Market Bulletin. China: Still sneezing hard. January 20, 2016 MARKET INSIGHTS. In brief

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1 MARKET INSIGHTS Market Bulletin January 20, 2016 China: Still sneezing hard In brief Slower 4Q15 GDP growth and soft December data add to concerns about China s economic health. On a more encouraging note, we see further evidence of the ongoing rebalancing away from a manufacturing-driven economy towards a service-oriented domesticdemand economy, with growth across China s tertiary industry, outpacing the growth in both secondary and primary industries. While the stable expansion in consumption-related activities helps cushion downside growth risks, the transition towards the service sector still requires policy support to offset the overhang of the manufacturing sector. In our view, stable labor market conditions and rising household income should help support consumption in the near term, but further counter-cyclical easing is necessary to lift aggregate demand and provide a stable macro backdrop as China continues its challenging transition to a consumer/services-led economy. Marcella Chow Global Market Strategist Slower 4Q15 GDP growth and soft December data add to concerns about China s economic health China s fourth-quarter real GDP came in at 6.8% year-over-year (y/y), down from 6.9% in 3Q15 and the lowest since 2009 (consensus 6.9%). For the full year, GDP rose 6.9% y/y, the least since 1990, but close to the approximate 7% target set by the government (Exhibit 1 on next page). On a quarter-over-quarter (q/q) annualized basis, the economy expanded at 1.6%, slower than 1.8% in 3Q15. December activity indicators further traced the deepening slowdown, with notably slower industrial production (IP) and fixed asset investment (FAI) as well as weaker retail sales growth in the month (Exhibit 2 on next page). Coupled with the mixed signals from December official and Caixin Purchasing Managers Indices (PMI) released earlier this month, the data continue to point to a challenging economic outlook.

2 China s 4Q15 GDP came in weaker than expected EXHIBIT 1: 4Q15 GDP BREAKDOWN % CHANGE GDP (y/y) GDP (q/q, seasonally adjusted) Actual Previous Consensus Management. Data reflect most recently available as of 19/1/16. Two-speed economic transformation is underway EXHIBIT 3: SHARE OF GDP BY INDUSTRY AND REAL GDP GROWTH, 3-MONTH MOVING AVERAGE Primary Secondary Tertiary % y/y (RHS) % 14% 12% December 2015 activity indicators all disappointed EXHIBIT 2: DECEMBER 2015 ACTIVITY INDICATORS Industrial production Fixed asset investment (YTD) Retail sales Actual Previous Consensus Management. Data reflect most recently available as of 19/1/16. On a more encouraging note, we see further evidence of the ongoing rebalancing away from a manufacturing-driven economy towards a service-oriented, domestic-demand economy. Underscoring the shift within China s two-speed economy, the share of tertiary industry in overall GDP accounted for 55% in 2015, a significant increase from 42% in 2006, while the secondary industry declined from 47% to 4 (Exhibit 3). In particular, growth across China s tertiary industry, predominantly services, rose by 8.3% y/y in 2015, outpacing the growth in both secondary (6. y/y) and primary (3.9% y/y) industries. There have also been some initial signs of green shoots in the real economy, underpinned by still-strong auto and property sales, strengthening credit growth (see more on the next page) as well as faster fiscal expenditure. 2 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 Management. Guide to the Markets Asia, 1Q 2016 [8]. Data reflect most recently available as of 19/1/16. For the month of December, we are encouraged by the stronger-than-expected trade data but we remain cautious on the overall export outlook in a global environment with subdued demand. Meanwhile, the still-low Consumer Price Index (CPI) inflation and the deep Producer Price Index (PPI) deflation suggest aggregate demand remains weak. Digging into the weak December IP, retail sales and FAI data In December, IP growth moderated to 5.9% y/y from 6.2% in November, against market expectations of 6., mainly due to the base effect and temporary production suspension at some manufacturing and construction sites in Northern China as part of pollution control measures. Retail sales growth slowed to 11.1% y/y in December from 11.2% last month, lower than the market expectation of 11.3%. We believe the moderation was likely due to front-loading of auto purchases in the past two months amid favorable policies (instead of waiting until the year-end promotion) and buying of other consumer items during the Singles Day promotion in November. 8% 6% 2 CHINA: STILL SNEEZING HARD

3 Meanwhile, dragged by disappointing infrastructure growth, FAI year-to-date growth lowered to 10., weaker than the market forecast of 10.2%. Strengthening December credit growth December total social financing surprised on the upside by rising to RMB 1,820 billion from RMB 1,018 billion in November (against consensus of RMB 1,150 billion), helped by better nonbank financing, especially bond and equity financing, while bank loan growth remained resilient. Money supply (M2) growth edged lower, likely due to a large decline in foreign exchange (FX) purchases, partially cushioned by policy easing. (Exhibit 4) December credit growth surprised on the upside EXHIBIT 4: DECEMBER 2015 CREDIT GROWTH New loans (RMB billions) Total social financing (RMB billions) Money supply (% y/y) Actual , Previous , Consensus , Source: FactSet, PBoC, J.P. Morgan Asset Management. Data reflect most recently available as of 15/1/16. The December credit data suggests the economy may have stabilized at a low level. However, we think this stabilization will only be temporary, as headwinds remain strong on structural problems like overcapacity and oversupply in the real estate market. We continue to expect the growth to slow gradually in Mixed signals from December official and Caixin PMIs Official PMI data published on January 1 offered signs of growth stabilization with both manufacturing and nonmanufacturing PMI rising modestly to 49.7 (vs in November) and 54.4 (vs in November), respectively (Exhibit 5). On the other hand, the alternative indicator, Caixin manufacturing PMI, which focuses on smaller and mediumsized enterprises, dropped to a three-month low in December to 48.2, as the result of sluggish exports and new orders. The Caixin December services PMI also slowed to 50.2 from 51.2 in November. Diverging PMI results EXHIBIT 5: DECEMBER 2015 PMI Source: Markit, FactSet, National Bureau of Statistics of China, J.P. Morgan Asset Management. Data reflect most recently available as of 7/1/16. The diverging PMI results suggest the economic outlook remains mixed. In particular, we believe stable service expansion should help cushion growth risks but industrial overcapacity and weak external demand will likely stay throughout the rest of 2016 (Exhibit 6). Stable service expansion should help cushion growth risks EXHIBIT 6: MARKIT PURCHASING MANAGERS INDICES LEVEL Official Services Official Non- Caixin Caixin Services Actual Previous Consensus '12 '13 '14 '15 Source: Markit, J.P. Morgan Asset Management. Guide to the Markets Asia, 1Q 2016 [8]. Data reflect most recently available as of 7/1/16. Better trade data points to demand stabilization but headwinds remain December export growth in dollar terms came in better than expected at -1.4% y/y, up from -6.8% y/y in November, compared to consensus expectations of -8. y/y, bringing the export growth for 2015 to -2.8% y/y (Exhibits 7 and 8 on next page). The stronger export growth was likely helped by stronger external demand mainly in developed markets, despite a high base from last year. Meanwhile, import growth improved to -7.6% y/y in December (vs. -8.7% y/y in November), above market consensus of -11. y/y. The improvement in import growth came in against an unfavorable base effect and lower commodities prices, pointing to some stabilization in domestic demand. The higher-than-expected trade surplus, at USD 60.1 billion, along with the notable fall in FX reserves, highlights significant capital outflow in December. J.P. MORGAN ASSET MANAGEMENT 3

4 Stronger than expected trade data EXHIBIT 7: DECEMBER 2015 TRADE DATA Exports (% y/y) Imports (% y/y) Trade balance (USD billions) Actual Previous Consensus Source: China Customs, FactSet, J.P. Morgan Asset Management. Data reflect most recently available as of 13/1/16. We stay cautious on the overall export outlook in a global environment with subdued demand EXHIBIT 8: MERCHANDISE TRADE GROWTH, 3-MONTH MOVING AVERAGE CPI edged up slightly driven by food; PPI deflation continues to be a challenge for corporate sector EXHIBIT 9: DECEMBER 2015 CPI AND PPI Consumer Price Index Producer Price Index Actual Previous Consensus Management. Data reflect most recently available as of 11/1/16. Still-low CPI inflation and deep PPI deflation EXHIBIT 10: DECEMBER 2015 CPI AND PPI 3 2 Imports Exports 5% - -2 '12 '13 '14 '15 Source: China Customs, FactSet, J.P. Morgan Asset Management. Guide to the Markets Asia, 1Q 2016 [8]. Data reflect most recently available as of 13/1/16. -5% CPI PPI - '97 '99 '01 '03 '05 '07 '09 '11 '13 '15 Management. Data reflect most recently available as of 11/1/16. The stronger-than-expected trade data was encouraging, however, we stay cautious on the overall export outlook in a global environment with subdued demand. We expect an elevated trade surplus to sustain in 2016 amid capital outflow pressure. Still low CPI inflation and deep PPI deflation In December, CPI inflation edged up on higher food prices amid poor weather while PPI deflation stayed deep (Exhibits 9 and 10). Note that PPI has been in deflationary territory for 46 months in a row, reflecting overcapacity on the domestic front as well as imported deflation pressure amid depressed global commodity prices. For full-year 2015, CPI inflation came in at 1.4% y/y while PPI fell 5.2% y/y. Going into 2016, we expect modestly higher CPI inflation and less entrenched PPI deflation on policy easing and base effects. Investment implications: Structural transformation remains work in progress As we step into 2016, with the policy focus set on supply-side reforms, we continue to expect the government to keep policy stance accommodative as they aim to accelerate the reduction in overcapacity against a backdrop of sluggish external demand. While the stable expansion in consumption-related activities helps cushion downside growth risks, the transition towards the service sector still requires policy support to offset the overhang of the manufacturing sector. In our view, stable labor market conditions and rising household income should help support consumption in the near term, but further counter-cyclical easing is necessary to lift aggregate demand and provide a stable macro environment as China continues its challenging transition to a consumer/services-led economy. 4 CHINA: STILL SNEEZING HARD

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