Economy

China’s Economy Defies Gravity: How the Shanghai Composite Index Outperforms Amidst Deflationary Pressures

China‘s markets thrived despite deflation. Shanghai Composite soared as economic recovery is tested.

September 18, 2025, 11:34 AM

The iconic Oriental Pearl Tower and other tall skyscrapers in the Shanghai skyline

A panoramic aerial view of the Shanghai skyline, featuring the Oriental Pearl TV Tower and numerous high-rise buildings. By MDL.

Executive Summary

China’s economy is facing significant deflationary pressures and a broad slowdown, evidenced by negative consumer price growth, slowed industrial output, and contracting fixed-asset investment and new home sales.

Despite these challenging economic indicators, China’s financial markets, particularly the Shanghai Composite Index, have shown surprising resilience and strong performance.

This market anomaly is partly driven by a sharp rotation of investment from bonds into stocks, as investors seek higher returns in a low-yielding environment.

The Story So Far

China is currently grappling with significant economic headwinds, marked by persistent deflationary pressures including negative consumer price growth, slowed industrial output, and weak credit growth, signaling a broad economic slowdown. Despite these challenging indicators, the nation’s financial markets have shown surprising resilience, with the Shanghai Composite Index performing strongly, largely attributed to a sharp rotation of investment from bonds into stocks as investors seek higher returns in a persistently low-yielding environment.

Why This Matters

China’s financial markets are exhibiting a paradoxical resilience despite persistent deflationary pressures and weakening domestic demand, raising significant questions about the true health of the nation’s economic recovery. This complex situation challenges the perceived effectiveness of Beijing’s current stimulus strategies and underscores the critical need for decisive action to stimulate and sustain domestic demand to counter these ongoing economic headwinds.

Who Thinks What?

Economic indicators, including negative consumer price growth, slowed industrial output, and weak credit growth, suggest persistent deflationary pressures and a slowdown happening earlier than anticipated.

China’s financial markets, particularly the Shanghai Composite Index, have shown surprising resilience and strong performance, driven by a sharp rotation of investment from bonds into stocks.

Observers question the true state of China’s economic recovery and the effectiveness of Beijing’s strategies to revive domestic demand, given the paradox between weakening fundamentals and robust market performance.

Despite a recent batch of challenging economic indicators suggesting persistent deflationary pressures, including negative consumer price growth and slowed industrial output, China’s financial markets have shown surprising resilience, with the Shanghai Composite Index emerging as a top performer. This paradox has prompted observers to question the true state of the nation’s economic recovery and the effectiveness of Beijing’s strategies to revive domestic demand.

Recent Economic Headwinds

In the past month, China’s consumer prices once again contracted annually, marking the fifth decline in seven months. This was coupled with the slowest monthly expansion in industrial output and retail sales observed this year, alongside the steepest contraction in fixed-asset investment since the acute phase of the COVID-19 pandemic in 2020.

Further evidence of deflationary pressures includes a sharper decline in new home sales and weaker-than-anticipated credit growth in July. Notably, new lending to financial institutions experienced its first contraction since July 2005, leading Societe Generale to comment that “with two consecutive months of weak data, the slowdown is happening earlier than we had anticipated.”

Market Resilience Amidst Concerns

Countering these grim statistics, the Shanghai Composite Index remarkably stood as the world’s second-best performing major financial asset last month and the leading stock market. On August 18, the index reached its highest level in a decade, despite onshore equities being particularly exposed to “deflation-affected sectors” such as consumer staples, materials, and heavy industrials, according to Morgan Stanley data.

Adding to this market anomaly, Chinese government bond yields have been rising instead of falling, which typically occurs during periods of sharp economic slowdown. The 30-year bond yield increased from 1.8 percent in June to 2.1 percent, while its 10-year equivalent rose from 1.6 percent in July to 1.8 percent.

Factors Driving Market Behavior

One significant factor contributing to the unexpected market performance is a sharp rotation of investment from bonds into stocks over the past several months. Investors are actively seeking higher returns in a persistently low-yielding environment, driving capital towards equities despite broader economic uncertainties.

Outlook on Domestic Demand

The confluence of weakening economic fundamentals and robust market performance presents a complex picture for China’s economy. While some indicators suggest the worst of the deflation scare may be subsiding, the primary challenge remains how quickly and decisively Beijing can implement policies to stimulate and sustain domestic demand.