Global Perspectives Weekly China: Headed in the Right Direction OCTOBER 22, 2014 In this Global Perspectives Weekly: Peter Donisanu Global Research Analyst ChinaвЂ™s Economic Retooling Alex Kun, CFAВ® Senior Investment Research Analyst Hong Kong Wisely Ngai, CFAВ®, CAIA Investment Research Analyst Hong Kong В» With the increasing risk of a global economic slowdown, China tilts towards credit easing and additional economic reforms. В» The central bank implemented liquidity injection measures to ease credit restrictions in the domestic housing market. В» The Shanghai-Hong Kong Stock Connect program is expected to enhance market liquidity and domestic capital markets. В» We believe these economic retooling efforts are helping ChinaвЂ™s economy but execution of the reforms will take time. We are maintaining our neutral recommendation on Chinese equities. The Fourth Plenary Session of the 18th Communist Party of China Central Committee is convening this week. The meeting is expected to provide market observers an update on several reforms that were announced during the third plenum last November. In addition, with the potential for slowing global economic growth, China is continuing its economic retooling process while tilting towards credit easing in the housing market. Having successfully curbed property speculation resulting from an overheating property market, the Chinese government has started loosening housing market restrictions once again. Also, work on the Shanghai-Hong Kong Stock Connect program is underway, aiming to deepen capital market reform and enhance market liquidity. We believe that China will continue expanding its arsenal of economic reforms, but likely will calibrate the pace and implementation of reform in response to changes in economic circumstances. Credit easing in the housing market вЂ“ In response to the slowdown in domestic home sales, the PeopleвЂ™s Bank of China (PBoC) rolled out policies to ease credit restrictions for borrowers. These adjustments included four liquidity injection measures. First, for first-time home buyers, banks can charge mortgage rates as low as 70 percent of the benchmark lending rate, reduced from a range of 90 to 110 percent of the benchmark rate currently being charged for loans that extend beyond five years. This change helps reduce financing costs for borrowers and maintains the maximum loan-to-value (LTV) ratio at 70 percentвЂ”meaning that first-time home buyers are allowed to purchase a residence with a 30 percent down-payment. Second, homeowners who already own a single property without a mortgage now can be considered вЂњfirst-time buyers,вЂќ granting them the 70 percent LTV ratio and possibly lower mortgage rates. Previously, mortgages on additional properties were limited to 30 percent of the property value and the mortgage rate floor was 110 percent of the benchmark rate. Third, home-purchase restrictions have been relaxed in some cities. Banks in certain regions are allowed to set the LTV ratio and mortgage rate based on a borrowerвЂ™s solvency and creditworthiness. This measure also applies to homeowners who have more than one property and 1 Global Perspectives Weekly have completely paid-off mortgages. And fourth, the PBoC supports property developers by encouraging lenders to address developersвЂ™ financing needs. Lending banksвЂ™ efforts may include the following: assisting qualified developers in issuing bonds to the fixed-income market, conducting pilot trials of real estate investment trusts (REITs), extending loan tenures for social housing and resettlement projects to 25 years, and issuing mortgage-backed securities while redeploying proceeds to increase mortgage quotas. In essence, the goal is for lending banks to help induce demand and offset the excess supply in the housing market. Chart 1: PBoC benchmark lending rate China 6 Months-1 Year Rate On RMB Loans - Interest Rates 7.5 Percent 7.0 6.5 6.0 5.5 5.0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Wells Fargo Wealth Management; Factset, 10/17/14 Shanghai-Hong Kong Stock Connect program вЂ“ In April 2014, Chinese Premier Li Keqiang announced that the Shanghai and Hong Kong stock exchanges would become connected, allowing daily cross-trading between the two exchanges. This program aims to further open the domestic market and enhance market liquidity. With the current quota systems in place, this program will serve as an additional channel for foreign capital to flow into the domestic equity market. This development is significant, as policymakers work towards increasing the importance of the Chinese yuan as an international currency. This program allows Hong Kong and mainland China investors to trade shares listed on each other's market. But, all such trades must be transacted in Chinese yuan. Through the Northbound connect, foreign investors can trade all constituents of the Shanghai Stock Exchange (SSE) 180 Index, the SSE 380 Index, and dual-listed stocks in the Shanghai market. For the Southbound connect, mainland China investors can buy and sell all constituents of the Hang Seng HK Large Cap Index, the Hang Seng HK Mid Cap Index, and dual-listed stocks on the Hong Kong stock exchange. The initial daily aggregate quota limits for Shanghai and Hong Kong are 300 billion yuan and 250 billion yuan respectively. It is expected that the quota limits will be raised over time and may be removed eventually. Our view вЂ“ Although concerns about global economic growth continue to mount, ChinaвЂ™s exports grew at a healthy pace of 15.3 percent on a year-over-year basis in September, their strongest level since January 2013. However, this improvement may have come at the expense of industrial profits growth, which slowed from a year-over-year rate of 11.4 percent in June to 10 percent in August. Admittedly, the improvement in exports during the month of September has helped China gain market share in global exportsвЂ”China is now the largest exporter of steel and iron. In fact, ChinaвЂ™s overall export volume of steel and iron now accounts 2 Global Perspectives Weekly for about 10 percent of global market share according to the International Trade Centre 1. In addition, the Producer Price Index (PPI) shrank by 1.8 percent in September, marking its 31st consecutive month of contraction. Prices of materials, like coal, steel, and cement, continue to trend downward due to excess capacity. At the same time, consumer demand has not yet reached a level allowing it to lead ChinaвЂ™s economic growth. Retail sales growth is still hovering around a relatively low level of 12 percent on a yearover-year basis. The overall picture of ChinaвЂ™s economy is mixed. We expect policymakers to respond to concerns about the unevenness of growth in certain sectors of the economy with more policy adjustments and reforms, but not necessarily broad-based stimulus measures like those implemented in 2009. Premier Li recently mentioned the possibility of additional monetary and fiscal policy support to achieve the 7.5 percent growth target this year. The current easing of credit standards in the housing market is an example of such a targeted measures crafted by the government aimed at stabilizing certain sectors of the economy. So far, the impact of this policy appears stronger than the market had anticipated. Moreover, if the Shanghai-Hong Kong Stock Connect program is implemented successfully, we believe it will benefit the long-term outlook for Chinese capital markets in spite of the near-term setbacks. Chart 2: Shanghai A-shares premium over Hong Kong H-Shares index 105 Percent 100 95 90 85 A-Shares Premium Over H-Shares Index 80 Source: Wells Fargo Wealth Management; FactSet, 10/17/14. Heng Seng China AH Premium index. Additionally, this weekвЂ™s plenary session is expected to focus on the theme of вЂњrule of law.вЂќ Generally speaking, there are two focal aspects of the legal system to be considered. The first one involves respect for the highest authority of the constitution in the stateвЂ™s administration. The second seeks to make the judicial system independent from administrative interference at the local level. The legal system in China most assuredly requires reform. A mature legal system not only helps to build public trust in the leadership, but also improves foreign investorsвЂ™ confidence about investing in China. Although such reform is not directly tied to fiscal or monetary policy, a sound legal system is critical to the success of the economic retooling process, especially as China expands domestic markets and promotes internationalization of the yuan. 1 International Trade Centre, Trade Competitiveness Map, 2013 3 Global Perspectives Weekly Investment implications вЂ” The Chinese stock market has outperformed other global equity markets over the past three months, and yet, it remains fairly valued. In fact, the forward price-to-earnings (P/E) of the MSCI China Index is trading at 8.3 times forward earnings. This P/E is lower than those of other major emerging markets, but reflective of investor concerns about ChinaвЂ™s reform efforts and its progress in rebalancing its growth strategy. The prices of companies listed as A-shares in Shanghai (priced in Chinese yuan) are still trading at discounts relative to their H-share listings (priced in Hong Kong dollars) in Hong Kong, particularly in the financial sector. We expect that the valuation gaps for cross-listed stocks eventually will narrow once the Shanghai-Hong Kong Stock Connect program is fully implemented. Chinese policymakers appear headed in the right direction through this latest series of policy adjustments and reforms. However, we believe the administration will take a measured approach to adopting these changes, prolonging the time for any effects to become evident. Meanwhile, we anticipate further setbacks related to public policy and the marketsвЂ™ response to them. Hiccups may also occur from time to time due to a weakening macroeconomic environment in many parts of the world. This week we learned that ChinaвЂ™s third-quarter gross domestic product (GDP) for 2014 was 7.3 percent, slightly better than the 7.2 percent forecasters were anticipating. This reinforces our view that the central government is keenly focused on softening the potential blows that may accompany economic retooling efforts. For now, we maintain our neutral view on Chinese equities. 4 Global Perspectives Weekly Weekly Capital Markets Activity (10/10/14 вЂ“ 10/17/14) Global Equity Markets 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 -0.9% -0.7% 0.7% -1.0% -0.5% -2.6% -1.9% -5.0% -1.3% -1.4% -0.7% -2.1% 0.7% -0.4% MTD -4.8% -5.9% -6.6% -8.7% -4.7% -10.5% -8.0% -10.1% -2.8% -1.0% -2.0% -5.9% 3.0% -3.8% YTD -2.6% -9.2% -7.3% -5.7% -6.3% -1.4% 0.6% -10.8% -2.5% 11.6% 23.5% -5.5% 8.2% 0.7% 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) 2.50 17.4 2.17 10.3 1.30 4.6 0.86 -2.8 7.93 140.3 3.30 34.6 2.19 -2.8 2.19 -8.7 0.48 -2.9 8.39 -6.6 Price -$86.2 $3.77 -$3.48 $9.52 -$1,238 $17.27 -$1,956 $6,689 -$0.91 $1.65 WK -3.3% -4.9% -2.4% 1.4% 4.2% 3.2% 1.1% 1.2% -0.7% -0.8% 2.8% -0.2% -2.7% -4.1% -0.2% Commodities Headline Equity Markets One-week Change 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 Ag 1.4% Livestock -2.7% PrecMet 1.1% IndustMet -0.8% Energy -3.3% 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 10/17/14. 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 Bl oomberg Commodi ty Index Fa mi l y. -6% -4% -2% 0% 2% 4% Currency Table (Pairs) Currency Table (Change in Pairs) Cross rate as of 10/17/14 One Week Change: 10/10/14 - 10/17/14 USD EUR BRL CNY AUD CAD CHF GBP 1.28 17.26 78.78 3.11 MXN 7.83 1.46 1.44 1.21 0.79 136.4 0.58 0.13 INR JPY EUR EUR USD MXN INR BRL CNY AUD CAD 1.1% 1.4% 1.4% 1.3% 0.9% 0.4% 1.8% -0.1% 0.9% CHF 0.0% 1.4% -0.4% 0.6% JPY 0.01 0.58 0.02 0.06 1.07 0.01 0.89 0.73 JPY 0.7% 1.6% 1.3% 2.0% 0.6% GBP 1.61 21.76 99.0 3.92 9.86 1.84 1.82 1.52 172.0 1.26 GBP 0.1% 0.4% 0.6% 0.4% 0.0% -0.6% 0.8% -1.0% 1.19 0.66 113.0 0.83 CHF 1.1% 1.5% 1.6% 1.9% 1.4% 0.84 0.55 94.78 0.69 CAD -0.7% -0.4% -0.1% 0.4% -0.8% -1.4% CHF 1.06 14.29 65.23 2.57 6.50 1.21 CAD 0.89 11.99 54.71 2.16 5.43 1.01 AUD 0.87 11.83 53.98 2.13 5.36 CNY 0.16 2.21 10.03 0.40 BRL 0.41 5.55 25.12 INR 0.02 0.22 MXN 0.07 USD 0.04 4.53 0.19 0.99 0.83 0.54 93.46 0.69 AUD 0.7% 1.1% 1.0% 1.0% 0.18 0.15 0.10 17.45 0.13 CNY 0.1% 0% 0.3% 0.4% 2.52 0.47 0.46 0.39 0.26 43.89 0.32 BRL -1.0% 0.0% -1.3% 0.10 0.02 0.02 0.02 0.01 1.74 0.01 INR -0.1% 0.5% 7.90 0.06 0.18 0.45 0.08 0.08 0.07 0.05 13.52 61.44 2.44 6.13 1.14 1.13 0.95 0.62 106.9 0.78 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 $1.28 U.S. dol l a rs (a s of 10/17/14). MXN -0.3% USD 0.6% 0.5% 1.9% GBP JPY EUR 0.3% -0.3% -0.6% -0.9% 1.1% 0.4% 0.1% -1.8% -0.8% -1.4% -1.8% 1.4% -0.4% 0.6% 0.0% -0.3% -0.6% 0.8% -1.0% 0.0% -0.6% -0.9% -0.3% -0.9% -0.6% -1.3% -1.2% -1.0% -1.3% 1.3% -0.3% -1.1% 0.5% -1.3% -1.0% -0.7% -1.0% -0.3% 0.0% -0.4% -0.9% 0.5% -1.4% -0.4% -1.1% -1.2% 0.3% 0.2% 0.3% -0.1% -0.7% 0.7% -1.1% -0.1% -0.7% -1.0% 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 and opinions in this report were prepared by the investment management division within Wells Fargo Wealth Management. Information and opinions have been obtained or derived from sources we consider reliable, but we cannot guarantee their accuracy or completeness. 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Hang Seng HK Large Cap covers about 80% of the market capitalization of the HSHKCI with 15 constituent stocks. In regular reviews, any stock with a market capitalization ranking that falls below 18th position in the HSHKCI will be removed from the HSHKLI, while any stock ranking above 12th position will be included. 6 Global Perspectives Weekly Hang Seng HK Midcap comprises 35 constituent stocks and covers the next 15% of the market capitalization of the HSHKCI, following the top 80%. In regular reviews, any stock with a market capitalization ranking that falls below the 60th position in the HSHKCI will be removed from the HSHKMI, while any stock ranking above 40th position will be included. Shanghai Stock Exchange (SSE) 180 Index is created by restructuring and renaming SSE30 Index. It selects constituents with best representation through scientific and objective method. SSE is a benchmark index reflecting Shanghai market and serving as a performance benchmark for investment and a basis for financial innovation. Shanghai Stock Exchange (SSE) 380 Index consists of the 380 stocks with Midcap, high growth and good earning records, which aims to comprehensively reflect the performance of the Shanghai new blue chip stocks. The MSCI China Index provides coverage of the large and mid-cap segments in the Chinese stock market and is constructed according to the MSCI Global Investable Market Indexes Methodology. The MSCI China Index is part of the MSCI Emerging Markets Index. Producer Price Index (PPI) measures the average change in selling prices received by domestic producers of goods and services over time. The PPIs measure price change from the perspective of the seller. Hang Seng China AH Premium index tracks the price premium (or discount) of A-shares to H-shares. The higher the index, the higher premium of Ashares over H-shares, and vice-versa. 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