Why long-term investors need to steer clear of China

China will grow this year at a rate that will put the developed world to shame. It will probably grow next year and the year after too. But in spite of the 7 percent gross domestic product (GDP) growth rate, that is not what the market cares about. It cares about momentum and performance relative to expectation. And it is in that area that I think China will underwhelm – and far more than people expect.

Read More China's current leaders have embraced some crucial changes - anti corruption, fiscal liberalisation and pro-consumerism are chief among them. China's extraordinary growth over the last decade has been state–led. But nothing beats the multiplier effects and longevity of consumer-led growth. Xi Jinping and Li Keqiang know this, but the problem is that the transition will be long and painful, and there is a risk of a big cyclical correction in the meantime.

Investors observe stock prices in Huaibei, China.
ChinaFotoPress | Getty Images
Investors observe stock prices in Huaibei, China.

This transition could perhaps have been massaged and supported if there was any monetary policy flexibility. But China has become indebted before it has developed. The proportion of debt to GDP is somewhere around 280 percent according to McKinsey. I say "somewhere" because the shadow banking system makes the exact number hard to be sure of. This is extraordinarily large for a country where GDP per capita is still relatively low and which is also embarking on one of the most challenging economic transitions the world has ever seen.

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Beijing has embraced important reforms, but it remains focused on hitting arbitrary growth targets to keep its increasingly irritable population satisfied. This type of robotic economic management has led to massive imbalances that at some point will pop. It means the liquidity taps are now, by necessity, always turned on, but are also having less and less effect. Everyone focuses on the slowing GDP rate, which is relevant, however it is the lending figures which highlight the pressing issue - they are pathetic given the stimulus that is being offered. For the long term, building up more debt is not desirable, but the point is that monetary policy is loose, and will get looser, but it is not even having a short-term effect anymore.

What I think is overestimated is the ability for China's growth to settle slowly from eight to seven to six per cent. Many companies in China are hugely inefficient having been carried by supernormal GDP growth and excessive state support. Will they all survive as growth slows? Probably not - there is a point where the transition is binary – companies continue or they go bust – they don't just make 1% less profit. Crunch point is getting closer.

And all of this comes amid the Shanghai stock exchange soaring. It closed last week on a seven-year high, and is up almost 150 percent over the last twelve months, and 65 percent year to date. It is genuinely one of the most extraordinary bubbles ever. Anyone who believes in investing in long-term fundamentals should steer clear of the China A-share market. Though, I pity those who are benchmarked to it and marked on short-term performance - they will be hurting from a rally that has persisted far longer than China bears like me have predicted. The latest leg has being driven by mainland retail investors who have nowhere else to put their money. Surely it cannot last?

Read MoreHuge growth in China's money funds poses risk

There is an important lesson though. China's growing middle class has extraordinary clout. What they decide to do with their growing wealth will have enormous impact in the world. It is why Britain is right to be a founding member in the China-led Asian Infrastructure Investment Bank. It is why foreign companies are right to do all they can to establish sales in China. I also think that there is a huge amount of money to be made by investment banks that get a piece of the financial liberalisation that is happening in China - that is where I would seek exposure as a public market investor.

But, and this is the important point, the stock market reacts to relative performance not absolute performance - and that is due to disappoint in a big way some time soon. I am a massive China bear relative to consensus, not in absolute terms, and none of my ISA is going anywhere near China's A Share stock market, at least not until valuations reflect the huge challenges the country faces.

-- Wilfred Frost is an anchor on Worldwide Exchange on CNBC. Follow him on Twitter: @WilfredFrost