Goldman: Beware EMs, China will drag them until 2020

Goldman highlights China's great dilemma

China's enormous, complex economic transition will keep emerging markets under pressure for the next five years, Goldman Sachs has warned.

In report setting out its forecasts on China, the bank told clients to "adjust their exposures" to EM assets.

"The country is trying to shift its economy away from an export-driven and investment-led one to a more balanced, consumption-oriented economy," Goldman said in the report, headlined "Walled In: China's Great Dilemma."

"A complex and interconnected reform agenda has never been achieved on this scale. The transition, if accomplished, is unlikely to be smooth."

That means China will spur market volatility not just this year, but for the next five years, with emerging markets likely to bear the brunt of the hit, Goldman said.

"We therefore recommend clients adjust their exposures to emerging market assets," it said.

"Developed economies will not be immune from any volatility emanating from China, but the direct and indirect economic impacts will be lower for them; still, we expect that financial markets in developed countries will overreact as they did in August 2015 and again in early 2016."

An investor stands in front of an electronic board showing stock information in Fuyang, China.
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For 2016, Goldman expects a total return of 5.6 percent on Chinese equities and an annualized return of around 4 percent for 2016-2020.

"Chinese equities, as measured by the MSCI China Index, are not sufficiently cheap relative to their own history to warrant a tactical overweight at this time," Goldman said. "They are not sufficiently cheap relative to U.S. equities either. "

The bank put a substantial caveat on its 2016-2020 forecast, noting that Chinese stocks could see a downdraft similar to Japan's 1990s post-bubble tumble. That could leave mainland equities with a 7-8 percent a year decline over the period, it said.

What's worrying for emerging markets in general is that China would likely try to depreciate its currency over the next few years, Goldman said, forecasting a 10-20 percent decline over the next two years.

"A steady by China will drag down emerging market currencies and offset the incremental yield in emerging market local debt," the bank said, noting that it had removed emerging market local-currency debt from its strategic model portfolios.

Men look an electronic board showing stock information at a brokerage house in Beijing, China, January 5, 2016.
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It's also reduced its allocation to emerging market equities in its well-diversified, moderate-risk portfolio, noting that MSCI China accounts for 26 percent of the MSCI Emerging Markets Index.

"Emerging market countries are also more dependent on Chinese demand for commodities related to manufacturing and real estate investments, and since we expect the pace of growth to continue slowing in both areas, we expect lower returns in those countries as well," Goldman said.

The bank is reallocating those funds to investment grade and high-yield fixed income and developed market equities.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1