Q&A on China and Japan: Parsing the Politics

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1 IN-D EPTH A NALYSIS OF THE I NTERNATIONAL MARKETS Peter Donisanu Investment Strategy Analyst Michael D. Taylor, CFA Investment Strategy Analyst Q&A on China and Japan: Parsing the Politics November 2, 2017 Key Takeaways» The conclusion of China s People Congress and stunning outcome in Japan s national elections last week have prompted a number of investor questions.» In this week s report, we attempt to hit some of the highlights from these key events in a question-and-answer format. What It May Mean for Investors» In general, we believe that the political outcomes in China and Japan offer some continuity and stability in a time of U.S. and European policy uncertainty. Last week, China s leader Xi Jinping was elected to a second five-year term, while Japanese Prime Minister Shinzo Abe s Liberal Democratic Party secured its leadership role in the lower house of the Diet following snap elections. Financial-market reactions to these events have been mixed but largely positive. Nevertheless, some investors have asked what these Chinese and Japanese political developments may mean for the future of their economies and for global financial markets. In this week s report, we address some of the topics on investors minds in a question and answer format. In general, we believe that the election results in China and Japan are likely to bring policy stability and continuity in two of the world s largest economies in an environment in which U.S. and European government policy remains fluid. We view this continuity as a source of stability for global financial-market sentiment. Yet, as we highlight in the following questions and answers, policy stability does not necessarily alleviate risks stemming from possible policy mishaps which investors should continue to monitor. What are the key political takeaways from the Chinese and Japanese elections? For China, a highlight of last week s Communist Party Congress was President Xi Jinping s consolidation of power and elevation in both stature and influence within the ruling party. Few communist leaders in China have held such power since founding party member Chairman Mao Zedong s days. What is important to note is that President Xi has achieved his personal level of success through an adherence to and extension of party influence, not outside of it. As a result, the body of the Communist Party, headed by core leader Xi, is likely to play a more active and visible role in driving reforms in the country s economy and markets in the coming years Wells Fargo Investment Institute. All rights reserved. Page 1 of 5

2 From 1989 through 2012, Japan had gone through one prime minister every 1.2 years, on average. Governing since 2012 and with his latest political victory under his belt, Prime Minister Shinzo Abe is poised to become Japan s longest-tenured leader in more than 30 years. This political continuity presumably has come from the measured success of the prime minister s economic policies popularly called Abenomics. Loose monetary policy, coupled with targeted economic reforms and stimulus spending, arguably has helped to anchor growth and inflation expectations in the country. While Abenomics has not borne fruit as quickly as Prime Minister Abe may have wished, his political victory last week is likely to give him enough time to see his policy through to fruition. How will the election outcomes affect the economic growth prospects in each respective country? Economic growth under President Xi Jinping has slowed from around 7.5 percent in the third quarter of 2012 to 6.8 percent in the third quarter of This comes in stark contrast to his predecessor, Hu Jintao, who saw growth slow from a peak of 15 percent during his tenure. In general, we expect the trajectory of President Xi s economic policies to remain largely unchanged from what was introduced during the last fiveyear plan that began in These policies specifically called for a slower pace of growth as the country s economy matures and transitions from a production-oriented focus to a services-based and consumption-oriented economy. We anticipate that reform implementation will gain pace over the next months following Xi s consolidation of power and influence within the Communist Party. While we expect Chinese economic growth to slow in the coming years, we also anticipate that policymakers will actively utilize credit levers to help cushion the slowdown. Under Abe s watch, inflation in Japan has grown steadily. We expect faster, yet measured, economic growth in Japan in the coming years as result of continued easy money policies from the Bank of Japan, along with fiscal spending by Mr. Abe s government. With that said, we expect Japan s economy to continue facing headwinds to growth from an aging population and waning productivity. Prime Minister Abe has targeted his economic policies toward addressing these headwinds, with some success in recent years. More women have entered the workforce; yet net population growth in Japan is negative. Japanese workers put in some of the longest hours among developed-market countries, yet per-hour output remains subdued. How should investors play the political outcomes in China and Japan in the near term? We view the election outcomes in China and Japan over the past week to be favorable for financial markets over the near and long term. As we mentioned above, we believe that the political outcomes in China and Japan bring potential stability to an environment in which policies are in flux, particularly in the U.S. and Europe. We believe that markets favor policy certainty over uncertainty, and they may continue to favor the Pacific and Emerging Market Asia region as a result. 1 International Briefing: China s NPC Conclusion Summary and Opportunities ; March 18, Wells Fargo Investment Institute. All rights reserved. Page 2 of 5

3 Indeed, Chinese offshore H- and A-share equity markets have rallied strongly year to date as have Japan s local equity markets. From here, however, we believe that stockmarket performance in China and Japan will diverge. For instance, we recently reduced our favorable guidance on the Emerging Asia region, given the strong rally in Chinese stocks (+47 percent year to date), driven largely by the Information Technology sector. While we expect that earnings growth in Emerging Asia companies is likely to continue in the coming months, our work shows that prices have grown faster than earnings, pushing valuations to historically stretched conditions. We maintain a favorable equity-market rating in the developed Pacific region (which is heavily weighted toward Japan). The global-trade rebound and accelerating Japanese economic growth have been a boon to corporate earnings. While the Nikkei 225 Index has rallied at a double-digit pace this year (+13.4 percent year to date), the faster-thanexpected earnings growth has kept valuations from running into overextended territory. What long-term investment opportunities exist in China and Japan? As we pointed out in a previous report, we believe that investors with patient capital can tap into long-term opportunities by focusing on the broad (and narrow) long-term trends that may play out across the Asia-Pacific region over the next decade. 2 In terms of broad long-term trends, we believe that the Asia-Pacific region has been a growth market for foreign multinational companies over the past two decades. Indeed, investors that had put money to work in U.S. and European companies targeting early investments in China, Korea, and Taiwan have, in some cases, been handsomely rewarded. Although we continue to believe that the Asia-Pacific region is a key growth market, we expect large Chinese, Japanese, Korean, and Taiwanese multinational companies to play a more influential investment role in countries like India, Indonesia, and Thailand. A key reason for this view is the fact that technological and infrastructure advancements have increased entrepreneurial know-how and eased the movement of people and ideas across the region. In terms of narrow long-term trends, demographic and income differences across the Asia-Pacific region can present investors with an opportunity to tap into investment opportunities. For example, the 60-and-over populations in Japan, Australia, and New Zealand are among Asia-Pacific s largest for that demographic segment. In five years, more than seven percent of the population of Hong Kong, South Korea, and Taiwan also will cross this threshold. High income levels, coupled with an aging demographic, are likely to produce opportunities in the region s Health-Care sector. In contrast, South and Southeast Asia s youthful population and rapidly rising incomes are likely to benefit real estate and consumer-oriented companies as disposable incomes rise and household formation grows in the coming years. What are some of the risks that investors should monitor in China and Japan? We believe that policy implementation and geopolitical risks are top-of-mind for investors in China and Japan. One key risk with respect to investing in China is likely to come from a policy-implementation misstep. We believe that President Xi will 2 International Strategy: Why Invest in Asia-Pacific?; August 3, Wells Fargo Investment Institute. All rights reserved. Page 3 of 5

4 redouble his efforts to implement needed forms outlined in the Party s latest five-year plan. With that said, it is possible that systemic imbalances may occur if policymakers, in addressing excesses in the country s manufacturing sector and consolidating State- Owned Enterprises (SOEs), fail to adequately utilize capital markets as a relief valve for reforms. 3 In other words, the government risks creating zombie companies if it simply injects state funds into failing industries, instead of transferring risk to public markets through recapitalization. We believe that this is a long-term risk to market sentiment, though one that many market participants are keenly watching. Geopolitical risks also are top of mind for investors in Japan. The Liberal Democratic Party and the Komeito coalition in Japan s lower house of the Diet now hold a majority exceeding two-thirds of the Japanese legislature following last week s election. What this means is that Prime Minister Abe can move forward with a promised constitutional reform aimed at potentially beefing up the country s military power. The heightened potential for military confrontation comes at a time when North Korea has become more provocative, and China continues to dispute sovereignty issues with respect to the South China Sea. While these risks are present, we believe that they are more than likely to be effectively managed. Nevertheless, we recommend that investors keep these risks (and others we have discussed) in mind when considering investment opportunities in the region. 3 International Briefing: Game Over for China? ; March 4, Wells Fargo Investment Institute. All rights reserved. Page 4 of 5

5 Risks Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing. Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund. Definitions [Include any index definitions for any indexes which have been utilized in the report] An index is unmanaged and not available for direct investment. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). 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