2011

Rising wealth of the middle class and high net

worth population is driving consumer spending

in China

International luxury brands and established

local companies that target these groups of

consumers have scope for tremendous

growth

Investing in such companies offers depth and

breadth of exposure to the Chinese

consumption theme

New trends in China’s economy

Over the past 30 years, China’s economy has

transformed dramatically to become the world’s second

largest economy. GDP growth per capita has increased

by up to 24 times1. For the big part of this transformation

process, China played the role of the “world’s factory”,

and created abundant wealth that resulted in the

emerging growth of the middle class and high net worth

individuals.

China currently has over one million millionaires, and this

is expected to double within four years (Chart 1).

J u l y

China has emerged as a global super-power and is

entering a golden age of consumption growth. Since its

economic reform, disposable income has climbed

alongside the growth of the middle class and number of

millionaires. Their desire for higher quality goods and

services is driving the consumer spending engine in

China.

The willingness to purchase higher quality everyday

items as well as high profile branded products creates

opportunities for both well-recognised local and

overseas brands, and in return, investors in these

companies. Today, the importance of consumer labels is

not just for the fashionistas, but for the savvy investors

as well.

Source: 2008-2010 data from Hurun Wealth Report 2011, data as at 31 December 2010, taking into account all private wealth, including privately-held businesses, private residences and art collections, in addition to investable assets. Forecast for 2015 is based on a compound annual rate of 14% for China’s wealth from 2010 to 2015, cited in the BCG Global Wealth Report 2011. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way.

Table 1: Profile of a Chinese millionaire of over USD1.5 million

The millionaire population in China ranks third globally behind the

US and Japan2. This surge of millionaires fuels growth of the

global luxury retail sector, as this population tends to search for

ways to display their wealth and status through purchasing

international branded goods. They would also look for superior

quality and potential investment value implicit in these luxury

goods (Table1).

Luxury sector booming due to Chinese spending power

Luxury goods look set to be the fastest-growing consumer

category in China. China’s luxury market is now worth around

USD13 billion, expected to grow by 23% per annum in the

coming decade. By 2020, China’s luxury market is expected to be

the largest in the world, worth around USD106 billion3.

If we include sales to Chinese tourists abroad, we estimate

Greater Chinese consumers to account for 15% of global sales.

But we are only at the start of this Chinese consumption cycle,

Greater Chinese customers are expected to account for 44% of

global luxury sales by 20203.

The Chinese are indeed restyling the luxury market. The growing

wealthy class differs quite significantly from their foreign

counterparts in that some 80% are less than 45 years of age,

compared with 30% in the US and 19% in Japan4. Such

differences have clear strategic implications for the international

luxury brands. In order to tap the big potential of the Chinese

consumption market, these companies must adopt a strategic

position and sales tactics to address the requirement and taste of

these consumers. For example, Louis Vuitton has been targeting

Chinese consumers by expanding its network throughout China

and is already generating substantial profits, and today China is

their largest market for key products3.

The distribution of Chinese luxury sales is around 45% domestic

versus 55% on overseas brands. Growing travel appetite brings

increased Chinese consumption abroad, especially in the luxury

goods category. On average, 65% of Chinese consumers buy on

their overseas trips, and these purchases represent around 50%

of their total consumption3.

Source: Hurun Wealth Report 2011, data as at 31 December 2010.

The wealthy Chinese have their eye on watches....

One product which signifies the impact on business growth of

Chinese consumers is Swiss watches. Greater China is

already the largest market for Swiss watches, accounting for

41% of total exports in Q410. According to Bain & Co Luxury

Market Survey, Chinese consumers spent USD2.2 billion on

luxury watches in 20094.

The power of the middle class masses

The emerging middle class, which has doubled in the past five

years to around 400 million currently, provides a strong pillar for

growth in the domestic consumption market. Projected that every

second person will be from the middle class by 20205, this section

of the population is expected to spend an even higher proportion

of their income on consumer staples and discretionary items in

the next decade.

By 2020, 700 million middle class is expected to support a

potential new wave of 20 trillion worth of the Chinese domestic

consumption market5. Rapid economic growth and urbanisation

bring forth increasing salaries and higher standard of living,

especially in the coastal cities. Average remuneration has been

growing at 12-19% year on year each quarter in the past ten

years3.

GDP per capita in China crossed USD4,000 in 2010 while per

capita disposable income is expected to grow 11% annually by

2015 (versus world’s 5% and Asia Pacific’s 7%)3. As middle

income households become wealthier, the likelihood of spending

more on higher quality goods would increase (Chart 2).

Source: National Bureau of Statistics of China, McKinsey Global Institute analysis, base case forecast, Q1 2006, RMB1=USD0.12.

Purchase from department stores tends to be the preferred way

of shopping for the middle class. Department store sales fueled

by the growing consumption power of the middle class, represent

9.6% of total retail sales in China, compared to 5% in Japan and

5.1% in the US6.

The Chinese local consumer brands have a competitive

advantage over their foreign counterparts trying to enter the

market in that they have much stronger local knowledge and on-

the-ground analysis of trends. Well-recognised domestic brands

which have high market share and brand awareness would foster

a higher level of brand loyalty and recognition among middle

class, and therefore better market competitiveness.

Population power is money power

Whilst the US has a population of around 300 million, and is

currently the world’s largest consumption market, China is ever

bigger with one fifth of the world’s population (around 1.3 billion),

indicating huge potential consumption power. By 2020, China is

expected to take over US to be the world’s No. 1 consumption

contributor7.

Average age 39 (15 years younger than overseas counterparts)

Male to female

Collections

Hobbies

Travel

Annual consumption

7:3

3.7 luxury watches and 3.3 cars

Travel, golf, reading

Travel 3 times a year on average, preferred locations are France, US and Australia

>USD450,000: 13%USD150,000 – 450,000: 50%<USD150,000: 37%

Fund Manager of HSBC Global Investment Funds – Taiwan Equity, Leilani Lam

I n v e s t m e n t d i a l o g u e

Q: What is your outlook for the Taiwan market?A: Year 2011 represents a new chapter for Taiwan as it is the first year of implementation

of the Cross Strait Economic Cooperation Framework Agreement (ECFA) with China. Closer social and economic relationship with China will help to reduce tariffs and remove commercial barriers between the two sides. As China has become Taiwan’s largest trading partner replacing the US since 2002, Taiwan as an export-driven market could benefit from the ECFA through export expansion. Given these catalysts, the outlook for the Taiwan market is positive.

An interview with our Taiwan Fund Manager on her investment strategy

Q: What other catalysts may drive performance of the Taiwan market, how about consumption and tourism?

A: Taiwan’s domestic demand is also showing strong momentum due to falling unemployment, rising wage growth and a surge in consumer confidence.

Low interest rates should further support domestic demand. Current monetary conditions should help keep financing costs low for capital investments. The labour market should continue to improve as well on the back of better growth prospects and capital inflows. An increase in mainland visitors should further fuel consumption and contribute to Taiwan’s economy. This year, individual travellers from China will be permitted to visit the island. This is a relaxation of previous rules that permitted only group visits to Taiwan.

The emerging Chinese consumption power is positively impacting

stock prices of both international and domestic consumption

companies. This can be partly shown in the performance of the

luxury consumption sector which has seen to be outperforming

that of the general global equities.

Source: Bloomberg, data from 31 December 2008 to 30 June 2011. Global luxury sector = Dow Jones Luxury Index, Global equities = MSCI AC World Index, price return in USD term.

The growth of China’s middle class and high net worth clients will

cause an unprecedented demand of consumer discretionary and

luxury products. The opportunities which these companies

provide not only appeal to those who want to ensure that they

have the latest trends on the catwalk, but also for those who want

strong returns on their investments.

Louis Vuitton’s biggest customers are already Chinese

buyers3

China will become the No.1 market for Lamborghini

luxury cars in 20118

Chinese shoppers account for the largest share of the

luxury market in Britain, a phenomenon known as the

“Peking Pound”9

Louis Vuitton was voted China’s preferred overall luxury

brand in 201010

Did you know?

Please check out these funds to participate in thehighlighted investment opportunities:

HSBC Global Investment Fund – Chinese Equity

Q: How do you think the island’s upcoming elections will impact the Taiwan equity market?A: The island’s presidential election will be in 2012. It will be to Kuomintang’s (KMT) interest to boost the

economy and the equity market ahead of the elections, as seen in past elections. The government is likely to launch favourable policies, such as increased subsidies for low-income households, construction of public housing and more benefits to families with children. With consumer confidence already at a high level, continued wage growth and falling unemployment rate, the Taiwan market could fare well this year.

Sources:1. IMF, as at March 2011.2. BCG Global Wealth Report 2011, as at 31 May 2011.3. CLSA Asia-Pacific Markets, Dipped in Gold report, as at 19 Jan 2011.4. Hurun Wealth Report 2011, as at 31 Dec 2010.5. Euromonitor, Morgan Stanley, as at 8 Nov 2010.6. JPM Research, CEIC, Euromonitor & Bloomberg, as at 17 May 2011.7. Credit Suisse, Bloomberg, as at Dec 2010.8. Forbes Online, as at 23 Apr 2011.9. Mail Online, as at 29 Dec 2010.10.Hurun Best of the Best Awards 2010, as at 14 Jan 2010.

O u t l o o kUnited States Europe Bonds

Asia ex-Japan Japan Currencies

At 18.0% for 2011 and 13.8% for 2012, the earnings outlook for US companies remains attractive and results are currently beating expectations. US equity valuation measures, such as the 12 month forward price earnings ratio of about 12x, continue to look undemanding. Moreover, government bond and cash yields remain low, increasing the attraction of equities by comparison. The US economy went through a few shocks during the first half of the year with bad weather at the beginning of the year, rising oil and commodity prices and supply chain disruptions from Japan’s natural disasters. These shocks took the pace out of the somewhat fragile US economic recovery, but as they fade, we expect the recovery to resume, albeit at a relatively muted pace.

Although economic growth remains lackluster in the major developed economies, corporate balance sheets remain in good health and companies are continuing to meet their debt payments. The global annualized speculative grade (ie high yield) default rate stood at 2.4% in May, as measured by Moody’s. This remains very low relative to history, and reinforces our positive view on the asset class, despite a slight increase from April’s level of 2.3%. Current Treasury yields remain unattractive both relative to history and relative to other asset classes. In addition, the growing US debt burden and the potential demand shortfall that the current quantitative easing programmehas ended are additional risks.

E c o n o m i c performance in Asia is experiencing mild moderation amid a tightening monetary environment. Slower

global growth also contributed to reduced exports. In general, countries in the Asia ex Japan region still enjoy a stronger growth picture relative to their peers. Looking into the 2nd half of 2011, we expect Asian central banks will continue to control prices using monetary measures. We believe current earnings expectations have factored in the scenario of slower global growth and a tighter monetary environment. The probability of negative earnings surprises therefore looks limited. Due to recent correction, the valuation of Asia ex-Japan equities has become more attractive, with the 12-months forward price earnings ratio trading at 11.5x at the end of June.

Economic data released in June remained soft. However, we expect that Japan has passed the worst of the earthquake and nuclear crisis. Also, we are seeing some month-on-month improvement in data which indicates that the recovery is on its way. We expect that the Bank of Japan will continue to maintain sufficient liquidity in the financial system to support reconstruction. Japanese equities are still attractive on valuations grounds as they are trading at a 12-month forward price earnings ratio of 12.9x at the end of June which is below the historical average.

The immediate risk of a major crisis triggered by the Greek debt situation appears to be lessening as the Greek parliament has passed new austerity measures thereby triggering the next round of funding from various monetary authorities. The ultimate resolution, however, is by no means clear and there remains the potential for significant event risk and high volatility around EUR. GBP is unlikely to find support in the immediate future as the aforementioned negative factors remain. JPY may fare better as there are signs of economic rebound in Japan following the destructive impact of the natural disaster in March.

F r o m a v a l u a t i o n perspective, Eurozoneequities are trading atreasonably undemanding levels, particularly relative to government bonds and cash, with their 12-month forward price earnings ratios at 10x. In addition, the consensus view is still for interest rates to

remain broadly accommodative in 2011 due to the potential impact on fragile growth in the region. The key risk of the peripheral Eurozone debt situation remains contagion to other larger Eurozone markets, such as Spain and Italy. The potential impact of fiscal austerity on economic growth in peripheral Eurozone nations remains a key concern. As such, the market remains focused on the fundamental long-term issues that the Eurozone financial system must still overcome.

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