendering diversification ineffective. It is only in later stages, when economic growth slows into recession and significant interest rate cuts become necessary, that long-duration bonds regain their role as safe-haven assets. Therefore, finding reliable safe-haven assets is currently difficult, making a "cash is king" approach the more prudent strategy for now.
For China’s economy, this represents a typical case of imported inflation. A 10% rise in Brent crude oil would push up China’s PPI by about 0.3 percentage points and CPI by 0.1–0.2 percentage points. However, this is cost-push inflation and should not be extrapolated as a healthy reflation. Drawing lessons from Japan’s history, Xing stressed that truly escaping deflation requires boosting consumption through social security reforms, not just industrial and tech investments.
Meanwhile, Morgan Stanley’s Chief China Strategist Laura Wang Ying noted that global risk appetite is receding as complacency gives way to rising risk-off sentiment. She currently recommends overweighting cash and adopting a defensive strategy while waiting for better entry opportunities. She believes that amid a global adjustment in risk assets, Chinese assets will significantly outperform other markets.
Sector-wise, Morgan Stanley has long recommended overweighting materials, energy, and IT—particularly semiconductors within IT—while underweighting real estate and traditional consumer sectors. In the China/Hong Kong Focus List, Tencent and Spring Airlines have been removed, while China Shenhua Energy and Zhongtian Technology have been added to increase exposure to energy security and efficiency.
Key takeaways from Xing and Laura’s insights include: - Production capacity has been damaged. - Inflation could escalate into demand destruction. - Recent earnings reports from major Chinese internet and e-commerce companies have been met with weak and volatile market reactions, indicating that investors remain skeptical about the AI narrative and large internet firms amid weak domestic demand and intense competition.
Globally, assets face significant challenges due to the Middle East conflict. Over the past month, analysis has focused on the conflict’s increasing intensity, duration, and scope, leading to major market reversals. International markets, particularly in energy-import-dependent regions like Europe and Asia, have seen sharp declines in stocks and bonds. U.S. markets have not been entirely immune, and investors are clearly seeking safety.
The core shift lies in the changed nature of the energy shock. The situation is no longer just about temporary logistics disruptions but extends to production facilities. Even if geopolitical tensions ease, restoring shipping capacity may be quicker, but repairing production damage will take months. This has effectively raised the energy price floor. Workarounds like alternative shipping routes, strategic petroleum reserve releases, or naval escorts can only alleviate pressure, not fill the substantial supply-demand gap.
Asian nations are urgently facing oil and gas shortages. India has reduced fuel taxes and imposed export duties on diesel and aviation fuel. Vietnam has extended tax cuts to lower gasoline prices, while the Philippines suspended spot market electricity trading amid acute energy shortages. These governments are now responding frantically.
The reversal of petrodollar liquidity also poses risks. Middle Eastern oil producers are not only energy suppliers but also major investors in global assets like U.S. Treasuries. A decline in petrodollar flows could add further pressure to global markets.
Markets have not fully digested these risks. A common misconception is that bonds serve as safe havens during turmoil. However, early in an energy shock, inflation fears often cause stocks, bonds, and gold to move in tandem, negating diversification benefits. Only later, during a recession accompanied by rate cuts, do long-duration bonds regain their safe-haven status. Thus, finding effective hedges is currently challenging. The core conclusion is that markets are underestimating the risks, reflecting excessive complacency.
In terms of asset allocation, global equities have been downgraded overall, and credit risk exposure reduced. For now, cash remains the most prudent defensive asset.
Regarding China’s economy, the primary impact is imported inflation—a cost-push phenomenon rather than healthy, demand-driven reflation. A 10% rise in Brent crude would raise PPI by 0.3 percentage points and CPI by 0.1–0.2 percentage points. For China to achieve genuine reflation, three steps are necessary: slowing investment in oversupplied sectors, gradually clearing existing excess capacity, and boosting consumer demand through social security reforms. While there are signs of progress in the first step, the second and third steps are advancing slowly.
This imported inflation leads to extreme profit divergence among companies. Recent industrial profit improvements have been concentrated in upstream sectors like energy and coal chemicals, which benefit from supply constraints and price increases. However, downstream manufacturers and consumer goods face higher costs, weak domestic demand, and fierce competition, preventing them from raising prices and squeezing their profit margins. Thus, this cost-push inflation should not be mistaken for broad, healthy reflation.
Laura Wang Ying reiterated that after a volatile week, global risk appetite is fading as complacency recedes and defensive sentiment rises. She advises overweighting cash and maintaining a defensive stance while awaiting better entry opportunities. Since the Middle East crisis began on February 28, Morgan Stanley has emphasized the resilience of China’s economy and markets, which becomes more evident as the crisis escalates.
China’s reliance on crude oil imports is high in absolute terms, but relative to GDP, it accounts for less than 2%—among the lowest of developing economies. Strategic petroleum reserves are substantial, and over 40% of domestic energy supply comes from coal, providing diversity and resilience against energy shocks. Chinese assets are increasingly appreciated by global investors, and this should be reflected in pricing over time.
However, for investors seeking absolute returns, Chinese equities are unlikely to rally independently amid global risk-asset adjustments. Instead, Chinese assets are expected to decline less severely than other markets.
Sector analysis based on China’s past reflation cycles—such as in early 2020, 2015, and 2009–2010—shows that materials, energy, and IT sectors tend to outperform over 12 months. This aligns with Morgan Stanley’s current overweight recommendations, particularly for semiconductors within IT. Conversely, real estate and traditional consumer sectors have historically underperformed during reflation and remain underweighted.
Recent adjustments to the Hong Kong China Focus List involved removing Tencent, due to short-term reductions in share buybacks and other return-friendly actions, and Spring Airlines, reflecting oil price pressures on the airline industry. Additions include China Shenhua Energy and Zhongtian Technology, increasing exposure to energy security and efficiency and reflecting the current allocation strategy.
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