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Global Perspectives Weekly
China: Economy Still in Transition
SEPTEMBER 17, 2014
In this Global Perspectives Weekly:
Peter Donisanu
Global Research Analyst
China’s Economic Retooling
» Recent economic data releases suggest that China’s services
sector appears to be moderating as manufacturing data
continues to disappoint.
Guest Contributors:
Alex Kun, CFA®
Senior Investment Research Analyst
Hong Kong
Wisely Ngai, CFA®, CAIA
Investment Research Analyst
Hong Kong
» 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.
» We have observed positive developments within the country’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 country’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 country’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 China’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.
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Global Perspectives Weekly
Stabilizing data, overcapacity still a concern – China’s services sector continues to show signs of
stabilization in spite of disappointing manufacturing activity. In August, the non-manufacturing Purchasing
Manager’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 government’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 government’s plans to rebalance the country’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 country’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 country’s
manufacturing sector. Given the manufacturing sector’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 we’ve observed since 2012. Recent figures show that producer prices
declined 1.2 percent in August, a “less-negative” 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.
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Global Perspectives Weekly
Property market excesses – 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 – 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 “high-quality” and “efficient” 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
People’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 country’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.
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Global Perspectives Weekly
Investment implications — Prior to last week’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 week’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 China’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 we’ve
outlined above.
We believe that long-term support for a rebound in China’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 country’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.
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Global Perspectives Weekly
Weekly Capital Markets Activity (09/05/14 – 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 – 49%;
Agri cul ture – 26%; Preci ous Meta l s
– 12%; Indus tri a l Meta l s – 9%;
Li ves tock – 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.
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Global Perspectives Weekly
All data in this Global Perspective Weekly was sourced from Bloomberg unless otherwise noted.
Disclosures
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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
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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.
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