Global Perspectives Weekly China: Economy Still in Transition SEPTEMBER 17, 2014 In this Global Perspectives Weekly: Peter Donisanu Global Research Analyst ChinaвЂ™s Economic Retooling В» Recent economic data releases suggest that ChinaвЂ™s services sector appears to be moderating as manufacturing data continues to disappoint. Guest Contributors: Alex Kun, CFAВ® Senior Investment Research Analyst Hong Kong Wisely Ngai, CFAВ®, CAIA Investment Research Analyst Hong Kong В» Excess capacity in the manufacturing and real estate sectors continue to work its way through the economy. We anticipate that government leaders will focus on structural reforms with limited stimulus to these sectors. В» We have observed positive developments within the countryвЂ™s services sector, but we anticipate that the economic shift may continue to present near-term uncertainty. For now, we are maintaining our neutral recommendation on Chinese equities. Recent data out of China continues to suggest that the countryвЂ™s aim to shift to a consumption-based economy is still underway: manufacturing and housing data continues to disappoint, while slowing activity in the services sector has been moderating. Nevertheless, signs of economic stabilization in China appear to have reinvigorated investor appetite for the countryвЂ™s equities, as the Shanghai Composite Index rose to a one-year high this month. We believe that the moderating-yet-resilient services sector data supports the thesis of ChinaвЂ™s economic retooling process that we have discussed for several months. Chart 1: Chinese manufacturing PMI vs. non-manufacturing PMI 57 56 55 PMI Index Level 54 53 52 51 50 49 48 47 46 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Non-manufacturing PMI Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Maufacturing PMI Source: Wells Fargo Wealth Management; Bloomberg, 9/16/14 But the implications of this economic shift may pose unpleasant surprises for investors, which is why we maintain our neutral recommendation on Chinese equities. 1 Global Perspectives Weekly Stabilizing data, overcapacity still a concern вЂ“ ChinaвЂ™s services sector continues to show signs of stabilization in spite of disappointing manufacturing activity. In August, the non-manufacturing Purchasing ManagerвЂ™s Index (PMI) came in at 54.4 (a level above 50 indicates expansion activity) maintaining a fairly measured pace of activity over the past 12 months. At the same time, consumer spending appears to be stabilizing following a period of deceleration. Retail sales figures have leveled out in the recent months to average 12 percent year-over-year growth following a slowdown in consumption. This slowing was a result of the governmentвЂ™s anti-graft campaign, which led to a decrease in demand for luxury goods and services (such as extravagant wine and dining). Although the latest data reflects the resiliency of the services sector, we remain mindful of unresolved structural issues and sizable imbalances in the economy. These problems may present hiccups in the governmentвЂ™s plans to rebalance the countryвЂ™s drivers of economic growth. Chart 2: Year-over-year change in Chinese producer prices 8.00 6.00 Y/Y Chg (%) 4.00 2.00 0.00 -2.00 -4.00 Jul-14 Aug-14 Jun-14 Apr-14 May-14 Mar-14 Jan-14 Feb-14 Dec-13 Oct-13 Nov-13 Sep-13 Jul-13 Aug-13 Jun-13 Apr-13 May-13 Mar-13 Jan-13 Feb-13 Dec-12 Nov-12 Oct-12 Sep-12 Jul-12 Aug-12 Jun-12 Apr-12 May-12 Mar-12 Jan-12 Feb-12 Dec-11 Nov-11 Oct-11 Sep-11 -6.00 Producer Price Index (YoY) Source: Wells Fargo Wealth Management; Bloomberg, 9/16/14 In 2009 amidst the global financial crisis, the Chinese government responded to the countryвЂ™s economic slowdown with a stimulus package worth four trillion yuan (roughly $570 billion). The effects of this large injection of financial capital led to some unwanted side effects, including overcapacity in the countryвЂ™s manufacturing sector. Given the manufacturing sectorвЂ™s oversupply and waning demand among consumers in recent years, the capacity utilization rate has declined. Data from the Ministry of Industry and Information Technology shows that certain key sectors, including steel, cement, aluminum, plate glass, and shipbuilding, have a capacity utilization rate of around 70 percent to 80 percent, below averages of recent years. Additionally, profit margins of the steel producers have been squeezed to single-digits from double-digits that were common during the investment-led boom. These Chinese industrial producers have had poor pricing power for the past two years due to this over-supply and excess capacity, reflected in negative Produce Price Index (PPI) data that weвЂ™ve observed since 2012. Recent figures show that producer prices declined 1.2 percent in August, a вЂњless-negativeвЂќ rate than in prior years and a possible indication that stimulus-induced excesses finally are working their way through the system. Nevertheless, it will take more time to resolve the overcapacity issue. In addition, it should be noted that this change in the trend away from overcapacity may continue to weigh on the rate of economic growth in China. 2 Global Perspectives Weekly Property market excesses вЂ“ The overcapacity issue not only exists in the manufacturing sector, but in the property sector as well. Real estate fixed asset investment fell to 12.4 percent year-over-year in the second quarter vs. 16.8 percent year-over-year in the first quarter. At the same time, housing inventories have been rising significantly. Stimulus-induced construction in recent years pushed up inventory levels in second-tier and third-tier cities, where the pace of urbanization-based demand has yet to catch up to supply. Moreover, data shows a growing demographics mismatch between supply and demand in first-tier cities where newhome development was targeted at middle-income buyers; however, it appears that demand has mainly come from lower-income buyers in recent months. Price appreciation in the structurally oversupplied property market has slowed since the beginning of the year. In July, a survey across 70 medium- and large-sized cities indicated that the sales prices of newly constructed residential buildings declined in 64 cities, remained unchanged in four cities, and increased in only two cities. This survey data contrasts with data published during the same period last year, when sales prices decreased in three cities, remained unchanged in two cities and increased in 65 of the cities surveyed. A similarly gloomy pattern is also being observed in the existing home sales figures. Our view вЂ“ The Fourth Plenary Session of the 18th Communist Party of China Central Committee, in which important economic policy decisions are expected to be made, will convene next month. In the near-term, given the moderate-to-stabilizing economic data in the services sector, we do not expect policymakers to announce additional broad-based stimulus measures beyond what was announced earlier this year. As a result, we may continue to see falling property prices in the coming months and possibly years, as the Chinese government is seeking вЂњhigh-qualityвЂќ and вЂњefficientвЂќ growth to shift the focus from investment to domestic consumption. Nevertheless, it should be noted that the government has continued to provide financial support to underpin systemically important sectors of the economy. As we wrote last month, the PeopleвЂ™s Bank of China (PBOC) provided $162 billion in low-cost financing to the China Development Bank in an effort to provide liquidity for property developers amid declining market activity. Also, this week it was reported that the PBOC would provide 500 billion yuan ($81.4 billion) to the countryвЂ™s five largest banks in a measure to boost interbank liquidity and that some of these funds are aimed at targeting existing lending programs. This move comes as foreign direct investments into the country fell to a two-and-a-half year low and industrial production fell to its lowest level since 2008. As for the continued economic retooling of the Chinese economy, we anticipate that the government may introduce more industry-specific reforms (state-owned enterprises reforms) to increase productivity and competiveness in the manufacturing sector in an effort to further reduce oversupply. In fact, on August 1, the Ministry of Industry and Information Technology issued revised guidelines for its campaign to address overcapacity in steel, aluminum, cement, and glass. All increases in capacity among firms within these industries must first pass through a new procedure that matches against closures of existing capacity. We view this new policy as one example of the government actively addressing overcapacity issues creatively. Nevertheless, we believe that the government is taking a measured approach to rebalancing excesses and believe that any unpleasant surprise, such as a sharp drop in activity in the services sector, may put additional reforms on hold. 3 Global Perspectives Weekly Investment implications вЂ” Prior to last weekвЂ™s data releases, Chinese equity prices had rallied on positivesurprises in economic data releases and key policy reforms. From the perspective of positive surprises in economic data, we believe that it is too soon to call an all-clear on increasing our tactical weight to China as part of our Emerging Markets allocation. This weekвЂ™s disappointing manufacturing data reminds us that negative surprises for investors are still not out of the question. Additionally, we also have observed that the near-term rally may have been influenced by government policies that provide greater ease of access to Mainland equities. Recently, the Hong Kong and Shanghai Stock Exchanges announced the Shanghai-Hong Kong Stock Connect program. As a result of this program, Mainland ChinaвЂ™s institutional investors are permitted to trade Hong Kong-listed stocks through the Shanghai Stock Exchange, while all Hong Kong and foreign investors may trade Shanghai-listed stocks through the Hong Kong Stock Exchange. Although this development initially has been a boost for Chinese equity market performance, it may be short-term in nature. Therefore, we are advising investors to remain cautious given the ongoing structural concerns weвЂ™ve outlined above. We believe that long-term support for a rebound in ChinaвЂ™s equity markets will require fundamental policy reforms, to which the government is presently focused. But, the investment-induced excesses and imbalances continue to work their way through the system, and it may be months, if not years, before they are resolved. Although we have observed some positive developments within the countryвЂ™s services sector, we anticipate the shift from an investment-driven to a consumer-driven Chinese economy may continue to present nearterm market uncertainties for investors. For now, we are maintaining our neutral recommendation on Chinese equities. 4 Global Perspectives Weekly Weekly Capital Markets Activity (09/05/14 вЂ“ 09/12/14) Global Equity Markets MTD -1.2% -1.2% 1.9% 1.4% -0.2% 3.0% 1.5% 3.4% -2.4% 5.2% 1.6% -1.3% -7.1% 0.4% YTD 4.6% -0.7% 1.0% 3.9% 1.1% 11.1% 10.0% -2.1% 6.0% 11.2% 28.0% 1.5% 10.5% 6.6% Global Sovereign Bond Market Commodity Prices Italy Spain France Germany Greece Portugal UK US Japan India Energy Brent Crude Oil $/bbl Natural Gas $/MMBtu Agriculture Corn $/bushel Soybean $/bushel Precious Metals Gold Spot $/oz Silver Spot $/oz Industrial Metals LME Aluminum $/Mt LME Copper $/Mt Livestock Lean Hogs $/lb Live Cattle $/lb Yield Wk Chg (BPS) 2.46 20.4 2.35 30.3 1.43 17.2 1.08 15.4 5.66 13.2 3.24 17.7 2.53 6.6 2.61 15.2 0.58 3.5 8.50 -2.1 Headline Equity Markets One-week Change Price -$98.0 $3.86 -$3.39 $9.85 -$1,230 $18.64 -$1,993 $6,866 -$0.96 $1.59 WK -1.2% -3.4% 1.7% -4.4% -4.9% -3.5% -2.8% -3.1% -2.9% -3.5% -3.6% -1.8% 1.0% 0.9% -1.0% Commodities Mexico IPC BOVESPA (Brazil) KOSPI (South Korea) BSE 100 (India) Shanghai SE (China) MSCI EM Nikkei (Japan) IBEX 35 (Spain) FTSE MIB (Italy) FTSE 100 (UK) CAC 40 (France) DAX (Germany) MSCI EAFE MSCI All Country Gra phi c repres ents the a vera ge s ector wei ghts of the S&P GSCI, Rogers Interna ti ona l Commodi ty, a nd Bl oomberg Commodi ty i ndi ces a s of 09/12/14. Energy вЂ“ 49%; Agri cul ture вЂ“ 26%; Preci ous Meta l s вЂ“ 12%; Indus tri a l Meta l s вЂ“ 9%; Li ves tock вЂ“ 4%. Da ta i n thi s gra phi c repres ents the one-week cha nge i n s ector pri ce a ccordi ng to thei r res pecti ve DJ-UBS s ub-i ndi ces . Ag -4.4% Livestock 1.0% IndustMet -3.5% Energy -1.2% PrecMet -2.8% MSCI All Country MSCI EAFE DAX (Germany) CAC 40 (France) FTSE 100 (UK) FTSE MIB (Italy) IBEX 35 (Spain) Nikkei (Japan) MSCI EM Shanghai SE (China) BSE 100 (India) KOSPI (South Korea) BOVESPA (Brazil) Mexico IPC Wk -1.4% -1.3% -1.0% -1.0% -0.7% -1.5% -2.3% 1.8% -3.2% 0.2% 0.1% -0.4% -6.2% -0.9% -8% -6% -4% -2% 0% 2% 4% Currency Table (Pairs) Currency Table (Change in Pairs) Cross rate as of 09/12/14 One Week Change: 09/05/14 - 09/12/14 USD EUR BRL CNY AUD CAD CHF GBP 1.30 17.19 78.49 3.03 MXN 7.93 1.43 1.44 1.21 0.80 139.2 0.57 0.12 INR JPY EUR EUR USD MXN INR 0.1% 1.8% 0.3% AUD CAD CHF GBP JPY #N/A -0.3% 3.9% BRL CNY 2.0% 0.3% 0.5% 2.2% JPY 0.01 0.57 0.02 0.06 1.03 0.01 0.87 0.72 JPY -2.1% -0.8% -1.7% 2.0% -2.2% 1.6% -0.3% -1.9% -1.8% GBP 1.63 21.56 98.5 3.80 9.98 1.80 1.80 1.52 174.6 1.25 GBP -0.4% 1.3% 0.0% 3.9% -0.5% 3.4% 1.6% -0.1% 1.19 0.66 115.0 0.83 CHF -0.2% 1.5% 0.0% 3.9% -0.3% 3.5% 1.7% 0.84 0.55 96.76 0.70 CAD -1.9% -0.2% -1.1% 2.3% -2.0% 1.8% CHF 1.07 14.20 64.92 2.51 6.57 1.19 CAD 0.90 11.95 54.93 2.11 5.53 1.00 AUD 0.90 11.98 54.96 2.11 5.54 CNY 0.16 2.16 BRL #N/A 5.67 26.10 INR 0.02 0.22 MXN 0.08 USD 9.89 0.38 2.62 1.00 0.84 0.56 97.01 0.70 AUD -3.6% -2.0% -2.9% 0.6% -3.7% 0.18 0.18 0.15 0.10 17.50 0.13 CNY 0.1% 0.47 0.47 0.40 0.26 45.91 0.33 BRL #N/A -2.5% -2.8% INR -1.3% 0.5% 0.04 0.10 0.02 0.02 0.02 0.01 1.76 0.01 0.18 0.46 0.08 0.08 0.07 0.05 8.10 0.06 13.26 60.66 #N/A 6.14 1.11 1.11 0.93 0.61 107.3 0.77 4.60 Thi s ta bl e repres ents a cros s -currency pa i r i n a ma tri x forma t. The col umn on the l eft denotes the l oca l currency a nd the row a t the top of the ta bl e the forei gn currency. For exa mpl e, i f the l oca l currency i s EUR (euro) a nd the forei gn currency i s USD (U.S. dol l a r), then 1 euro buys $1.3 U.S. dol l a rs (a s of 09/12/14). 2% MXN -1.7% USD 1.7% 0.5% 4.4% EUR -2.2% 1.8% -0.5% 0.1% 1.9% -0.3% -1.7% -1.5% 0.2% -2.0% -1.8% -3.4% -3.2% -1.6% -3.7% 3.9% 2.0% 0.4% 0.5% 2.3% 0.0% -4.3% -0.6% -2.2% -3.9% -3.7% -2.1% -4.2% 2.8% -0.5% 2.3% 0.6% -1.3% -1.0% 1.4% -1.4% -0.5% 2.6% -1.8% 2.1% 0.2% -1.4% -1.3% 0.4% -1.7% 0.4% 2.0% #N/A -0.1% 3.7% 0.2% 0.4% 2.1% -0.1% Thi s ta bl e repres ents the one-week cha nge for a gi ven cros s -currency pa i r. A pos i ti ve va l ue i ndi ca tes tha t a l oca l currency ha s a ppreci a ted (or you ca n buy more of a gi ven forei gn currency). The i nvers e i s true for a nega ti ve va l ue. 5 Global Perspectives Weekly All data in this Global Perspective Weekly was sourced from Bloomberg unless otherwise noted. Disclosures Wells Fargo Wealth Management, a business division of Wells Fargo & Company, provides products and services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries. This report is made available in the United States only by Wells Fargo Wealth Management a business division of Wells Fargo Bank N.A. Wells Fargo Wealth Management takes full responsibility for the distribution of the report. Any unauthorized use, duplication, redistribution or disclosure of this report is prohibited. The information in this report was prepared by the investment management division within Wells Fargo Wealth Management. Opinions represent Wells Fargo Wealth ManagementвЂ™s opinion as of the date of this report and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information and opinions in this report were principally prepared by representatives of Wells Fargo Securities Asia Limited (вЂњWFSALвЂќ), which is regulated by the Securities and Futures Commission in Hong Kong, for Wells Fargo Bank, N.A. The information in this document has been obtained or derived from sources believed by WFSAL to be reliable, but WFSAL does not represent that this information is accurate or complete. WFSAL may have received assistance from the issuers or managers referred to in this report including, but not limited to, discussions with management of these entities. Wealth Management policy prohibits analysts from sending draft reports to funds or managers. However, it should be presumed that the author of this report has had discussions with each featured issuer and/or its manager to ensure the accuracy of the facts presented in this report. Any opinions or estimates contained in this document represent the judgment of WFSAL, at this time, and are subject to change without notice. Notwithstanding the fact that other business divisions within the firm may advise issuers or managers discussed in this report, information obtained in such roles is not used in the preparation of research reports. WFSAL and its affiliates may from time to time provide advice with respect to, acquire, hold, or sell a position in, the securities or instruments named or described in this document, including selling to and buying from customers. They may engage in transactions in a manner that is inconsistent with the views expressed in this report. Wells Fargo Bank, N.A. and/or its affiliates may receive remuneration in respect of a wide variety of services and for acting in various capacities that may relate, directly or indirectly, to any of the funds or managers covered. They may receive rebates in relation to initial public offerings and/or receive fees or other remuneration in connection with advisory services or the performance, management, servicing, administration or distribution of investment products. They may participate in the creation or redemption of securities or interests covered in this report and may acquire such securities from the issuers for the purpose of resale. Wells Fargo Bank, N.A. and/or its affiliates may receive remuneration for executing trades in investment products. They may also earn compensation through fees embedded in the features of certain products. Wells Fargo Bank, N.A. and/or its affiliates may receive non-monetary benefits from product issuers for the sale or distribution of investment products. Examples include research and advisory services, market or portfolio analysis, training/seminars, travel and hospitality, de minimis gifts and nominal value promotional items. Where Wells Fargo Bank, N.A. has an existing business relationship or seeks to establish a business relationship with a manager or a fund that is a subject of Wells Fargo Wealth ManagementвЂ™s research reports, these relationships may give rise to a conflict of interest that could affect the objectivity of this report. Wells Fargo Wealth Management makes disclosure of such conflicts in accordance with applicable law. Analysts receive no direct compensation in connection with the firmвЂ™s investment banking business. Analysts may be eligible for annual bonus compensation based on the overall profitability of the firm, which takes into account revenues derived from all the firmвЂ™s business activities, including the investment banking business. Past performance does not indicate future results. The value or income associated with a security may fluctuate. There is always the potential for loss as well as gain. Investments discussed in this report are not insured by the Federal Deposit Insurance Corporation or any other government agency and may be unsuitable for some investors depending on their specific investment objectives and financial position. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Your individual allocation may be different than the strategic long-term allocation above due to your unique individual circumstances. The asset allocation reflected above may fluctuate based on asset values, portfolio decisions, and account needs. 6 Global Perspectives Weekly Indices represent securities widely held by investors. You cannot invest directly in an index. S&P 500 Index is a capitalizationweighted index calculated on a total-return basis with dividends reinvested. The index includes 500 widely held U.S. market industrial, utility, transportation and financial companies. Wells Fargo and Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. This report is not an offer to buy or sell, or a solicitation of an offer to buy or sell the securities or strategies mentioned. The investments discussed or recommended in the presentation may be unsuitable for some investors depending on their specific investment objectives and financial position. Investing in foreign securities presents certain risks that may not be present in domestic securities. For example, investments in foreign and emerging markets present special risks, including currency fluctuation, the potential for diplomatic and potential instability, regulatory and liquidity risks, foreign taxation and differences in auditing and other financial standards. Some complementary strategies and real assets may be available to pre-qualified investors only. Real estate investments carry a certain degree of risk and may not be suitable for all investors. The Producer Price Index (PPI) is an inflationary indicator published by the U.S. Bureau of Labor Statistics to evaluate wholesale price levels in the economy. The Shanghai Stock Exchange Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange. The index was developed on December 19, 1990, with a base value of 100. Index trade volume on Q is scaled down by a factor of 1,000. В© 2014 Wells Fargo Bank, N.A. All rights reserved. 7