China: Local Equity Markets Rally

China: Local Equity Markets Rally DECEMBER 3, 2014 Peter Donisanu Global Research Analyst In this Global Perspectives Weekly: Government structural reforms» China s A-share equity markets have posted double-digit gains since the beginning of the year.» While the local-market rally has caught the attention of international investors, performance of Chinese H-shares (stocks listed on the Hong Kong exchange) has been rather muted for the year.» We believe that macroeconomic and policy concerns will continue to weigh on H-share performance in the nearterm. For now, we maintain a neutral tactical recommendation on Chinese equities. A sharp rally in local Chinese equity markets has caught the attention of international investors recently. The People s Bank of China s (PBoC) rate cut last month coupled with several policy reforms have supported the rally in Chinese equities during the course of this year. While local market participants have been driving the price of A-shares stocks that trade on Mainland China s exchanges considerably higher, we continue to anticipate challenges facing the Chinese economy and its financial markets. These economic challenges seem to be priced in the country s internationally oriented H-shares shares of Chinese companies that trade on the Hong Kong stock exchange, denominated in Hong Kong dollars. Given the uncertainties surrounding the macroeconomic environment and questions about the health of China s financial sector, for now we maintain a neutral tactical recommendation on Chinese equities. Chart 1: Chinese equity market performance; Local (A-Shares) and MSCI China (in CNY)* 140 130 Shanghai Composite MSCI China (CNY Currency) 12/31/13 = 100 120 110 100 90 80 12/13 01/14 02/14 03/14 04/14 05/14 06/14 07/14 08/14 09/14 10/14 11/14 Source: Wells Fargo Wealth Management, Bloomberg; 11/2/14. *MSCI China Index adjusted for currency effects in Chinese yuan. 1

Still fragile economy The latest data from both public and private sources released on Sunday, indicated that manufacturing activity in China during the month of November remained tepid. For large firms the headline manufacturing Purchasing Manager s Index (PMI) figure came in at 50.3 compared to a reading of 50.8 in October, its fourth consecutive month of declines. The HSBC China PMI, which is a survey of purchasing managers across smaller firms, came in at 50 for both November and October, indicating that activity and expectations for these firms have remained flat compared to previous months. While some China watchers have argued that the weak readings are simply reflective of factory shutdowns that occurred ahead of the Asian-Pacific Economic Cooperation (APEC) summit last month, data across other sectors reinforce our less-than-stellar view of the country s economy. For example, producer prices wholesale prices that measure the amount of money that manufacturers receive for goods shipped from factory doors have remained on a downward trajectory for 30-straight months. China s once overheated housing market, which has long been a concern for investors inside and outside of the country, continues to show signs of cooling and has the potential to act as a further drag on the domestic economy. One measure of the health of the country s property market is the Chinese National Bureau of Statistics monthly Property Prices Summary. Figures published last month indicate that apartment prices declined in more than 60 of 70 large urban cities in October. Residential property prices are now lower than last year in a majority of China s larger cities, a trend that has accelerated since August. Chart 2: China s housing market prices are declining in most cities (year over year) 70 60 New Apartment Prices Existing Apartment Prices 70 60 50 50 # Cities 40 30 20 10 40 30 20 10 0 0 04/13 05/13 06/13 07/13 08/13 09/13 10/13 11/13 12/13 01/14 02/14 03/14 04/14 05/14 06/14 07/14 08/14 09/14 10/14 04/13 05/13 06/13 07/13 08/13 09/13 10/13 11/13 12/13 01/14 02/14 03/14 04/14 05/14 06/14 07/14 08/14 09/14 10/14 Increase Unchanged Decrease Source: Wells Fargo Wealth Management, Bloomberg; 12/2/14 Our view In the medium-term, we believe that China s decelerating economic growth trend will stabilize and do not anticipate a hard-landing for the economy. It is in the central government s interest to ensure that slowing economic activity does not weigh on individual sentiment in a bid to prevent civil unrest in the face of a number of social concerns already percolating. In the near-term, however, we anticipate the Chinese economy will face a number of headwinds as a result of overcapacity in certain economic sectors and the private sector s high debt load. This debt load coupled with lower demand and pricing pressures have resulted in higher relative debt servicing costs for manufacturers and other businesses. These debts typically financed through large state-owned banks, smaller private banks, and a shadow banking sector, may place additional strain on China s financial sector. 2

Over the course of several months we have written about how the Chinese central government, as well as the PBoC, have taken a number of measures to inject liquidity into targeted segments of the economy, to support the financial sector. Recently, policy has expanded beyond these targeted measures to broader areas of the financial sector, such as the central bank s rate cut last month. While the central bank has not explicitly indicated its intention to engage in additional broad-based monetary action, consensus among China watchers and market participants is building that the PBoC may resume an expansionary monetary policy in the coming months to address mounting liquidity concerns in the financial sector. At first glance, such a top-down approach to address economic problems may seem reassuring; however, it should be noted that execution of central government policy in China is largely a local affair. The effectiveness of this type of implementation strategy is questionable. For example, data gathered by two Chinese government-affiliated researchers and as reported by the press 1 indicates that government stimulus introduced in 2009 has led to more than $6 trillion in estimated financial misallocation over the past five years. We believe that broad stimulus measures may need to be tailored to a certain extent in order to prevent the same sort of misallocation of capital that had occurred in 2009. Investment implications Some investors have been encouraged by the performance of China s local equity market, namely the Shanghai Composite, which is up nearly 30 percent so far this year. But there are several factors that overseas investors should note when considering this year s equity-market increases. First, over one-half of the price appreciation in mainland Chinese stocks has been attributed to a single sector: financials. We believe that the appreciation in the Shanghai composite and other local market indices reflect, among other things, speculation about government support of financial institutions through monetary policy, rather than an improvement in underlying macroeconomic fundamentals. Second, shares purchased on local exchanges, known as A-shares, are available for purchase almost exclusively by mainland Chinese investors. Looking ahead, last month s launch of the Shanghai-Hong Kong Stock Connect pilot program may provide foreign investors additional access to China s local markets; however, operational and regulatory challenges surrounding the program became evident early on, and may take several months to resolve. Finally, for overseas investors seeking exposure to Chinese equities, much of that exposure comes through H- shares, mainland companies listed on the Hong Kong stock exchange (for which the MSCI China index is a key measure). In Hong Kong dollar terms this index has returned 2.2 percent and a mere 0.6 percent in U.S. dollar terms year to date both far smaller compared to the year-to-date return of the Shanghai composite index valued in Chinese yuan. While speculation has been increasing about benchmark provider MSCI adding A- shares to its MSCI China index following the introduction of the Shanghai-Hong Kong Connect Program, that decision has yet to be determined due to the challenges outlined above. When and if A-shares are added to the index, the MSCI China price index may appreciate as portfolio managers rebalance large amounts of capital in an effort to track underlying MSCI index holdings into the newly available share class. For now, our neutral recommendation on Chinese stocks is largely influenced by the softening near-term macroeconomic outlook for China coupled with uncertainty in the country s financial sector. 1 Financial Times, China has wasted $6.8 trillion in investment, warn Beijing researchers ; 11/27/14 3

Weekly Capital Markets Activity (11/21/14 11/28/14) Global Equity Markets Global Sovereign Bond Market Commodity Prices Wk MTD YTD Yield Wk Chg (BPS) Price WK MSCI All Country 0.1% 1.5% 4.5% Italy 2.03-17.9 Energy -- -10.4% MSCI EAFE 0.5% 1.2% -3.9% Spain 1.90-11.8 Brent Crude Oil $/bbl $70.2-12.7% DAX (Germany) 2.6% 7.0% 4.5% France 0.97-14.1 Natural Gas $/MMBtu $4.09-7.4% CAC 40 (France) 1.0% 3.7% 2.7% Germany 0.70-7.0 Agriculture -- -0.2% FTSE 100 (UK) -0.4% 2.7% -0.1% Greece 8.24 40.5 Corn $/bushel $3.89 0.9% FTSE MIB (Italy) 0.3% 1.2% 5.5% Portugal 2.84-15.7 Soybean $/bushel $10.16-2.2% IBEX 35 (Spain) 2.4% 2.8% 8.8% UK 1.93-12.2 Precious Metals -- -2.7% Nikkei (Japan) 0.6% 6.4% 7.2% US 2.16-14.6 Gold Spot $/oz $1,167-2.8% MSCI EM 0.0% -1.1% 0.3% Japan 0.42-4.1 Silver Spot $/oz $15.45-6.0% Shanghai SE (China) 7.9% 10.9% 27.9% India 8.09-8.3 Industrial Metals -- -4.0% BSE 100 (India) 1.3% 3.0% 35.7% LME Aluminum $/Mt $2,031-1.7% KOSPI (South Korea) 0.8% 0.8% -1.5% LME Copper $/Mt $6,412-5.5% BOVESPA (Brazil) -2.4% 0.2% 6.2% Livestock -- -1.0% Mexico IPC -1.0% -1.9% 2.9% Lean Hogs $/lb $0.88-2.5% Live Cattle $/lb $1.69-1.7% 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 Headline Equity Markets One-week Change IndustMet -4.0% Commodities Energy -10.4% PrecMet -2.7% Ag -0.2% Livestock -1.0% Graphic represents the average sector weights of the S&P GSCI, Rogers International Commodity, and Bloomberg Commodity indices as of 11/28/14. Energy 49%; Agriculture 26%; Precious Metals 12%; Industrial Metals 9%; Livestock 4%. Data in this graphic represents the one-week change in sector price according to their respective Bloomberg Commodity Index Family. -4% -2% 0% 2% 4% Currency Table (Pairs) Currency Table (Change in Pairs) Cross rate as of 11/28/14 One Week Change: 11/21/14-11/28/14 USD MXN INR BRL CNY AUD CAD CHF GBP JPY EUR USD MXN INR BRL CNY AUD CAD CHF GBP JPY EUR EUR 1.25 17.34 77.24 3.19 7.64 1.46 1.42 1.20 0.80 147.7 EUR 0.5% 2.8% 0.6% 2.5% -0.5% 2.4% 2.1% 0.0% 0.6% 1.2% JPY 0.01 0.12 0.52 0.02 0.05 0.99 0.01 0.81 0.54 0.68 JPY -0.7% 0.9% 0.2% 1.3% -0.4% 1.3% 0.9% -1.1% -0.6% -1.2% GBP 1.56 21.80 97.3 4.02 9.61 1.84 1.79 1.51 185.6 1.26 GBP -0.1% 2.2% 0.5% 1.9% 0.3% 1.9% 1.6% -0.6% 0.6% -0.6% CHF 1.04 14.43 64.25 2.66 6.36 1.22 1.18 0.66 122.9 0.83 CHF 0.4% 2.7% 0.6% 2.4% 0.8% 2.3% 2.1% 0.5% 1.2% -0.1% CAD 0.88 12.20 54.45 2.25 5.38 1.03 0.85 0.56 ##### 0.70 CAD -1.6% 0.6% -0.5% 0.3% -1.3% 0.3% -2.1% -1.5% -0.9% -2.1% AUD 0.85 11.85 52.82 2.18 5.23 0.97 0.82 0.54 ##### 0.68 AUD -1.9% 0.4% -1.6% 0.0% -1.6% -0.3% -2.4% -1.9% -1.2% -2.4% CNY 0.16 2.27 10.10 0.42 0.19 0.19 0.16 0.10 19.31 0.13 CNY -0.3% 2% 0.1% 1.7% 1.6% 1.3% -0.7% -0.3% 0.4% -0.8% BRL 0.39 5.43 24.27 2.39 0.46 0.44 0.38 0.25 46.23 0.31 BRL -2.0% 0.3% -1.0% -1.6% 0.0% -0.4% -2.3% -1.9% -1.3% -2.5% INR 0.02 0.22 0.04 0.10 0.02 0.02 0.02 0.01 1.91 0.01 INR -0.9% 1.4% 1.1% -0.1% 1.1% 0.5% -1.3% -1.0% 0.1% -1.5% MXN 0.07 4.47 0.18 0.44 0.08 0.08 0.07 0.05 8.52 0.06 MXN -2.2% -1.3% -0.2% -1.9% -0.4% -0.6% -2.7% -2.1% -1.6% -2.7% USD 13.93 62.03 2.57 6.15 1.18 1.14 0.97 0.64 118.6 0.80 USD 2.3% 0.4% 2.0% 0.3% 1.9% 1.6% -0.5% 0.0% 0.7% -0.5% This table represents a cross-currency pair in a matrix format. The column on the left denotes the local currency and the row at the top of the table the foreign currency. For example, if the local currency is EUR (euro) and the foreign currency is USD (U.S. dollar), then 1 euro buys $1.25 U.S. dollars (as of 11/28/14). This table represents the one-week change for a given cross-currency pair. A positive value indicates that a local currency has appreciated (or you can buy more of a given foreign currency). The inverse is true for a negative value. 4

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. Opinions represent Wells Fargo Wealth Management 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. 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. Indexes represent securities widely held by investors. You cannot invest directly in an index. S&P 500 Index is a capitalization-weighted 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. 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 1000. The CSI 300 Index is a free-float weighted index that consists of 300 A-share stocks listed on the Shanghai or Shenzhen Stock Exchanges. Index has a base level of 1000 on 12/31/2004. The MSCI China A Index is a free-float weighted equity index, designed to measure performance of China A share securities listed on either the Shanghai or Shenzhen Stock Exchanges. The index was developed with a base value of 1000 as of November 30, 2004. The MSCI China Index is a free-float weighted equity index. It was developed with a base value of 100 as of December 31, 1992. 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. 2014 Wells Fargo Bank, N.A. All rights reserved. 5