The Chinese consumer market is the second largest in the world, behind only the U.S.

At over $6 trillion, household consumption in China is one-third of that of the U.S. and only 20% smaller than that of the entire European Union.

Yet, China's economic growth is lagging behind the levels its own leadership was expecting for the first half of 2023.

Domestic demand has not recovered convincingly after the country abruptly re-opened its borders and said goodbye to years of strict COVID-zero policies in late 2022. China's GDP growth failed to meet economist estimates for the second quarter of this year.

With the foreign policies of both the U.S. and China currently aimed at hampering each other's growth, holding a share of the Chinese market can be a good way to exercise diversification in any U.S.-heavy portfolio.

However, the country's domestic market is facing an undefined trajectory, which could make or break the performance of U.S.-listed ETFs focused on the Chinese market.

"China faces the new challenge of coping with multipolar world pressures from the US in particular," wrote Morgan Stanley analysts.

Morgan Stanley issued a new report focused on emerging markets in Asia, after nine months of a bull market that began in October. The iShares MSCI Emerging Markets ETF (EEM  ) is up over 19% since late October lows. For comparison, the S&P 500 is up 26% since its lowest point in mid-October, a few weeks earlier.

Specifically, U.S.-listed Chinese stocks present one of the best trajectories within emerging markets, with the iShares MSCI China ETF (MCHI  ) up 36% since October lows. The fund, which follows the MSCI China Index, has seen better days this year: it is down 13% from its highest recent peak in late January.

Morgan Stanley downgraded the MSCI China Index to Equal Weight.

"The China market is overwhelmingly dominated by domestic demand stocks," says the report. These comprise 85.5% of the MSCI China Index.

Consumers continue to be stuck in cautious behavior patterns that are hurdling economic growth. The government announced this week a package of measures aimed at boosting consumption, which include subsidies for new car purchases and home improvements. Waiving fees for tourist hotspots are also meant to boost internal tourism.

Earlier this week, CNBC host Jim Cramer criticized the country's "guns-and-butter" approach to economic growth and said that "military and luxury spend stimulation are a lousy combination."

For Morgan Stanley analysts, the investor debate around China is currently centered on whether the country's demographic decline, a high domestic debt/GDP ratio and over-investment in property and infrastructure are starting to generate a balance sheet recession.

The country is facing a massive real estate crisis. New home sales by China's 100 biggest developers dropped by 33% in July from a year ago, according to a recent report by CNN Business. Many Chinese investors are turning to U.S. real estate as a way to hedge against their own country's real estate slump.

Last week, a Politburo meeting, which gathers the country's top leaders, announced new measures meant to stimulate demand for the property market across the country.

"Recent statements from the Politburo have begun to acknowledge the need to reverse some of the measures that have pressured the property market, but there is no easy way out of the intertwined property and local government financing/debt burden that built up in the years when the growth model did not transition fast enough," wrote Morgan Stanley analysts.

High unemployment in the young population and weak wages are also pressuring the country's economic outlook. Youth unemployment - people aged 16 to 24 - reached a new record high in June of 21.3%, pushing Gen-Zers and households to moderate spending.

To make things worse, in July, manufacturing contracted in China for the fourth month straight. The official Purchasing Managers' Index came in at 49.3 in July. Any mark below 50 means contraction.

However, in spite of all the headwinds, Morgan Stanley analysts continue to see possibilities of fair weather for the Chinese economy.

"We do not rule out moving back to a more positive stance on China should policy implementation be more aggressive than hitherto and solutions to these structural problems start to fall into place," wrote the analysts.

Chinese ETFs are up on Thursday, correcting from a slump generated on Wednesday by the Morgan Stanley report.

• iShares MSCI China ETF is up 2.7%.
• KraneShares CSI China Internet ETF (KWEB  ) is up 4.3% on Thursday, recovering most of its losses from Wednesday's drop.
• Xtrackers Harvest CSI 300 China A-Shares ETF (ASHR  ) is up 2.3%.
• SPDR S&P China ETF (GXC  ) is up 2.5%.
• Invesco China Technology ETF (CQQQ  ) is up 3.5%