GavekalResearch

October 2015

London Seminar

Anatole KaletskyFrançois Chauchat

Neil NewmanTom MillerLouis Gave

GavekalResearch

October 2015

Four Weddings And A Funeral

Anatole Kaletsky

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Is this the end of a cyclical bounce?

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Or just a correction after a structural break-out?

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Five big events have changed the world this year…

• US: employment growth drives self-sustaining expansion

• EU: ECB bond-buying resolves the euro crisis

• Oil: US$50 price cut redistributes US$2trn to consumers

• Japan: Abe’s Three Arrows all shoot in the same direction

• China: orderly slowdown turns into collapse ???

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… but markets are back where they started

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US cycle has dominated the world—until 2015

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US GDP has grown faster than 3% for 5 years

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Volcker’s message to Yellen: stay behind the curve

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The European QE is bigger than that of the US or Japan

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EU credit conditions are strongly improving

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… as are economic conditions in the “periphery”

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Oil prices: long slides follow big jumps

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Is US$50 a ceiling or a floor for oil?

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Myths and truths about the China “crisis”

Myth 1: The economy is collapsing.Truth: The economy continues a structural slowdown as China transitions from capital-intensive to consumption-led growth.

Myth 2: China’s data is a pack of lies—growth is “really” 2-4%.

Truth: China has not shied away from reporting bad numbers, but its statistical system does underestimate volatility. Growth is ca. 6%.

Myth 3: China will competitively devalue the renminbi. Truth: A competitive devaluation is not in China’s interests, but inclusion in the SDR basket requires a more market-driven currency.

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China is slowing but not collapsing

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There are huge disparities in regional and sectoral growth

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What China’s mini-devaluation was trying to fix

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Bullish investors must now look beyond the US

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Outside the US, the end of the crisis still is not priced in

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The US dollar is getting too expensive

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In 1994 the main losers were the US dollar and US bonds

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In 2004 the US dollar fell again, but other assets rose

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October 2015

Will Europe Absorb These shocks?

François-Xavier Chauchat

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European indexes are heavily exposed to EMs

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The large caps crisis

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Small & mid caps: 2.5 years of strong profit growth

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The successful theme on Europe’s equity market

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Italy and France will win the race this year

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More growth and more countries involved

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Average GDP growth in the Euro area (LHS)Weighted country dispersion (standard deviation on 11 countries, RHS)Dispersion trend Gavekal Research

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What a few decimals of GDP growth changes

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The European consumer is back

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The end of super-austere fiscal policy

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Europe’s labor markets are improving

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The fragmentation of financial conditions has almost ended

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The revival of the credit cycle in France

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The key reason why France has lagged in this cycle

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Intra-European trade outperforms

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Intra-European trade velocity accelerates

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Will German exports stop rising at last?

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Will the VW scandal turn into a gigantic car-scrapping scheme?

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Germany’s huge room to maneuver

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German demographists are being proven wrong

Projection by Destatis made in 2009

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An unfriendly move

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The ECB’s massive QE could be extended

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A new, gradual uptrend in cross-border financial velocity

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The EM crisis seems to be priced in

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Euro Stoxx broad

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Risk reversal?

GavekalJapanAlpha

Three Emerging Themes In Japan

Neil Newman

October 2015

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What happened this summer

Events in the summer of 2015:• “Japan’s deflationary period is over”, energy prices fall, 2015 Robert Walters salary survey showed large pay rises in Tokyo.• Demand for apartments in Central Tokyo remains strong, as does refurbishment of old buildings and redevelopment in central cities. • Dreadful weather with two storms colliding; the price of fresh food increased. •The Trans-Pacific Partnership was agreed upon, which will lead to an immediate reduction in tariffs once it takes effect. These events will likely spur farmers into action—rather than expect more government handouts.• Volkswagen’s deception is leading to aggressive development of alternatives.

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Three themes are emerging

1. Construction boom—and gross profit margin expansion for construction companies.

2. “Internet of Farms”—the “internet of things” is expanding to agriculture, making it more appealing for young people.

3. Evolution of cars—electric, hybrid and self-driving cars.

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• Mori is building a development in Kamiyacho(the GPIF is moving in).• Building works contracted in 2012 lead current margin expansion for contractors.• Refurbishment of old office blocks—government subsidies along “national routes”.• Creation of cheap accommodation; dormitories.• Disaster-proofing buildings. Small business boom.• Demand for apartments in Central and East Tokyo is extremely strong—impact of white collar salary increase.• New trendy areas: Tsukiji, East Ginza, Hamamatsucho.• Prices of refurbished 10+ year old builds are similar to off-plan new builds.

Construction boom

Model of the new Shibuya Station; Nagoya Station (end of Maglev line); a refurbished apartment (1971 build)

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• The TPP will have a limited impact on farmers.• “Cannot be called an industry” —1.5% of GDP, 4% of the workforce and 4x the votes of city folk.• Land is considered too valuable to sell and is usually inherited, slowing consolidation.• Severe shortages of green vegetables this summer.• Dairy, particularly butter, has been in extremely short supply for over a year.• Technology is arriving to improve efficiency and attract young talent. • Data collection is not difficult, transmission is the issue. Data analysis leads to the “Internet of Farms”.• Indoor farms now powered by LEDs. Fully automated lettuce “factory” in 2016.

“Internet of Farms” (IoT)

Electronic scarecrow sensor, remotely checking the heath of dairy cattle; small fields; strawberry robot.

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• VW scandal calls into question the future of clean diesels. Focus on hybrid, electric and new technologies.• Toyota will phase out conventional combustion engine cars by 2050.• Honda and GM expand alliance from hydrogen fuel-cells to hybrids and electrics.• Battery costs to be lowered, range to be improved. How?• Tesla 7.0 software update “adds features”.• Honda is stepping up production of the Mirai.• DeNA/ZMP self-driving “Robot Taxi” in Fujisawa next March. • Toyota, Nissan and Honda announce schedule for self-driving cars.

Evolution of cars

Honda’s fuel cell car; Tesla unwrapped; self driving Lexus; Fujisawa’s Robot Taxi.

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Japan Alpha

Neil Newman, Analyst Japanese EquitiesNeil Newman has over 32 years' experience in Japan, kicking off his career in London with a small Japanese stockbroker, Nippon KangyoKakumaru in 1983, which later became part of Maizuho, he found himself working for the same firm 25 years later in Japan with the Nikkei225 back at the same levels when he started. Undaunted, he decided to go for another ride on the roller coaster. He has now spent a total of17 years living in Japan and 7 years in Hong Kong. During this time Neil has worked for buy and the sell side firms including SBC‐O'Connor,Schroders, Morgan Stanley Japan, Mizuho Securities and Senrigan. He still can't eat raw fish.

Ideas are generated by analyzing macro themes, performing technical analysis, due diligence through fundamental screening and on-the-ground, first-handknowledge; then identifying share price levels based on chart patterns. This is essentially what Japanese retail investors—who are almost 30% of the TSE firstsection turnover in 2014 and 80% of the second section—do today.

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Appendix—companies involved

Construction boom: Obayashi (1802), Obayashi Road (1896), Matsui Construction (1810), Nichiha (7943), Taisei (1801), Shimizu (1803), Kajima (1812), Nishimatsu (1820), Maeda (1824), Kumagai Gumi (1861), Kuraray (3405). The market is focusing on second line construction companies.

“Internet of Farms”: Kanematsu (8020), SoftBank (9984), Gree (3632), Colopl(3668), Hitachi (6501), Soracom (wait for IPO). Many firms are experimenting with indoor farming as an offshoot of their main businesses, particularly with LED lighting experiments—Nisshinbo (3105), Toshiba (6501), Panasonic (6752), Fujitsu (6702). Expect a fully automated lettuce farm in 2016 by Spread Co.

Evolution of cars: Robot taxi by DeNA (2432) and ZMP (IPO 2015), Meidensha (6508), Nisshinbo (3105), Renesas (6723), Alps (6770), Pioneer (6773), Panasonic (6752), Sony (6758), Aisin Seiki (7259), Denso (6902), Fujitsu (6702), Hitachi Maxell (6810), Nippon Ceramic (6929), Rohm (6963), TDK (6762), Toshiba (6502), Zenrin (9474). Jonny Cab will arrive soon.

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Contact and disclaimer

All research is available online at: japan.gavekal.com

Copyright © Gavekal Japan Alpha. Redistribution prohibited without prior consent.

This presentation has been prepared by Gavekal Japan Alpha mainly for distribution to market professionals and institutional investors. It should not be considered as investment

advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information

contained herein has been obtained from sources believed to be reliable, but not guaranteed.

GavekalResearch

October 2015

China: Big Friendly Giant Or Big Hairy Monster?

Tom Miller

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What sort of power is Xi Jinping’s China?

“We Chinese love peace… China will never seek hegemony or expansion”

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Big Friendly Giant or Big Hairy Monster?

Economic partner and engine of growth? Strategic competitor gobbling up territory?

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The ‘Chinese dream’ of national revival

Moderate prosperity

(2020)

National rejuvenation

(2049)

Ancient greatness

(221BC-1842)

Century of humiliation (1842-1949)

Rebuilding (1949-2012)

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China’s grand economic strategy

• Xi Jinping is pursuing “great power” diplomacy to secure:1) respect as a great power, 2) influence in global affairs, and 3) leadership in Asia

• The “Belt & Road Initiative” and Asian Infrastructure Investment Bank are designed to advance China’s interests by promoting China as an engine of global economic development.

• China insists its economic statecraft is “win-win,” but other countries fear it is a smokescreen for strategic control. In truth, China’s goals are both economic and strategic.

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BRI officially refers to:1) The “Silk Road Economic Belt” 2) The “21st Century Maritime Silk Road”But it has become a catch-all term for any number of possible infrastructure projects.China aims to push development over its borders, create new trade routes, and tie its neighbors’ prosperity to their relationship with China.

The ‘Belt & Road Initiative’

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Economic aims of the ‘Belt & Road Initiative’

• Boost investment at home—all 31 provinces have Belt & Road projects.

• Better integrate western China into global commerce, bringing economic development to some of China’s least developed regions.

• Export overcapacity by finding new markets for domestically produced cement, steel, ships, rolling stock and heavy equipment.

• Foster the internationalization of the renminbi, requiring a commitment to a strong currency.

• Increase returns on China’s huge pile of foreign exchange reserves.

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The big strategic goal: keeping China safe

• China’s strategic aim is not hegemonic expansion: it is to create a benign external environment and minimize outside threats.

• BRI is designed to persuade China’s neighbors to put their economic interests first, creating a more secure environment for China.

• The ‘Belt & Road’ will redirect a portion of China’s vast foreign exchange reserves into projects that boost security:

- energy security (diversified sources and transport routes)- maritime security (protect supply lines)- anti-terrorism (Xinjiang and Pakistan)- border security (Pakistan, Tajikistan, Kyrgyzstan)

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Neighbors such as India and Vietnam believe the Belt & Road Initiative is a dastardly plot for China to gain control of the South China Sea and Indian Ocean.The Belt & Road is underpinned by strategic aims, but its primary focus is to benefit Chinese firms and advance China’s interests through economic development.

Commercial trade route—or ‘string of pearls’?

Colombo South Container Terminal, Sri Lanka

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Construction firms and exporters of capital goods hope to be big beneficiaries.“Use overseas construction projects and foreign investment to strengthen exports of equipment” (State Council).The Silk Road 11 continue to outperform the benchmark.

Winners on the New Silk Road?

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The Silk Road 11

Company Industry

China Communications Construction Co Ports, roads, railways

China Machinery Engineering Corp Power, transport, telecoms

China Merchants Holdings Ports, cargo, transport

China Railway Construction Corp High-speed rail

China Railway Group High-speed rail

China State Construction International Roads, bridges, railways

Cosco Pacific Ports, shipping, cargo

CRRC Corp Locomotives, rolling stock

Sany Heavy Equipment Construction machinery

Sinopec Engineering Group Engineering, equipment

Zoomlion Heavy Industry Construction machinery

 

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China says it will invest US$1.25trn abroad by 2025.

The bulk of financing will come from China Exim Bank and China Development Bank.

The US$40bn Silk Road Fund will act as a lender and equity investor.

The Asian Infrastructure Investment Bank will mainly finance commercial projects.

Financing the Belt & Road

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The AIIB—the hangover after the party?

• With 57 founding members, the establishment of the AIIB was a diplomatic triumph for China and a diplomatic disaster for the US.

• The AIIB could have a positive impact: it will bring a new pot of money to the table and has helped persuade the World Bank, ADB and Japan to boost infrastructure lending in Asia.

• But it will be hard to create a bank that is “lean, clean and green”:- only 400-600 employees- lack of technical capacity- lack of bankable projects- how to be commercial and competitive?

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China financed projects worth nearly US$5bn in Sri Lanka in 2009-14.Its banks funded vanity projects and paid kickbacks to government cronies.A US$210mn airport in the ex-president’s hometown of Hambantota shut after just two years.

Exporting white elephants?

Mattala Rajapaksa International Airport, Sri Lanka

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What can go wrong?

• Economics: - misallocation of resources at home and abroad- commercially unviable projects will make a loss- capital goods exports may be too small to offset overcapacity- massive headline “investment” numbers rarely match reality

• Politics: - shifting political winds can scupper even the largest investments- projects in volatile states may fail (e.g. Pakistan) - risk of harm to Chinese workers- risk of reputational damage and anti-Chinese backlash- neighbors may seek closer alliances with US

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Conclusion: an aggressively friendly giant

• China views itself as a friendly giant with the power to fund economic development over its borders—but its partners must accommodate its “core interests,” especially on maritime security, in return.

• The Belt & Road Initiative has the potential to bring substantial economic gains (and losses), but China will struggle to build a “community of common destiny” in Asia.

• China believes it is destined to become the region’s pre-eminent power, whether the US and its allies like it or not. Washington must allow China to play a greater role in Asian security—or conflict is inevitable.

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Aims Mechanisms Consequences

Pragmatic pursuit of economic reward

Vision of common prosperity

“Win-win”

Improve connectivity along the Belt & Road

Foster new trade networks

Provide capital via policy banks, new funds, AIIB

Predictable (playing by established rules)

Positive force

Investment opportunities greater than risks

Idealistic pursuit of great-power status

Grand vision of restoring China’s dominance in Asia

Zero-sum

Create client states and economic vassals

Challenge global institutions

Pursue territorial control

Unpredictable (willing to break rules)

Disruptive for markets and investors

Investment risks will grow

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How to think about China’s ‘proactive’ economic diplomacy

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October 2015

A Solvency Crisis Or A Liquidity Squeeze?

Louis-Vincent Gave

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A solvency crisis or a liquidity squeeze?• Whenever global markets fall in unison by more than -10%, we are forced to confront a

simple question: are we facing a liquidity squeeze or a solvency crisis? This question is pertinent for two reasons:

1. Global debt has increased by 40% of global GDP since 2007.2. Over the past few decades, investors have bounced around from “solvency crisis” to

“solvency crisis” every three to five years.• It is our belief that, once again, we are confronting a solvency crisis. But it is a fairly localized

crisis; one that is decimating the commodity producing sector. It is also an ironic crisis. Indeed, six or seven years ago, when confronting ZIRP and QE, investors could find one of two reasons to be bearish:

• The first was that ZIRP would allow zombies to stick around, hereby weakening growth and returns on invested capital (the Japanese scenario).

• The second, more widely held view, was that the activism of Western central banks would trigger hyper-inflation. As such, many argued that portfolios needed to allocate into energy, precious metals and agricultural land in order to “hedge” the coming inflation risk.

• But instead, what we witnessed was massive mal-investment into commodities and we have now entered the capital destruction phase of the cycle.

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Commodities attracted hundreds of billions on false premises

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Between 2005 and 2014, money poured into commodity products on the false premises that:

1. The world was set to run out of most commodities (i.e.: Malthusian theories).

2. Commodities would prove a good hedge against the inflation triggered by ZIRP.

Instead, the money that has poured into commodities has triggered a boom-bust cycle of enormous scale. And we are now in the bust phase.

These bust phases usually do not end without bankruptcies/industry consolidation.

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Instead, what we have is a typical cycle

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The pain is now spreading from the equity owner to the debt holder

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How the commodity bust will unfoldCountries dealing with

the bust through devaluation with little

inflation risk

Countries dealing with the bust through

devaluation and risking inflation

Countries dealing with the bust through activity and asset

deflation

NorwayIndonesiaSingaporeAustralia

New ZealandColombia

Canada

RussiaBrazil

South AfricaArgentina

Kazakhstan

Saudi ArabiaUAE

Finland

Export deflation to the rest of the world

Trigger asset impairments and volatility in bonds

and equities

Little impact on other countries as these

countries are “too small”. The question is whether pegs will hold? And how much local asset prices will fall (for an example see Hong Kong in 1997)

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The unfolding commodity bust has had ripple effectsCommodity bust

Trouble in a number of EM (Russia, Africa, Latam…)

Large redemptions from EM funds (debt

& equity)

Wider spreads

Corporate and EM bond markets freeze up for

primary issues

Tighter financial regulations prevent investment banks from being liquidity providers in periods of stress

Possible bankruptcies?

Fewer sharebuybacks?

Weak exports & weak capexeverywhere

Tech slowdown

China, Asia slowdown

Fears of China devaluation

Feeling that PBoC is behind the curve

Equity markets priced for close to perfect outcomes get hit

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1- The Biggest Ripple Effect: The China Panic

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The commodity bust and the China slowdown• For most investors, China is a “black box” . The data can’t be trusted, the leadership can’t be trusted, the

companies can’t be trusted… This (well-justified?) paranoia has led most investors to look outside China for signs of how the country is doing. And in the past decade, most have grown to equate commodities with China.

• With commodities collapsing, this “Commodities=China=Commodities” allowed the market to whip itself into a bearish China frenzy this summer. Of course, the Shanghai equity market crash and the botched currency policy change did not help (more on that later).

• And China is undeniably slowing. But the central question is whether the economy is confronting a deflationary bust, or just a slowdown? Importantly, one can not place the blame for the collapse in commodity prices on China alone:

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This is not to belittle the slowdown in Chinese growth

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Undeniably China is slowing down… but is that such a surprise?

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The question is whether China is slowing? Or falling apart?

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So why did the market freak out?

Mike Tyson once said “Everybody has a plan until they get punched in the mouth ’”. As we write, most China watchers have sore noses as recent months delivered:

• Fear #1: China is devaluing its way to growth.

• Fear #2: China is hard-landing and China’s economic collapse threatens growth not only across EMs, but also across the developed world.

• Fear #3: Policymakers are losing control of the situation.

• Fear #4: We thought China’s policymakers were following a non-election encumbered roadmap. But now we realize that they are useless and making it up as they go along…

Some of these fears are of course legitimate. But they are most likely overblown. Here is how we see the situation:

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2- Policy Disappointments From China

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A devaluation would do little to help China’s slowing sectors• China is experiencing a nasty slowdown in big and important parts of the

economy. Much of this slowdown is structural and not easily reversed by monetary or fiscal policy.

• Just as importantly, the parts that are slowing (infrastructure spending and construction) are not likely to be boosted by a currency devaluation. China could place the renminbi at RMB10/USD, and still China would not be needing more steel, cement, coal etc…

• The growing parts of the economy, mostly the service sector, are doing well but aren’t big enough or growing fast enough to fully offset the slowdown.

• What is needed are structural reforms to:Remove barriers to growth in the expanding sectorsUse market mechanisms to facilitate reallocation of resources toward the expanding sectors

• Following the Third Plenum, this is what investors expected—and this is where some of the disappointments lie today:

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The to-do list from the Third Plenum was long—too long1. Improving the property rights protection system.2. Vigorously developing a mixed economy.3. Promoting a modern corporate system for SOEs.4. Supporting the healthy development of the non-public sector.5. Enacting market rules that are fair, open and transparent.6. Improving the mechanism whereby prices are mainly determined by the market.7. Forming a unified construction land market for both urban and rural areas.8. Improving the financial market. 9. Deepening reform of the management system for science and technology.10. Improving the macro control system.11. Fully and correctly performing government functions.12. Streamlining the government structure.13. Improving the budget management system. 14. Improving the taxation system. 15. Establishing a system whereby authority of office matches responsibility of expenditure. 16. Accelerating the building of a new type of agricultural operation system.17. Endowing farmers with more property rights.18. Promoting equal exchanges of factors of production and balanced allocation of public

resources between urban and rural areas.19. Improving the institutions and mechanisms for promoting the sound development of

urbanization.20. Relaxing control over investment access. 21. Speeding up the construction of free trade zones.22. Further opening up inland and border areas.23. Bringing the people's congress system in line with the times.24. Promoting wide, multi-tiered and institutionalized consultative democracy.25. Giving full play to democracy at the community level.26. Protecting the authority of the Constitution and laws.27. Deepening reform of the administrative law-enforcement system.28. Ensuring the independent exercise of the judicial and procuratorial power in accordance

with the law.

29. Improving the mechanism for the use of judicial power.30. Improving the judicial system to protect human rights.31. Forming a scientific and effective mechanism to check and coordinate power.32. Be more innovative in creating mechanisms and institutions to combat corruption.33. Having systemic rules to improve work style.34. Improving the cultural management system.35. Establishing and improving a modern cultural market system.36. Building a modern public cultural services system.37. Improving cultural openness.38. Deepening the comprehensive reforms in the area of education.39. Improving systems and mechanisms that boost employment and business startups.40. Forming a reasonable and orderly distribution pattern of income.41. Instituting a fairer and more sustainable social security system.42. Deepening reform in medicine and health care.43. Improving methods of social governance.44. Kindling the vigor of social organizations.45. Innovating systems that can effectively prevent and solve social conflicts.46. Improving the public security system.47. Improving the system of natural resource property rights and the system of natural

resource utilization control.48. Delimiting the red line for ecological protection.49. Implementing sound compensation systems for use of resources and for damage to the

ecological environment.50. Reforming the ecological protection management system.51. Deepening the adjustment and reform of the military administrative setup and staffing.52. Promoting adjustment and reform of military policies and systems.53. Deepening the integration between the military and civilian sectors.54. Ensure that the decisions of the Party Central Committee are carried out effectively.

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The Third Plenum is not the actual reform strategy

1) Internal contradictions2) No ranking of priorities3) Many important recent initiatives are not discussed

Look at what Xi Jinping & Co. are actually doing

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First big priority: anti-corruption and tighter political control

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Second big priority: reset foreign policy and boost global profile

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The southwestern province of Yunnan is a “bridgehead” for strengthening China’s clout in the Mekong Basin. Its companies are building roads, dams and power grids, and investing in mines, real estate and agriculture.

A new US$4bn highway runs from Kunming, Yunnan’s capital, to Bangkok.

China is also set to build a US$7.2bn high-speed railway through Laos, financed by China Exim Bank using untapped minerals as collateral.

China is expanding south…

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The Bangladesh-China-India-Myanmar (BCIM) Economic Corridor will consist of a highway and other infrastructure connecting Kunming and Kolkata. Twin oil and gas pipelines already run from Kyaukphyu to Kunming.

Beijing’s ultimate aim is to secure a western seaboard in the Bay of Bengal, enabling it to extend its sphere of influence into the Indian Ocean.

Myanmar canceled a planned railway, but both it and India have given the go-ahead to the BCIM plan.

… and south-west

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Economic reform or national revival?

Q: Why has economic reform lagged expectations?

A: Because economic reform is not Xi Jinping’s top priority. The great project of national revival and tying all of

China’s neighbors into China’s economic orbit is.

But some reform is still happening…And a large renminbi devaluation would go against the

political goal of national revival.

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This does not mean a lack of reform: Lou Jiwei’s is making progress

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And Zhou Xiaochuan’s financial liberalization agenda has progressed

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3- What Just Happened To China’s FX Policy?

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On August 11th, China delivered a big surprise on the renminbi

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Why did China change its FX policy?

China changes its FX policy

Scenario 1: China’s policy-makers are attempting to devalue their way to growth; becoming “currency warriors!”

Our take: If that is the case, why did the PBoC intervene with US$130bn (at least) in the past six weeks to prevent the renminbi from falling?

Scenario 2: China completely mistimed and mis-communicated on a necessary adjustment to its FX policy.

Our take: much more likely… but it does raise the concern that in recent months China’s policy-makers have failed to cover themselves with glory, on all fronts!

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The idea that China needs to devalue to be competitive is nonsense

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As high as China’s trade surplus is, it will get at least US$100bn bigger

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Why the IMF is likely to vote for SDR inclusion in November

1. Better to be inside the tent pissing out, than outside the tent pissing in: The creation of the AIIB showed that China is not against creating its own set of multilateral institutions. With that in mind, it might be better to include China in the existing ones than to see China create a rival set of institutions.

2. The IMF vote is in the next 5 weeks, but the US does not seem to be lobbying anyone to block China. This either means that the US is inept diplomatically, or that the US has made its peace with China joining the SDR. In fact, what seems more likely is that a deal was done between Presidents Xi and Obama during the recent Washington summit.

3. Blocking China would seriously undermine reformers like Zhou within the leadership—is this really what the West would want?

4. The IMF asked for a one year delay in implementation of the November vote… Why ask for a delay in implementing the vote unless the odds that China joins are quite high?

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Implications of financial liberalization & SDR inclusion

• Financial liberalization and renminbi internationalization mean:

A “strong renminbi” policy. Strategically, it is more important for the renminbi to be seen as a reliable store of value than to be used as a subsidy for exporters. This rules out competitive devaluation. Renminbi will be pushed abroad through loans and ODI. To increase the currency’s international use, China will not rely on running a trade deficit, as the US has done since the early 1970s. Instead, it will rely on renminbi loans and infrastructure investments along the New Silk Road.Yields will continue to fall as the renminbi is re-rated as a reserve asset. Bond yields are sure to fall, and foreign investors will gain greater access.Equity prices will keep rising. Substitution of equity for debt finance will help get leverage under control. Falling rates will boost stock prices, as will foreign flows prompted by China’s inclusion in global indices.Falling rates/higher equity prices reduce the risk of a real estate crash. This, in turn, should ease concerns over the banking system’s health.

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Is the crocodile mouth slowly closing?

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The smart bet would be that renminbi use continues to expand

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Is change in RMB policy fundamentally US$ bullish?

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The fact that the renminbi is no longer following US$ should be bearish US$!The currency world of yesterday The currency world of tomorrow?

USD, 0% yield

Euro, 0% yield

JPY, 0% yield

USD, 0% yield

JPY, 0% yield

Euro, 0% yield

RMB, 2.5% yield

RMB, 1.5% yield?

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As should the continued widening of the US trade deficit

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4- Where To From Here?

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Key takeaways from a few turbulent months

1. China is not looking to devalue its currency: a large devaluation would go against China’s economic and geopolitical goals.

2. This explains why the PBOC has intervened to the tune of hundreds of billions of US$ to prevent the renminbi from falling. If China really was a currency warrior, the devaluation would have happened. Instead, China has “cashed out” the foreigners lining up to fire-sale the renminbi.

3. Thus, the “bearish renminbi” argument now has to rely on the fear that not only foreigners, but also Chinese people, will move to push capital out of China. This may happen, but the overall odds still seem low, if only because domestic investors still have a positive carry.

4. This fear of capital flight may help explain why the PBOC is so far behind the curve in slashing interest rates? The fear being that, if domestic investors no longer have positive carry to stay in renminbi, they will flood China’s very large pool of domestic savings to US$.

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Stabilizing Chinese reserves is an encouraging sign

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Already the dim sum bond market is ‘mending’ itself and making new highs

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Offshore renminbi seems to be settling down

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Put it all together: the unleashing of the pain trade

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US + Chinese consumers keep on consuming

US trade balance deteriorates

Foreign central bank reserves rise again

EM currencies start to stabilize

China devaluation fears abate & the renminbi rises

on short covering

The PBoC slashes interest rates without a fall in the renminbi

Dim sum and EM bond yields come down

EM equities outperform in US$ and LC terms

Cyclicals everywhere outperform

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5- Why Asia Is The Right Way To Play The “Pain Trade”

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A positive and proactive policy mix• In Asia, policy makers (Xi Jinping, Modi, Abe etc.) are clearly trying to SHAPE events. • Contrast that with the Western world where, at best, policy makers are simply REACTING to events (i.e.: immigration crisis, Euro crisis, Shia-Sunni civil war…). • But is the SHAPING going the right way? One might argue that the proactivity of Asian policy makers sets their countries towards conflict. This is possible, (i.e.: China doesn’t have much of a diplomatic team, Japan remains paranoid etc…). • Nonetheless, all the major policy announcements of recent quarters (TPP, OBOR, The New Silk Road, AIIB, renminbi internationalization…) encourage grater infrastructure spending, more trade, greater economic integration and thus greater Ricardian growth down the line. • These announcements also weaken dependence on the Western world, making Asia a more attractive target for those seeking to diversify their portfolios.• As an aside, it could also be argued that the Japan vs China rivalry is a boon to the rest of Asia, insofar as it permits the whole of Asia to industrialize and modernize on the cheap and on credit!

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Valuations: crocodile mouths everywhere?

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One obvious concern is EPS growth

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Momentum: the roll-over in the USD should help

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The outperformance of the US feels “long in the tooth”

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After all, as spreads widen, the ability to manipulate earnings disappears

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Upcoming catalysts for Asian markets

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• The November SDR decision on the renminbi should finish calming underlying fears on the renminbi. It could also trigger some “short-covering” and, if we see mild upward pressure on the renminbi, this will open a window for the PBOC to cut rates. • Another important event in November is the MSCI decision to include USA-listed Chinese equities (mostly tech names) into the MSCI China, Asia and EM. This re-weighting will occur in two phases taking place in November and May. • The coming months should see the benefits of the collapse in commodity prices filter through to most Asian economies, not least of which visible in the trade data.• Combine that with abating pressure on the US$ and, all of a sudden, Asia’s terms of trade and balance of payments look a lot healthier than one might have feared a few months ago. • As markets settle down, what will happen to all the cash that rushed for the sidelines in the summer sell-off?

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After massive repatriation, where will cash now go?

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Simple trends emerging in the near term• North Asia & Europe suffered through a liquidity squeeze—NOT a solvency crisis. The pullback should be seen as an opportunity to deploy capital there. This is all the more so since North Asia & Europe are the key long-term beneficiaries of the commodity bust and valuations (whether currencies or asset prices) across Asia and Europe are typically very attractive.

• China is not going bust. And with H-shares trading at 6.7x PE and 0.7x sales, valuations are back to the levels of the 2008 crisis or below. A very attractive buying opportunity.

• Europe is no longer the epicenter of the deflationary bust. This means that shorting the euro is no longer an appropriate hedge for portfolios. It also means that Europe’s export champions are no longer the place to hide.

• The commodity bust entails a serious solvency crisis for a number of companies. Meanwhile, while most commodity producing countries should be sheltered in the near term by the years of accumulated gains, the pain will be long-lasting and will have to be absorbed through devaluations and/or write-offs.

• The US market is a primary concern: it now has negative momentum, it remains overvalued, and recent volatility (especially in ETFs) may keep retail flows away. Recent strong GDP data should boost Fed’s willingness to raise rates, thereby boosting US$ and, hopefully, the US current account deficit—a wider US current account deficit would help Europe and Asia tremendously.

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