What's Next for China

• Viewpoint

The liquidity crisis that hit China in June was a brief but sobering event. Quickly dubbed the "Shibor shock," it crystalized for investors the issues facing the world's second-largest economy: a potentially destabilizing amount of credit, amassed over the last four years when China fueled its growth by borrowing and investing in real estate and infrastructure; and the need for Beijing to institute the reforms that will likely rebalance the nation's economy away from its dependency on investment and credit and toward a more sustainable model supported by on its own rising consumer classes.

As a structurally slower-growing China addresses these twin challenges, it will likely create ripple effects for investors around the world. "What's Next for China" explains the landscape and details how investors might prepare their portfolios to both mitigate the risks and take advantage of the opportunities created by China's epic transition.

• To start, investors should reconsider the set of multinationals best situated to benefit from a changing China. Natural resource extractors and heavy industrials may over time become less important than well-known consumer-focused companies, whether it's U.S. fast-food brands, French luxury-goods conglomerates, South Korean electronics companies, or German and Japanese automakers.
• In consultation with their advisors, investors should rethink their emerging market portfolio allocations. Commodity-rich developing nations whose economies have depended in the past on selling raw materials to China's industrial complex may well suffer. Meanwhile, a group of so-called frontier markets are already vying to take China's place as low-cost exporters to the world. As a result, investors might consider favoring smaller emerging markets over the larger, better-known EMs.
• Other regions outside Asia are also ripe, not only because of quickening growth driven by their own burgeoning consumer populations but also because they remain largely untouched by other investors. Countries to watch here include Nigeria, Mexico and Peru.
• Because gaining true exposure to small and frontier economies remains a challenge, investors should seek out nonconstrained active managers who specialize in these markets and have the freedom and expertise to unearth the companies, sectors and countries poised to thrive in the new EM landscape.
• Despite a sharp tactical bounce in the MSCI China index since the end of the Shibor shock, narrow corporate profit margins could cast a pall over Chinese stocks for another two years. Longer term, though, investors need to be open to opportunities. That means, once again, favoring the active over the passive, focusing on those managers able to gain exposure to the local industries that stand to benefit the most from a new kind of China. These include consumer staples, durable goods and some sectors that barely exist yet in China, such as consumer banking, financial services and health care.

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