Emerging Markets Equity | September 2012

Chinese economic slowdown strengthens the case for consumer-oriented sectors within the country

By Jerry Zhang, Ph.D., CFA—Portfolio Manager, Wells Fargo Advantage Emerging Markets Equity Fund

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The ongoing debt-related troubles in Europe and signs of a slowing economy in the United States have led investors to worry about the potential effect on export-driven economies such as China. According to the National Bureau of Statistics of China, the European Union was China's main export market in 2011,1 followed by the United States. Although China is showing signs of a slowdown in its industrial production, its consumer consumption sector within its borders has remained relatively robust. The possibility of a slowdown in China's export economy has only strengthened our view that better investment opportunities exist in companies that are tied to China's nascent but developing consumer market.

Export growth and real estate appreciation have receded

In the past, China has relied on two main engines for gross domestic product (GDP) growth: exports and real estate. Exports to both developed and developing markets have been the foundation of China's economic growth, but weaker export markets have resulted in softer industrial growth. Additionally, Chinese banks appear to have substantially overinvested in the real estate market in recent years through property and land development loans. According to Citigroup Inc., investment in residential property accounted for 6.1% of China's GDP in 2010, approximately the same level that U.S. real estate investment reached in 2005 prior to the subprime crisis. As in the U.S., real estate overinvestment migrated throughout the economy, leading to increased demand for building-related materials such as steel and cement. In our view, many of these real estate projects will not lead to sustainable growth.

China's consumer spending is gaining traction

Even though China is known for having a strong savings culture, the country's retail spending has lately proved more resilient than its industrial production. We see far better growth prospects in stocks that benefit from domestic consumption as the Chinese spend more on discretionary items. Even as China's rate of growth in year-over-year industrial production slowed noticeably through July, the rate of change in retail sales showed far more resilience, as shown in the chart below. In a July 2011 report, the Boston Consulting Group projected that Chinese consumers could account for 30% of the global fashion market's growth over the next five years.2 Another significant source of growth is the special administration region of Macau, a former Portuguese colony that is the only place in China where gambling is legal. In 2011, Macau earned more than five times the gambling revenue of the Las Vegas strip; in May 2012, the region booked the second-highest gambling revenue in its history.3

Source: Bloomberg
Past performance is no guarantee of future results.

A savings culture slowly begins to spend

The transition to a consumption-based economy will not happen quickly because the Chinese have historically maintained a high savings rate. Compared with developed economies, China lacks a social safety net and adequate health insurance, which is one reason why the Chinese maintain high savings. A 2010 report by the Economist Intelligence Unit showed that in large cities such as Shanghai and Beijing, 67% of survey respondents reported saving 25% or more of their household income and 33% said they saved 35% or more. However, the country has taken significant steps toward building a consumer economy and seems likely to take several more. For example, the Chinese government's 12th five-year plan—which was debated in late 2010 and approved in early 2011—lists increased domestic consumption as one of its primary goals.

Concluding observations

The emerging Chinese consumer is a long-term trend that we believe is gathering momentum and should reward patient investors. It will most likely take several years before China's domestic consumption can generate the same level of GDP growth as its export and real estate-related markets, perhaps longer than some investors believe. We continue to see secular opportunities in companies that stand to benefit from Chinese consumers' greater propensity to spend, including companies in the consumer discretionary and consumer staples sectors, as well as companies in a variety of sectors that are positioned to take advantage of growing wealth in rural areas.

Stock fund values fluctuate in response to the activities of individual companies and general market and economic conditions. Foreign investments are especially volatile and can rise or fall dramatically due to differences in the political and economic conditions of the host country. These risks are generally intensified in emerging markets. The use of derivatives may reduce returns and/or increase volatility. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to regional risk and smaller-company securities risk. Consult the fund's prospectus for additional information on these and other risks.

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