ASIA PACIFIC STRATEGY REPORT 2017 - Northern Trust · ASIA PACIFIC STRATEGY REPORT 2017 ... James...

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ASIA PACIFIC

STRATEGY REPORT

2017

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ASIA PACIFIC STRATEGY REPORT 2017

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CONTACT DETAILS

Australian Content;

Douglas Morton, CFA.

SVP, Head of Research Asia

Northern Trust Capital Markets

Tel +(44) 207 982 3225

Email [email protected]

The Northern Trust Company

50 Bank Street

Canary Wharf

London

E14 5NT

www.northerntrust.com

Ben Brownette

Equities Analyst

Northern Trust Capital Markets

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Email [email protected]

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Level 22, Goldfields House,

1 Alfred Street,

Sydney,

NSW 2000


ORDERS

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Neil Hetherington [email protected] +(61) 2 8058 3502

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TABLE OF CONTENTS

CONFIDENTIALITY STATEMENT ........................................................................................................... 2

CONTACT DETAILS ................................................................................................................................ 3

KEY UNDERSTANDINGS FOR 2017 ...................................................................................................... 7

REGIONAL 7

IN AUSTRALIA........................................................................................................................................................... 10

‘POST QE’ AND THE GREAT ‘REFLATION ROTATION’ ....................................................................... 11

1. 2017 AND A POTENTIAL ‘POST QE’ ENVIRONMENT. ..................................................................................... 11

2. THE GREAT ‘REFLATION ROTATION’ ............................................................................................................ 11

3. ROTATION NOT JUST COMMODITIES, BUT BONDS TO EQUITIES – FLOWS AND IMPLICATIONS FOR EM AND ASIA 12

4. IS THIS THE FINAL ‘TAPER TANTRUM’? EM IMPLICATIONS ............................................................................. 13

5. THE RELATIONSHIP BETWEEN INFLATION, EM AND COMMODITIES ................................................................ 13

THE USD – THE MOST IMPORTANT EM QUESTION FOR 2017 ......................................................... 15

6. THE USD – THE NUMBER ONE QUESTION FOR 2017 ................................................................................... 15

7. IS A STRONG USD POSING A GLOBAL RISK? ............................................................................................... 15

8. RMB DEVALUATION – AN ISSUE OF FUNDING NOT OF TRADE ........................................................................ 16

9. USD TIGHTNESS – THE NEW TAIL RISK ....................................................................................................... 17

10. COULD US RATES BE CAPPED BY GLOBAL CREDIT LEVELS? ......................................................................... 18

11. YIELD DIFFERENTIALS ARE NOT THE SUPPORT TO THE USD THEY ONCE WERE ............................................. 19

12. EXPECTATIONS FOR US RATE HIKES HAVE NEVER BEEN THIS HIGH – WHERE IS THE PAIN TRADE? ................. 21

13. LITTLE CORRELATION BETWEEN US RATES AND USD HISTORICALLY – YET USD STRONGER THAN ANY PRIOR

CYCLE ...................................................................................................................................................... 21

INFLATION AND THE COMMODITY CYCLE ........................................................................................ 23

14. IS INFLATION A SURE THING? – POSITION THROUGH FINANCIALS OVER COMMODITIES .................................... 23

15. WHAT TO TRADE ON INFLATION EXPECTATIONS .......................................................................................... 26

16. INFLATION AND THE COMMODITY CYCLE ..................................................................................................... 27

17. LIKE COMMODITIES VS USD, SO TOO EM VS MINING HAS BROKEN DOWN. ................................................... 28

18. IRON ORE, COAL AND STEEL CASH MARGINS ............................................................................................. 28

19. CHINESE PROPERTY AND THE USD - DOUBLE DOWNSIDE TO STEEL, DESPITE RECENT UPGRADES. ................ 29

20. COMMODITY PRICES AND CHINESE SPECULATION – SPECULATIVE PRESSURE IN 2017 COULD HAVE POLAR

IMPLICATIONS ........................................................................................................................................... 30

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THE WORLD’S MANUFACTURER HAS BEGIN TO EXPORT INFLATION ........................................... 31

21. THE WORLD’S MANUFACTURER HAS BEGUN TO EXPORT INFLATION .............................................................. 31

22. CHINESE INFLATION AND A STRONG USD MAY DRIVE A SURGE IN ROBOTICS IN 2017 .................................... 33

ASIAN TRUMPENOMICS ...................................................................................................................... 35

23. CHINA’S “CURRENCY MANIPULATION” AND US CASH REPATRIATION ............................................................. 35

24. IMPLICATIONS OF THE DISSOLUTION OF THE TRANS PACIFIC PARTNERSHIP (TPP) ........................................ 37

CHINESE REFORM MOMENTUM BUILDS DESPITE THE APPROACHING CONGRESS. .................. 39

25. MIXED OWNERSHIP REFORM AND THE CONSOLIDATION OF CHINESE XCOMMERCE ........................................ 39

26. MIXED OWNERSHIP MOMENTUM BEGINNING TO RE-CATALYSE ENERGY REFORM IN 2017 ............................... 41

27. INSURANCE AND PENSIONS REFORM – UTILISING CASH DEPOSITS DOMESTICALLY – A PROFOUND SHIFT ........ 42

28. 2017 COULD PRESENT THE ULTIMATE SOLUTION TO CHINA’S CREDIT PROBLEM. ........................................... 43

29. SOME CONTEXT TO THE OFTEN QUOTED 15-19% UNDERLYING NPL RATIOS ................................................ 45

CHINA – FISCAL VS FINANCIAL ........................................................................................................... 46

30. THE CASE FOR RAIL INVESTMENT – REBALANCING AND R&D – ‘MADE IN CHINA’ MEETS OBOR ..................... 46

31. CEMENTING CHINESE GROWTH ................................................................................................................. 48

32. FISCAL EXPOSURE WHILE AVOIDING PROPERTY AND FINANCIAL RISK ............................................................ 48

AV, BIG DATA AND XCOMMERCE ....................................................................................................... 49

33. AUTONOMOUS VEHICLES – THE ROUTE TO CHINA’S REBALANCE? ................................................................ 49

34. AV – THE FINAL STEP IN CHINA’S ‘BIG DATA’ CONSUMER REVOLUTION AND A RISK TO GLOBAL OEMS ............ 50

35. OEM “EXTINCTION” IMMINENT? CAPACITY VS R&D .................................................................................... 52

36. THE NEXT STEP FOR AV, SMARTPHONES AND ECOMMERCE IS AI – SPEED OF DEVELOPMENT COULD BE

EXPONENTIAL ........................................................................................................................................... 54

37. E-GAMING LONGEVITY TO SHOW THROUGH IN 2017 .................................................................................... 56

38. THE RETURN OF THE CHINESE CONSUMER ................................................................................................. 58

39. E-FINANCE – CATALYSTS LOOM IN 2017 ..................................................................................................... 59

AUSTRALIAN EQUITY STRATEGY ....................................................................................................... 60

BULLISH: 60

BEARISH: 60

KEY THEMES FOR 2017 ....................................................................................................................... 61

EFFECTIVE TIGHTENING OF MONETARY POLICY; INDEPENDENT OF THE RBA ................................................................ 61

STAY LONG OIL NAMES ............................................................................................................................................. 61

COMMODITY HYPE .................................................................................................................................................... 61

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FEBRUARY REPORTING SEASON LIKELY TO SORT THE SHEEP FROM THE GOATS ........................................................... 62

AUSTRALIA RESIDENTIAL ................................................................................................................... 63

1. INCREASING BORROWING COSTS ............................................................................................................... 63

2. MACRO .................................................................................................................................................... 64

3. PRICE ...................................................................................................................................................... 64

4. APARTMENT SUPPLY PEAK / SETTLEMENT RISK ........................................................................................... 64

5. STOCK POSITIONING: ................................................................................................................................ 64

SELL PREMIUM OFFICE NAMES: DXS, GPT, LLC ....................................................................................................... 65

US GROWTH ......................................................................................................................................... 67

ACONEX 67

MACQUARIE ............................................................................................................................................................. 67

OIL 68

STOCK POSITIONING: ................................................................................................................................................ 68

SHORT QAN ............................................................................................................................................................ 68

GOLD 70

COMMODITIES ...................................................................................................................................... 71

IRON ORE 71

COAL 71

SELL DOW AU ........................................................................................................................................................ 73

PAIRS 74

LONG E&P (SANTOS, BHP) SHORT SERVICES (WOR) AND QAN ............................................................................... 74

LONG A/B GRADE OFFICE; SHORT PREMIUM .............................................................................................................. 74

OUT-OF-CONSENSUS .......................................................................................................................... 75

CONSENSUS RECOMMENDATIONS ............................................................................................................................. 75

CORPORATE TRAVEL .......................................................................................................................... 76

STAR ENTERTAINMENT ....................................................................................................................... 76

WOOLWORTHS .................................................................................................................................... 76

REVIEW OF LAST YEAR’S STRATEGY REPORT (2016) ..................................................................... 77

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KEY UNDERSTANDINGS FOR 2017

REGIONAL

Inflation or rotation?

The great ‘reflation-rotation’ is as much about positioning as about the sustainability of global inflation and the

correction of excessive ‘lower for longer’ positioning of the past five years (and therefore the direction of global

markets in the short term) is dependent of very specific factors currently (the USD and US yield curve)

The USD is an underappreciated risk -

A higher USD is presenting (in our opinion) as yet underappreciated global credit risks, particularly to EM markets

(greater than at any point over the past five years). Chinese property developers are the most exposed to these risks

although from an allocation point of view, China is already a record underweight. Sell Zoomlion, Buy Bank of

China, China Life

Historic relationships between the USD, Inflation, Commodities and EM may correct in 2017 –

The historic relationship between the USD, inflation, EM and Commodities has broken down – a higher USD (as a

funding risk) has been priced in to EM exposures while its deflationary implications have been ignored within the

commodity complex – look to Sell commodity strength while Buying EM exposure (particularly financial). The

potential of higher inflation should be invested in through financial exposures rather than commodities –

Sell Angang, Buy Bank of China

Sentiment of ‘Strong Dollar is bullish’ may not sustain over 2017 –

A higher USD will present Asian funding risk while a lower USD may be indicative of a broad (risk off) short term

correction that should be bought in Asia (as in 2016).

The same tail risk as catalysed the GFC is looming (an underappreciated potential) –

Offshore USD liquidity is a very high risk currently that has little to do with the direction of the USD (an onshore

issue) and cannot be controlled by central banks. Divergence between overnight LIBOR vs FED Funds rate must be

watched very closely as the primary (USD liquidity) tail risk indicator for 2017 – Japanese Banks are most negatively

exposed to this tail risk while most positively exposed to continued inflation expectations. BUY US exposed

Japanese Banks (MUFG) vs Sell more domestically focused names (SMFG)

USD has more downside than upside risks in the short term (much like January 2016) –

Firmly against current consensus; US interest rates may be capped (certainly vs expectations), yield differentials are

not as supportive as many assume and expectations of US rate hikes have never been this high, yet USD

correlation to historic rate cycles is marginal. Downside risks to the USD remains high in our opinion (as in Jan

2016). Short term correction will lead to broad risk off which should be bought (particularly in China). Short term -

Sell Chinese property exposures and commodity exposures to cover potential correction and look to buy

Banks and OBOR exposures on potential weakness. Cover the potential of higher US rates by Selling HK

Property exposures.

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The potential of inflation is being mispriced inter sector –

A strong USD remains a deflationary force in the long term while inflation expectations remain fragile in the short

term. Inflation upside is being priced into commodity exposures while not into financial exposures. Inflation

excitement vs disappointment will likely define up and downside volatility over 2017. Buy financial weakness, Sell

commodity strength. Japanese banks (pair long MUFG with sell SMFG), Buy Bank of China, Chinese

Consumption (Tencent, Sands China, Anta, Alibaba, JD and Fosun), Korean Shipbuilders (Hyundai Heavy

and Samsung Heavy), Sell HK Property, Sell Zoomlion, Sell Angang Steel.

The reality of the commodity supply/demand outlook may be being mispriced –

Commodity strength has not been demand led and Chinese property weakness will be a stronger force than Trump’s

longer term inflationary policies once underweight positioning normalises. Excitement surrounding capacity cuts may

prove short lived. Chinese speculative pressure will remain a strong force in 2017 but likely shift from commodities to

credit and financial exposures. Cautious Iron Ore and steel. Coal price will determine steel cash margins. Sell

RIO, Whitehaven Coal, Downer, Angang, Zoomlion, Sell Nine Dragons strength, Buy BHP

Chinese economic strength has been low quality. Loosening may come in 2H –

Chinese economic strength has been predominantly due to coal (an underappreciated fact) and may wane over the

year. Contrary to expectations the 2H may see some monetary loosening. Buy Bank of China, China Life

The RMB will be driven by financial risk not trade pressure –

The direction of the RMB is more about financial risks and the USD than about trade pressure – continued USD

appreciation will cause further Chinese outflow pressure – Sell Nine Dragons, Zoomlion and Chinese property

exposures

Chinese Inflation may see a surge in Robotics in 2017 –

Buy Yaskawa, Fanuc and Midea

Chinese regional influence will grow in 2017 –

The greater the pressure to Asia from a strong USD and Trump’s anti globalisation policies, the more Chinese

regional influence will grow – buy Chinese funding plays (Bank of China) and Chinese OBOR exposures

(Zhuzhou CSR, CCC), Sell TPP exposures (Li&Fung and Japanese Autos)

Trump’s policies on China are contradictory although certainly destabilising –

Labelling China as a currency manipulator will have far less impact to Chinese GDP than to the smartphone supply

chain and US cash repatriation could precipitate further USD offshore liquidity tail risks.

Chinese reform momentum will continue to build, particularly post Congress –

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Inflation, Trump and the approaching Congress has sped Chinese reform momentum – Buy China Unicom,

PetroChina, CNBM, Bank of China, Zhuzhou CRRC, China Agri, Tencent, Baidu, China Life

Fiscal vs Financial –

1H may see fiscal expansion vs increased funding risks while the 2H may see some monetary loosening in China –

Buy rail exposures and cement (BBMG, Anhui Conch and CNBM). Pair; buy Lonking with sell Zoomlion

Expect sentiment on rail to build in China –

Further rail investment will support rebalancing, R&D and connects ‘Made in China’ with OBOR – Buy Zhuzhou

CRRC and China Communications Construction

Further AV commitment may prove the route to Chinese rebalancing over 2017 –

Buy Tencent, Baidu, DeNA, Jiangsu Protruly, Mando, Nexteer, Renesas, Sunny Optical, Tung Thih Electronics, and Buy Denso / Sell Aisin Seiki

Chinese ‘big data’ consumer revolution may reveal itself further in 2017 –

Buy Tencent

Further global OEM pressure may become apparent due to Chinese policies over 2017 –

Buy Denso / Sell Aisin Seiki

Artificial Intelligence will gain momentum in 2017 –

The next step in AV, eCommece, smartphones and big data - Buy Baidu, Tencent, Denso, TSMC and AAC

Technology

eGaming longevity will show in 2017 –

Buy Square Enix, Nintendo, DeNA and Tencent

The Chinese consumer will return in 2017 –

Driven by inflation and a reversal of the increasing savings rate of recent years. The Congress may signal the

reduction in anti-graft momentum – Buy Sands China, Anta, Tencent, Alibaba, JD and Fosun

eFinance momentum will build over 2017 –

Buy Fosun, Tencent, Alibaba and JD

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IN AUSTRALIA

Australian property risk will precipitate in 2017 –

Driven by tightening monetary policy, increased funding costs, mitigation of foreign demand (capital controls and

settlement risk), valuation, ‘Peak apartment’ and positioning - Sell Australian residential property (AS51PROP,

Dexus Property, Lend Lease, Mirvac, Stockland, Adelaide Brighton, CSR)

US infrastructure and inflation exposures –

Australian companies have relatively high exposure - Buy Aconex and Macquarie

Oil – bullish price, but not activity –

Supply and demand will rebalance more quickly post OPEC production cut and underinvestment in supply over the

past few years. E&P capex continues to be revised down however. Buy Santos, BHP, Sell Worley Parsons,

Qantas

Gold bulls –

Higher inflation yet high index volatility. Gold net long has halved since peak alongside capex since 2012 - Buy

Newcrest, Northern Star, ALS Global

Commodities / Miners – when do supply / demand dynamics takeover from asset rotation?

Sell RIO, Whitehaven Coal, Downer and Pair Long BHP, Short RIO

Trading pairs

• Long E&P (Santos, BHP) short services (WOR) and QAN

• Long A/B grade office (Investa); short Premium (Dexus)

Out of consensus basket –

Sell Corporate Travel, Star Entertainment, Lendlease, Mirvac, Qantas, Buy Woolworths

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‘POST QE’ AND THE GREAT ‘REFLATION ROTATION’

1. 2017 AND A POTENTIAL ‘POST QE’ ENVIRONMENT.

� Rarely has the global environment been defined by so few risk factors, particularly the US

yield curve and consequently the USD

� The implications of this and the potential return of global inflation make it of fundamental

importance to spend some time on these factors when assessing the outlook for Asia Pacific

in the year ahead

As we enter into 2017, global markets are digesting the potential that (for the first time in nearly 10 years) we may be

approaching a ‘post QE’ environment. The implications of this are stark, not least as the great reflation trade stands

in sharp contrast to the ‘hunt for yield’ trade that has defined global markets for the last decade, but also as

investors are categorically not positioned accordingly. The implications for Emerging Markets and Asia of what may

become one of the greatest rotation trades of the last 10 years is arguably greater now than was the case even

three years ago (particularly given the ballooning EM credit seen in recent years as the search for yield has moved

further up the risk curve) and as such we feel analysing Asian strategy for 2017 would be pointless without spending

some time on the current global environment. Given the polarity of current positioning and potential outcomes

globally, rarely has the global environment been able to be distilled into so few risk factors (namely the US

yield curve and consequently the USD), as such, we feel it is of fundamental importance to spend some time on

these factors when assessing the outlook for Asia Pacific in the year ahead.

2. THE GREAT ‘REFLATION ROTATION’

� Rising yield curve is causing capital to flow relatively indiscriminately due to prior polar and

highly consensual positioning

� Ironically however, higher yields mean a workable risk free rate and the potential for alpha

over 2017.

� The normalising of positioning may not be indicative of the reality of markets over 2017

however

While cognisant of the great reflation trade currently underway, the approach to 2017 in global stock markets

actually strikes us remarkably similar to this time last year where same way positioning was as stark as it had been

since the GFC (as highlighted in our 2016 strategy note last year (link)). There seems to us some irony in the fact

that consensus views and investor positioning seem in somewhat of a self-fulfilling marriage in the short term where

momentum rules all (particularly in recent commodity moves), despite (and indeed because of) the fact that yield

curves are steepening sustainably for the first time in 5 years. Although global investors seem to have been caught

short of the great ‘reflation rotation’ causing capital to flow relatively indiscriminately and for positioning and

momentum to define short term performance, steepening yield curves may actually finally bring back the concept of

a workable ‘risk free rate’ and with it (potentially) the breaking of the excessive correlations that have defined

investing over the last decade, 2017 may actually be a year for active investing and stock picking (!)

Currently however, global markets do seem driven by just a handful of factors (at least until positioning normalises);

the USD, the US yield curve and the potential unveiling of the great global reflation trade. Given the length of time

the ‘lower for longer’ trade has been in the market, it is maybe of little surprise the speed and aggression of rotation

that has followed this change in sentiment, but we think it will be of prime importance in 2017 to have a clear idea of

what is and what is not happening within the reflation trade, in particular when it comes to Asian investing. As such,

we think it worthwhile spending a little time on these individual factors, while bearing in mind that the huge sell off

seen in January 2016 was ultimately a result of overly consensual positioning.

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3. ROTATION NOT JUST COMMODITIES, BUT BONDS TO EQUITIES –

FLOWS AND IMPLICATIONS FOR EM AND ASIA

� Rotation not just bond like equities to commodities, but bonds themselves to equities

� Positioning as important as inflationary potential

� The reality of past flows show both significant potential within Asia, but also highlight large

global risks in 2017.

� A strong USD is a large global risk currently (particularly for EM).

If current market moves are indeed due to a ‘reflation rotation’ it is important to note that this is not just a sector

rotation from ‘bond like’ equities to commodities but more importantly from bonds to equities themselves.

Additionally, the longevity of the trade may be as much about assessing positioning (the rotation aspect of ‘reflation

rotation’) as the sustainability of inflation trends themselves.

Since January of 2016 (according to EPFR) there has been a cumulative widening of flows from equities to bonds

globally of a net USD 250bn (similar to that seen in 2011-2012). Cumulative flows since 2001 have been USD 1.1b

into bond funds and just USD 400b into equity funds with the two sustaining a period of continual divergence that

began 2009. The current great rotation would seem to be a correction of this dynamic as positioning shifts from

‘lower for longer’ to the potential of the resumption of global inflation and the suggestion is that this could lead to a

>USD 3-400b correction of cumulative flows globally back to equities over the coming years.

Source: EFPR

The problem comes however from the fact that the ‘lower for longer’ trade has been around for such a long time

that the hunt for yield has bled into demand for EM credit itself (rather than just EM bond funds) and particularly

US denominated EM credit (Eurobonds). This has directly led to the current situation of a massive USD liquidity

squeeze which may have significantly increased the risk and implications of any further USD strength,

particularly to EM equities (see ‘Is a strong USD posing a global risk?’ below).

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4. IS THIS THE FINAL ‘TAPER TANTRUM’? EM IMPLICATIONS

� Unlike other ‘taper tantrums’ outflows have preempted steepening (particularly in China).

� GEM fund allocations to EM Asia relative to MSCI EM is now at all time lows

The last time flows began to travel from bonds back to equities globally was over the latter part of 2013 and into

2014 (the first taper tantrum). 2015 also saw a similar trend as the US yield curve steepened and in both cases (as

now) it defined a period of significant EM underperformance vs the US. On this occasion however (unlike other taper

tantrums) outflows have already happened from EM equity over the 1H of last year. In fact, in EM Asia equity fund

outflows continued over the whole of 2016, mainly driven by China (a cumulative USD 20b outflow vs a total EM

outflow that is currently flat for the year following a 2H recovery in flows in 2016). GEM fund allocations to EM Asia

relative to MSCI EM is now at all-time lows according to MSCI in fact at 6% underweight vs the rest of the asset

class (Lat Am is at all-time highs at 2% overweight relative).

5. THE RELATIONSHIP BETWEEN INFLATION, EM AND

COMMODITIES

� The relationship between higher inflation expectations and EM vs commodities has broken

down in the short term

� Higher USD has been priced into EM (as a negative for funding risk), but not into deflationary

implications for commodities

� Selling commodity strength vs buying EM exposure may be a good strategy over 2017

While a steeper US yield curve has tended to cause EM underperformance vs the S&P, on this occasion this

relationship has completely diverged from the historic correlation of EM equities to the mining sector. Effectively, a

higher USD is currently already being priced into EM equities (as funding risk increases) while higher inflation

expectations (and therefore a relatively weaker USD) are being priced into global mining stocks. If history (and likely

profitability outlook) holds, this divergence is unlikely to sustain throughout the year. We would therefore be looking

to sell short term commodity strength and buying EM exposure (particularly financial exposures that are yet

to reflect the potential heightened inflationary outlook and currently are significant underweights in

portfolios)

As the US yield curve has continued to steepen (orange), EM has underperformed vs the S&P (white).

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Usually highly correlated, the relative performance of EM vs the S&P (white) has recently diverged from the

relative performance of Mining equities vs S&P (yellow)

Looking to sell commodity strength against a long EM exposure may be an interesting trade over 2017.

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THE USD – THE MOST IMPORTANT EM QUESTION FOR 2017

6. THE USD – THE NUMBER ONE QUESTION FOR 2017

� The inference and in fact the global implications of the direction of the USD have rarely been

this important. Particularly for EM and Asia

� Our slight concern remains how consensual a higher USD is

As was the case this time last year, it seems once again that the number one question on investors’ lips is in regard

to the direction of the USD (see even the front page of December’s “The Economist”). The global implications of this

have in fact never been more important, not just in terms of an indication of the sustainability of the reemergence of

global inflation, but also due to the particular sensitivity the world now has to incremental USD moves. Indeed USD

positioning has rarely been this stark and has led to the largest USD shortage seen in recent history with significant

liquidity implications for most central banks globally (see below). For 2017, it seems to us that if you get the USD

right then by implication you will find that many other things may fall into place for the year ahead. Conceptually we

have a slight concern on how consensual a stronger dollar is and similar consensual positioning last year

(highlighted in December 2015 as the very first point in our 2016 strategy note Global same way positioning starts

2016 at levels not seen since the GFC ) led to the sharpest USD correction seen in seven years in the first few

weeks of 2016.

7. IS A STRONG USD POSING A GLOBAL RISK?

� A stronger USD has recently been a ‘risk on’ indicator, yet presents (we believe) as yet

underappreciated global risks, particularly following a period of extended ‘lower for longer’

positioning

� The risks of a stronger USD are greater now than they have been for five years

The USD strength of late has been indicative of a stronger, more inflationary US economy, however even ‘The

Economist’ are beginning to worry that (ironically) a stronger USD (that has proved to be the number one “risk on”

indicator of the past few months) may actually be bad for the world economy (and indeed for the US herself).

According to the Economist, the US and those currencies that are effectively pegged to her exchange rate make up

60% of the global population and GDP and its market share in terms of financing is greater still. Importantly, since

the GFC, low US rates have led pension funds to seek yields in USD denominated securities offshore (eg

Emerging Markets Eurodollars) which by last year (according to the BIS) accounted for almost USD 10tn (having

risen 70% since 2008) with 1/3 in EM. In September 2012 for example Zambia issued its debut Eurobond (USD

denominated debt) for 5.4% and received USD 12bn of orders. When the USD rises, so does the cost of servicing

that debt. This capital inflow has also led to a boom in the domestic credit markets of these countries that could

potentially also unwind should the USD remain strong. The risks associated with a stronger USD are therefore

greater than they have been in the past five years. From an EM perspective this puts Indonesia at particular risk

given the offshore weighting of its fixed income ownership, particularly should the current commodity led bull run

dissipate in any way. Although economically speaking China should be well insulated from this risk given their large

foreign reserves, the fact that the US is only their 4th largest trade partner (and mainly in electronics which (as we

discuss later – see ‘The world’s manufacturer has begun to export inflation’) has not participated in recent

inflationary trends) and the fact that (at 8% underweight) GEM funds are already negatively positioned. Having said

this, sentimentally speaking, China remains at the forefront of most broad risk off trades (as seen in Jan last year),

particularly should concerns build of an RMB devaluation (see ‘RMB devaluation – a function of USD strength’).

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Sectorially in China the largest holders of USD Debt is the Energy sector but this has USD revenues also. Next

largest is Chinese Property that still has a USD debt balance of 330b RMB which accounts for 30% of the sectors

total debt according to CEIC. Further strength in the USD could therefore exacerbate the looming Chinese

property downturn and in the US, a strong USD would cause the trade deficit to widen as imports become

stronger further stoking protectionism. Additionally, the FED has historically shown some sensitivity to USD

related EM risk that could see current expectations of further USD strength begin to diverge from the FED’s comfort

over the course of the next 12 months.

Companies : Nine Dragons, Chinese Property, Zoomlion

8. RMB DEVALUATION – AN ISSUE OF FUNDING NOT OF TRADE

� RMB depreciation would seem more a function of USD strength than of RMB weakness

� On a trade weighted basis the RMB has not depreciated to the same extent and the US is only

China’s 4th largest trade partner (and mainly in one product (smartphones)

� The majority of the offshore liability boom has however been in USD

Over the course of 2016, Chinese outflow pressure abated somewhat as concerns of consecutive US rate hikes

abated throughout the year. In fact, what RMB weakness there has been has been against the USD and not vs a

trade weighted basket of currencies. As mentioned above; the US is only China’s 4th largest trade partner (and

mainly in electronics which (as we discuss later in ‘Asian Trumpenomics’) has not participated in recent inflationary

trends). A weaker RMB is not therefore a function of trade, but one of financing as the majority of the recent offshore

liability boom in China has been in USD.

Should the USD continue to appreciate from here we would expect to see renewed pressure to China’s capital

account as capital outflow pressure re-emerges which may prove a negative feedback loop as in 2015.

RMB depreciation vs USD has not been replicated by their largest export market (Europe)

Source: Bloomberg

Companies : Nine Dragons, Chinese Property, Zoomlion

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9. USD TIGHTNESS – THE NEW TAIL RISK

� Contrary to popular belief, it was this very factor that triggered the beginning of the GFC

� This is not an issue central banks can control

� Trump and ‘de-globalisation’ could potentially exacerbate the problem

� Any divergence in LIBOR vs the FED funds rate will be the primary tail risk indicator for 2017

Offshore USD liquidity is now becoming a primary concern of many international agencies (The Bank of International

Settlements highlighted it as a major concern in November for example) and it is beginning to show up in a

concerning lack of interbank liquidity in many large banking markets (most notably Japan). Despite this, few fully

appreciate the risk in our opinion. It is worth therefore bearing in mind that it was a lack of offshore USD liquidity

that actually triggered the initial stages of the GFC as foreign central banks tried to close out USD liabilities that

were less then than the current balance. This scramble in the USD funding market led to the bifurcation of the global

dollar market and the volatility and divergence of the offshore LIBOR vs the FED funds rate lasted throughout the

crisis, despite the FED pumping money to try to relieve the pressure. On the 9th of August 2007, two BNP Paribas

hedge funds failed to price causing a scramble for USD liquidity that led to a massive divergence in the offshore

LIBOR rate and the FED funds rate. Despite the FED pumping huge liquidity into the market this failed to relieve

offshore funding pressure (as contrary to popular belief the two markets are entirely separate and the FED do not

backstop offshore USD funding). There was, in reality, little the FED could do to relieve the pressure to the offshore

market and the bifurcation lasted until the end of the crisis.

With this in mind, the tightness currently being seen in the Eurobond market (offshore USD) should be of significant

concern, particularly as this comes before any unwind of the recent growth in offshore USD liabilities. EM markets

have very little room currently to close out USD liabilities. The recent Trump win may also further exacerbate the

risks with a potential ‘de-globalisation’ trend adding to his plans to repatriate corporate profits further pressurising

offshore liquidity and causing concern that swap lines may fail to be offered.

A primary risk indicator we will be watching closely in 2017 therefore will be any divergence in LIBOR vs the

FED funds rate.

A lack of USD liquidity is a particular risk in China and the lack of a USD swap between the FED and the PBOC

is a huge omission given the balance of USD liabilities. The Fed’s current dollar swap arrangement is with

developed world central banks yet 70% of the increase in offshore dollar debt since the crisis has been dominated

by the emerging world, especially China. Regionally therefore, the more pressure Asian nations face from a

stronger USD and Trump’s policies, the more China’s regional political power will grow (in terms of funding

with the AIIB) (Buy Bank of China), trade through China’s equivalent to the TPP (the Regional Comprehensive

Economic Partnership (RCEP) (Sell Li&Fung, Sell Japanese auto exposures) and reliance of China’s regional

fiscal expenditure plans (the OBOR policy) (Buy Zhuzhou CRRC (3898 HK) and China Communications

Construction (1800 HK)). The USD funding problem is also a particular risk to the Japanese banking system

which has been struggling with interbank liquidity for some months now.

For these reasons, the current ‘strong dollar is bullish’ trades may not sustain over the course of 2017 and in fact a

strong dollar may exacerbate dollar illiquidity which is something that (as explained above) central banks cannot

adequately control. This may ultimately undermine any attempt to stimulate inflation by Trump in the short to

medium term (see ‘Is inflation a sure thing?’ below).

Companies : Bank of China, Li&Fung, Japanese Autos, Denso, Aisin Seiki, Zhuzhou CRRC, CCC, Japanese

Banks.

18NTAC:3NS-20


10. COULD US RATES BE CAPPED BY GLOBAL CREDIT LEVELS?

� Lower for longer has supported huge increases in global credit in the last eight years

� Despite this, global growth has also far lower now than eight years ago

� The world if far more sensitive to the downside of marginal interest rates now than it has been

in the past

How much higher the US yield curve can go is a big question given how correlated global positioning is currently to

the US yield curve (see Japan in particular) and the sheer size of the current global debt balance - high interest

rates are actually a significant risk given the amount of debt that has been accumulated the world over (a matter of

mathematics rather than subjectivity). US government debt has increased USD 8.7trn since 2008 (more than

doubled), and using CBO forecasts including the effect of Medicare, Medicaid and pensions, this could increase

another 33% by 2020. But even though debt has been climbing at this rate the interest expense as a percentage of

GDP has actually been falling due to the falling average cost of bonds on issue. The average cost is currently

around the 2.2% mark, having fallen significantly in recent years alongside bond yields. Without adding in the Trump

stimulus, the interest expense as a percentage of GDP before the crisis would be matched with a 10 year rate of

3.3% now (equivalent to 4% in 2020). While this gives a fair amount of headroom to current 10 year rates (roughly

2.4%), it must be remembered that trend GDP growth is far lower now than it was pre-crisis so that same interest

expense as in 2008 is far more damaging to growth now. The capacity to pay interest has declined significantly so

the upper limit in Treasury yields is even lower than 3.3%.

Additionally, historically the FED has proved sensitive to increasing EM volatility when raising base rates.

If yield curve does continue higher however, HK property may come under renewed pressure particularly give

renewed property tightening measures in HK (increased stamp duty)

Global positioning is currently highly correlated to the US yield curve – Japan (for example) has recently

been entirely driven by the US yield curve and not its own yield curve. US yield curve (white), Japan yield

curve (orange) and JPY (blue).

19NTAC:3NS-20


In Q2 2014, McKinsey estimated that global debt amounted to USD 199 trillion, so we are now well above

USD 200 trillion.

11. YIELD DIFFERENTIALS ARE NOT THE SUPPORT TO THE USD THEY

ONCE WERE

Currently real US interest rates are 9% lower than that delivered by 'Reganomics' in the mid-1980s when they

reached 10%, despite the similarities being touted between Regan and Trump’s policies. In terms of real differentials

(often used as a supportive argument for a stronger USD) the US real yield is currently mid-way between the Aussie

and the Japanese (so two opposing factors) and the differentials themselves are significantly less than they have

been historically. These differentials were a strong argument for the USD strength seen in 2014-15 and into 2016,

directly leading to the sharp USD strength seen in 2014 (prior to the US first rate hike) as real yield differentials

reached 4%. Similarly in the 1999 cycle (the ONLY other US rate cycle that saw USD appreciation following the first

rate hike) real yield differentials were up at 4%. By the time differentials reached their current 0.9% it defined the

peak of the DXY rally in 2001 and the dollar collapsed for the next seven years continuously.

Yield differentials vs the DXY - Yield differentials are no longer the support to the USD they once were.

20NTAC:3NS-20


Real yields through time (US, Japan and Australia) – US real rates are 9% lower than that delivered by

'Reganomics' in the mid 1980s when they reached 10%.

21NTAC:3NS-20


12. EXPECTATIONS FOR US RATE HIKES HAVE NEVER BEEN THIS

HIGH – WHERE IS THE PAIN TRADE?

Expectations of higher rates have never before (in any prior rate cycle going back to the 1980s) been this engrained.

If expectations of higher rates are indeed driving global stock markets currently, it may pay to be cognisant of how

consensual higher rates now are and where the marginal pain trade may now lie. Rate hike expectations for

December 2016 reached 100% one month prior to the FED meeting, a situation not seen in any other rate cycle in

recent memory. Going back to 1994, 90% of the 31 rate hikes were priced at 50% 30 days ahead with the median

only rising to 95% as the meeting approached. There were only ever two deviations from this, both of which seeing

far lower expectations - March 1997 (one and done) when probability only rose to 51% three days prior and the USD

actually depreciated despite the surprise hike (!) and November 1999 (the only historic US rate cycle to see

sustained USD appreciation with the popular debate at the time being that the business cycle was so strong it had

actually extended (unemployment rate dipped under 4% vs current 4.9%)). The first hike in 1999 had just a 58%

probability assigned to it prior to the hike and the first hike was followed by a further nine in the 12 months that

followed (vs just one further hike in the current cycle). If higher rate expectations are driving markets, expectations

have only one way to go in the current cycle and historically, even surprise rate hikes have not been enough to

categorically drive the USD higher on a sustained basis.

13. LITTLE CORRELATION BETWEEN US RATES AND USD

HISTORICALLY – YET USD STRONGER THAN ANY PRIOR CYCLE

� History suggests little correlation between US rate cycles (divergent or otherwise) yet USD

appreciation is now the greatest than at this point in any cycle since the 1980s

USD appreciation is now greater than at this point in any prior US rate cycle since the 80s, despite already

appreciating by the most into the 1st hike of any prior cycle; despite this being the slowest rate progression of any

cycle in history and despite expectations of higher rates at the highest level of any prior cycle. The last time US rates

diverged from global rates was in 1994 (green line in chart) in a direct effort by the US to bolster the USD. They

failed and the USD depreciated over the following two years. The USD appreciation is now higher even than the

1999 cycle (the ONLY rate cycle that saw USD appreciation). The popular debate at the time was whether the

business cycle had been elongated vs history and so no longer applied (PE rose higher than 20X) as the

unemployment rate dipped under 4% in early 2000 (so by about now in the comparative cycle. US unemployment is

currently 4.9%. Subsequent excess investment in 1999-2001 (particularly in IT and telecom) caused the subsequent

rolling over of profits by 2001 to turn into a bear market and the DXY to depreciate continuously for the following

seven years.

22NTAC:3NS-20


White line – current cycle. Orange line – ’86 cycle. Blue line – ‘04 cycle. Yellow line – ’99 cycle. Green line –

’94 US rate divergence

23NTAC:3NS-20


INFLATION AND THE COMMODITY CYCLE

14. IS INFLATION A SURE THING? – POSITION THROUGH

FINANCIALS OVER COMMODITIES

The first point to make is that a stronger USD is clearly deflationary (see the below chart). The rise in the US dollar

from mid-2014 to late 2015 significantly tightened financial conditions for the US, leading to growth falling from 4-5%

(quarterly annualised) in mid-2014 to a low of just under 1% (quarterly annualised) in early 2016. In fact the last six

months have seen the trend of the USD vs the outlook for G7 inflation diverge the most since 2006, yet many see

the rise in the USD as indicative of the return of global inflation (led by the US).

USD (inverted) vs G7 Inflation – stronger USD is clearly a deflationary force.

While cognisant of the many pro inflation policies of a Trump government (not least fiscal expenditure and wage

inflation) we remain mindful that there remain some significant deflationary forces globally to contend with in the

medium term (namely capacity, deflationary mind-sets (see the experience of wage negotiations in EU and Japan

recently) and the USD itself) and that (as alluded to above) the comparisons with ‘Reganomics’ has significant flaws

aside from the fact that Regan ultimately massively reduced inflation and despite his wins in GDP growth he ushered

in the longest period of sustained USD depreciation in recent history (see ‘Little correlation between US rates and

USD’).

The fact is that the impact from many Trump policies is yet to be seen and despite the excitement, the current

inflation impetus in the US could be argued to be temporary (base effect, energy prices, Brazil and Russia out of

recession and China PPI). While inflation may indeed come, we must slightly caveat recent moves in rotation trades

with the fact that US core inflation (ex food and energy) there has been no clear uptrend. Disinflationary forces also

remain relatively high although potentially mitigated by the potential of future wage inflation in the US coupled with a

continued rise in commodity prices.

24NTAC:3NS-20


Inflation expectations, as yet, remain fragile in our opinion, particularly given the length of time low realised inflation

has been present, which seems to now be causing second round effects. Both EU and Japanese trade unions for

example, have failed to enact wage inflation (despite every government effort) due to (according to the unions

themselves) the impact of (backward looking) realised inflation on future expectations. Deflationary mind-sets are

becoming somewhat self-fulfilling.

Neither inflation (nor indeed the reactions that commodities have had to its potential re-emergence) have (as yet)

been driven by a global demand response (see ‘Inflation and the commodity cycle’ below). If anything, this is a

capacity story and there remains significant excess capacity in many sectors and economies globally currently

meaning that recent inflationary excitement may prove temporary in the short term.

Prices of financial assets have already detached from the real economy (US durable goods vs S&P)

Is inflation real? US TIPS vs Mining index – Tips are implying inflation expectations have begun to decline

yet the mining index implies the opposite

25NTAC:3NS-20


World trade volumes are not implying inflation is as yet demand led.

Having said this, given global medium term positioning and the length of time the ‘lower for longer’ trade has been in

place, the long lead time Trump will have to prove his policies inflationary and the likely sensitivity the FED has to

any downside risk may mean that inflationary excitement may rear its head continually in the months and

years to come. As such it is certainly worth covering its potential, but in our opinion far better within financial

sectors than in commodities that already have some inflationary excitement cooked in (judging from their moves

in recent months)

Buy financial weakness, Sell commodity strength.

26NTAC:3NS-20


15. WHAT TO TRADE ON INFLATION EXPECTATIONS

� Pro Inflation trades

• Japanese Banks – probably the most exposed to the re-inflation trade globally although have recently been

more correlated to the US yield curve than the Japanese. MUFJ remains best exposed given their US banking

exposure although the sector as whole remains one of the most at risk globally from the USD (and therefore

interbank) illiquidity and the tail risk of further ventures into NIRP over 2017. Within the banks, it may be worth

pair trading a US inflationary trade (MUFG) vs more Japanese exposed names (SMFJ) or avoiding the

interbank issue completely with a name such as Orix. We remain very cautious of uncovered net long positions

here however, despite their sensitivity

• Chinese Banks – Generally speaking, the rise of global inflation (both in the US and in China) should make

China’s domestic (non USD denominated) debt mountain less formidable and therefore her banks more

attractive. Buy Bank of China

• Chinese consumption - Higher inflation in China is chipping away at the country’s recently rising savings rate

(the real deposit rate has been negative for nearly all of 2016). Given that the phenomenal wage inflation of the

past three years has not yet flowed through to consumption (as the savings rate has only risen) what this may

do is catalyse a significant catch up trade in China’s impetus to consume (already being signalled by global

luxury retailers in China) and with few other viable options available to investors (as the property market is

cooled, wealth management products constrained and off shore flows capped) this could bring renewed flows

into both Chinese consumer products and into domestic equities during 2017 (Buy Tencent and Sands

China). (See ‘The return of the Chinese Consumer’)

• Korean Shippers – more work required, but I a nutshell; positively exposed to both physical inflation (through

commodity reflation driving order demand) and financial inflation (reducing pressure of highly geared balance

sheets). A rising oil price will also provide support as will further capacity reductions

• Sell HK Property – higher inflation means higher rates in the US and consequently HK. Global REIT indices

have retained their negative sensitivity to a rising US yield curve although HK property has lagged this trend

significantly vs historical precedents

• Sell Zoomlion – As discussed above, the Chinese property market is one of the most exposed globally to USD

funding. Higher US inflation, higher US rates, more costly USD funding. Zoomlion is already seeing working

capital pressure from its large extension of credit to Chinese property developers over the past few years.

Should further pressure come to bear c. 83% of their book equity could be at risk. Compelling to pair trade with

Lonking in our opinion (see ‘China – Fiscal vs Financial’ below)

� Con inflation trades

• Sell Angang – see ‘Inflation and the commodity cycle’ section below.

27NTAC:3NS-20


16. INFLATION AND THE COMMODITY CYCLE

While a stronger dollar is usually a headwind for the global commodity spectrum, in this instance this relationship

seems to have reversed in the short term. Interestingly however, recent broker upgrades have predominantly come

through due to the contention that current stock prices are not discounting current spot commodity prices rather than

any commodity price upgrades or contention that the outlook for the commodity complex may be anything other than

volatile over 2017 (effectively valuation upgrades rather than earnings). Most agree however that China will be the

most important driver of commodity prices over the year that follows (rather than the US) and the fact is that China is

actively trying to cool her property market. 34% of global copper demand is attributed to China (vs the next most

important country, the US, at just 4% of global demand) and 60% of this is attributed to the property market. While

Trump’s infrastructure plans are certainly a driver of sentiment, their impact to sustainable demand seem

questionable in the short term, particularly given lead times and the fact that China that consumes 40-50% of most

industrial commodities.

The excitement surrounding the global reflation trade has therefore not (as yet) been demand driven.

Chinese apparent commodity consumption (volumes) has been relatively benign

Relative strength in Chinese apparent steel consumption (volumes) will likely collapse with the property

market in 2017

28NTAC:3NS-20


17. LIKE COMMODITIES VS USD, SO TOO EM VS MINING HAS

BROKEN DOWN.

Much like the relationship between the USD and commodities, so too the relationship between Mining equities and

EM equities has broken down in the short term. This makes little logical sense unless we only think about the USD

rally in terms of EM debt risk and not in terms of self-sustaining commodity demand. This would suggest the reflation

trade (aside from the closure of commodity underweight) is more a financial reflation rather than a physical one.

Playing through Banks would therefore seem the trade. Either EM is due a rally or commodity equities due a

correction or a strong USD is a greater risk for global financial stability than headlines would suggest.

18. IRON ORE, COAL AND STEEL CASH MARGINS

In 2016 iron ore was driven higher by the steel price which in turn reacted to capacity cuts and some loosening. The

prior year (in 2015) however, over supply in iron ore caused prices to almost halve YoY. While the steel price may

get impacted from a falling property market in 2017 c.70mt of iron ore capacity are due to come online from Australia

and Brazil in 2017. We would therefore be cautious Iron Ore exposures over the year ahead, particularly on

strength.

The outlook for the coal price remains the key to many things in 2017 in our opinion. Firstly, coking coal will

likely drive the outlook for steel cash margins (currently expected to recover) and secondly (as we will explain later

in this note), contrary to popular belief, it has been the coal price that has been the main driver of the recovery in

China’s economic releases in the past 6 months. Despite short term weakness in the coking coal price following its

large 2016 rally, inventories remain close to trough levels and the domestic Chinese coking coal price is still at a

significant discount to imports. As such, coking coal may well remain a drag to Chinese steel cash margins over

2017 particularly should a cooled property market cause any weakness in the steel price.

29NTAC:3NS-20


Chinese HRC vs steel cash margins

19. CHINESE PROPERTY AND THE USD - DOUBLE DOWNSIDE TO

STEEL, DESPITE RECENT UPGRADES.

The last property cycle saw steel demand shrink from +9.2% YoY growth in 2013 to -5.5% YoY in 2015 according to

Mysteel yet consensus expectations are for the decline in steel demand to be just 2% YoY over the next two years,

despite concerted efforts for the Chinese to cool their property market. Construction accounts for 50% of Chinese

steel demand (c360mt) and fell by 6% in 2015. Demand from this segment has continued to fall by 2% YoY each

year since, despite the property boom and expectations are that this rate will sustain. There are significant downside

risks to this in our opinion. Should steel demand follow prior trends of a tightening steel market this could shave

c.21mt from steel demand which accounts for 50% of the capacity closures targeted for 2017 (45mt the same as

2016), which is causing the current short term excitement in the steel market. Despite excitement to the contrary,

pricing power produced by the merger of Baosteel and Wuhan will be unlikely to extend to the like of Angang also.

Together the merged companies account for 60% of the autosheet market and 85% of the silicon steel market in

China vs Angang at just 12% (the same size as net imports) and 4% respectively, meaning the consolidation may

have actually reduced their competitive positioning.

As mentioned above also, the Chinese property market is by far the most exposed sector to credit risk of any further

USD strength, so the USD may be presenting a double downside for the steel price currently should historic

USD/commodity relationships normalise and funding risk rear its head for the Chinese property sector alongside

renewed capital outflow pressure.

Sell Angang and Zoomlion.

30NTAC:3NS-20


20. COMMODITY PRICES AND CHINESE SPECULATION –

SPECULATIVE PRESSURE IN 2017 COULD HAVE POLAR

IMPLICATIONS

The Chinese government are currently in the process of trying to curb foreign outflows (see exchange reserves),

while dampening speculative commodity trading (see recent curbs on margin finance) yet still constraining physical

commodity capacity - a very difficult balancing act. While trying to determine how much of the recent steel price rally

has been physical demand vs speculative it is important to note that the moves in steel have been followed by the

iron ore price (thus the still depressed cash margin) which has doubled in the past 12 months. As an illustration of

speculative flow (although curbing illegal steel production may increase demand for iron ore), the rally in iron ore has

come despite inventories near peak historic levels in China, new supply coming on next year and most analysts

expecting the price ‘death knell’ in October. Over less than two weeks in November, the value of daily transactions

on China’s three commodity exchanges more than doubled to peak at USD 226 billion on November 14th. While this

surge was instigated by a Trump win, it has been propagated by the fact that China has been actively cooling the

property market, capital outflows and wealth management products. There are few other places for capital to flow,

particularly as the Chinese property market may see a top in 2017.

Speculative pressure in 2017 will likely move away from commodities and the property market leaving only two

routes left open – offshore flows or domestic credit and equity demand, with starkly divergent implications.

Should offshore flows continue concerns may once again rise over RMB weakness in 2017 (Sell Nine Dragons and

Zoomlion) or given the government’s recent focus on deepening the capital market further (Shenzhen Connect,

fiscal bond market expansion, opening of the CDS market and encouragement of Insurance companies to utilise

cash reserves) this newly fluid capital may be encouraged into finding a new home in more varied investments.

Generally these deeper capital markets are ultimately designed to underwrite China’s historic NPLs and better

delineate risk and allocate capital. In a year where Chinese Bank NPL pressure has begun to wane (showing the

slowest growth in five years) and the beginnings of the collateralisation of NPLs has begun (a vehicle which

ultimately cleared the NPL balance during the last cycle) the outlook for the Chinese Banks in 2017 will likely be

much improved. With some of the best dividend yields in the region and some of the largest underweight positioning

they will likely attract significant capital flow either into their equities or more directly into any NPL sales over 2017.

In the context of the Shenzhen Connect (and the implications for equity speculation following the Shanghai Connect

in 2014) it may be worth noting that A share market turnover and margin balances began to rise following property

tightening measures in October 2016 and picked up further following the tightening of restrictions on cross border

purchases of various savings-type insurance products in HK the same month. A falling property market and

tightening of cross border flows may consequently see increased equity market investing in China in 2017. More

generally, the rise of global inflation (both in the US and in China) should make China’s domestic (non USD

denominated) debt mountain less formidable and therefore her banks more attractive. (Buy Bank of China).

Companies : Bank of China, Nine Dragons, Zoomlion

31NTAC:3NS-20


THE WORLD’S MANUFACTURER HAS BEGIN TO EXPORT

INFLATION

21. THE WORLD’S MANUFACTURER HAS BEGUN TO EXPORT

INFLATION

� China has begun to export inflation just when Trump led potential tariffs loom – all is not quite

as it seems though. Chinese strength has been led almost entirely by coal and does not yet

seem self fulfilling. Consequently, China’s monetary position may loosen through the year,

against consensus expectations.

China has begun to export inflation as the PPI recovery is now well underway (after 54 months Chinese PPI

deflation has finally subsided). Important to note however that this has not been demand led rather supply and wage

inflation. Of these two factors the first would seem to have been of most importance. Looking at the detail of the PPI,

the sharp recovery in 2017 has not been driven by factory gate prices of either food or consumer goods. Indeed

China’s largest export (electronics) has neither seen a particular recovery in prices and one would assume this is

also the case when looking at China’s traditional low cost garment manufacture. Where this inflation has come from

has been entirely down to the commodity segment and (most particularly coal). While much of this will be down to

sustainable capacity removal, the fact that it has not been driven by a change in demand may give some insight into

how sustainable it is and the likely response of Chinese monetary policy.

Chinese PPI inflation (the first in 54 months) is almost entirely down to coal.

These results are also reflected in the recent strength in Chinese Industrial Profitability, the recovery of which has

been down (almost entirely) to the coal sector in the last six month. The quality of the current Chinese economic

strength is therefore questionable currently in our opinion.

The proportion of Chinese Industrial Profits coming from ‘mining’ has been steadily increasing in recent months,

reaching 61% in October (vs a long term average of 10%). Given recent moves in commodities, this move may seem

obvious, however, contrary to popular sentiment, China’s IP has not been driven by ferrous or non ferrous

commodities, but following an oil led recovery in the 1H 16 (Oil Extraction within ‘mining’), the last three months has

been down to one single sector - Coal.

NTAC:3NS-20 32

Source: NBS, NTCM

One must therefore question the sustainability of China’s apparent economic strength, in our opinion,

particularly as the recent strength in the coal price has been purely a supply response (bottlenecks) rather

than any change in underlying demand. Chinese Industrial Profits will look very different indeed should the

coal price correct.

Even recent PMI strength has been of a lesser quality. The end of last year saw the largest beat in PMI since

the beginning of 2012 (and the 3rd largest beat for the Caixin survey) but importantly these were largely

driven by expectations of price increases. Normally price expectations within the PMI come alongside

improvements in ‘business expectations’ as a function of improved future demand. Currently however

expectations on price is diverging from ‘business expectations’ for the first time in nearly three years. The

PMI is not therefore necessarily pointing to a change in the outlook for demand, but more likely pointing to a

change in potential inflation.

Chinese Price PMI (white) and Price vs Business Expectation PMI (yellow)

Source : Bloomberg

The inflation that China has begun to generate would seem therefore to be ‘cost push’ rather than ‘demand

pull’ and as such we would be exposing portfolios to Chinese ‘reflation’ not through the commodity stocks,

but through the financials for whom credit risk will continue to be eroded at the margin and who should also

benefit from any loosening of monetary stance throughout the year. Recent price rises in China have in fact

been more to do with Chinese margin pressure due to wage rises than any improvement in demand (link).

CPI in China affects corporate costs while PPI impacts sales prices predominantly. This PPI recovery

therefore benefits Chinese corporate ability to pay back debts and given much of the PPI strength is down to

NTAC:3NS-20 33

coal, the credit risk in this segment would seem mitigated at the margin currently. Having said this it is the

property developer sector that accounts for the largest credit risk for China (alongside steel) and increasingly

as the USD appreciates. The currently PPI strength is unlikely to provide much respite for these sectors

unfortunately.

Companies : Buy Bank of China (3988 HK); Sell Angang Steel (347 HK)

22. CHINESE INFLATION AND A STRONG USD MAY DRIVE A

SURGE IN ROBOTICS IN 2017

As mentioned above (see ‘The world’s manufacturer has begun to export inflation’) recent price rises in

China have in fact been more to do with Chinese margin pressure due to wage rises than any improvement

in demand (link). With China approaching her economic ‘Lewis Point’ and with stated goal to climb the

manufacturing value chain, the country has begun to heavily invest in R&D (see’ Autonomous vehicles –

the route to China’s rebalance?‘) in an effort to become a technological powerhouse in areas such as IoT,

AV and others over the next decade. With the potential further consolidation of President Xi’s power following

this year’s Congress (see ‘Chinese reform momentum builds despite the approaching Congress.‘) and

the potential pressure presented by Trumpenomics (see ‘Asian Trumpenomics’), 2017 may see renewed

momentum in areas of technological advancement such as robotics as China speeds up reform in an effort to

protect margins, mitigate wage inflation (even with the fastest ageing population on the planet and a peaking

workforce) and as a strong USD puts Chinese corporates under renewed financial pressure (see ‘Is a strong

USD posing a global risk?’).

Last year China made robotics a focus for its industrial policy, aiming to have 150 robots for every 10K

factory workers (3 X the current ratio) and to produce half its own robots by 2020. Even on 2017 estimates,

the number of robots per industrial employee in China will remain nearly 10X lower than the levels currently

seen in Japan and Korea.

Local governments have begun to offer subsidies to companies who buy or build robots and as China looks

to jumpstart its own robotics industry, M&A is at the forefront of their plans with Midea recently approved to

become the largest shareholder of German industrial robot manufacturer Kuka. The president of Japan’s

Yaskawa Electric was also recently quoted in an interview that he “worries his firm might be the next

takeover target” (Bloomberg) although also noting that any strength in the demand for robots globally is a

positive for them given that 50% of their sales come from components for sophisticated motors used by their

competitors also. The company plans to double their revenue over the next 10 years and plans to increase

capacity from 3K to 5K units per month “within the next few years”, with its first overseas robot plant opened

in Changzhou, China in 2013.

NTAC:3NS-20 34

China is currently the world’s largest buyer of robots (with their cost of labor rising 3X faster than other Asian

manufacturers) but has little robot manufacturing capability currently with almost all industrial robots globally

built by just four companies; Switzerland’s ABB, Germany’s Kuka (the smallest of the four), Japan’s

Yaskawa and the largest; Fanuc.

Companies : Midea (000333 SZ), Yaskawa Electric (6506 JP), Fanuc (6954 JP)

NTAC:3NS-20 35

ASIAN TRUMPENOMICS

While many of President Elect Trump’s domestic policies are being taken well by the market it is his

diplomatic stance (particularly wrt China) that could cause the most short term volatility in our opinion. While

introducing tariffs to Chinese exports may put China under some economic pressure, the likely outcome of

his cancelation of the Trans Pacific Partnership (TPP) could (in our opinion) easily turn into the biggest own

goal his government could make, significantly increasing Chinese influence in the region.

A Trump government could therefore become negative for the Asian Apple supply chain at the margin while

supporting many of China’s OBOR stocks and those exposed to the financing and expansion of China’s intra-

regional ambitions. Separately, the scrapping of the TPP may put one of the world’s largest auto

manufacturing markets (Japan) under further pressure (in addition to that being felt due to AV and Peak Car

trends) and Trump’s efforts to reverse the last 10 years of globalisation may further exacerbate global risks

by pressuring the offshore USD funding market still further over 2017 with significant implications for the

global risk premium (as explained above)

23. CHINA’S “CURRENCY MANIPULATION” AND US CASH

REPATRIATION

Although Trump has revealed plans to label China a “currency manipulator”, as mentioned above, China’s

“currency manipulation” has not been to the benefit of their general trade. Rather the weakness in her

currency has been specifically against the USD (a financing risk to China rather than a trade benefit) and

could therefore to be argued to have been more a reflection of USD strength (and Eurobond shortages) than

specific targeting by the Chinese (see above). Given that Chinese trade currently makes up just 35% of GDP

(down from c. 64% at the time of the GFC and similar to levels last seen 16 years ago) targeting Chinese US

exports may not have the impact Trump hopes it might. Of China’s trade, by far the largest export component

is electronic goods (smartphone supply chain etc) and overall the US is only China’s 4th largest trade partner

(just 18% of exports and 9% of imports). Targeting Chinese exports to the US may consequently have the

greatest impact to the margins of the largest companies in the US market (Apple etc) rather than to the

Chinese economy as a whole. Add to this Trump’s plans to repatriate foreign cash balances of these self-

same corporates and 2017 could be an interesting year for some of the largest US listed companies.

NTAC:3NS-20 36

The repatriation of USD 1.7t of offshore cash balances (Moody’s estimate) is seen by many as a positive

move, particularly on the assumption of higher shareholder pay-outs as a consequence and while some

believe that this move may further support the USD, the reality is that many of these funds are already held

offshore in USD. As discussed earlier, there is a distinct difference between the on and offshore USD funding

markets and supply and demand factors in each have vastly different consequences. This repatriation of

USD may therefore have less effect on the direction of the USD than it does to the potential further

destabilisation of the Eurobond market and as such significantly increase global risks (as seen just prior to

the GFC).

While the headlines of Trumps policies seem a cohesive stance on anti-globalisation and domestic

manufacture, the reality is that many of his policies could prove contradictory and certainly destabilising.

Trump’s tag line of “Make America great again” and “… Made in America, by Americans, for Americans” is

unapologetically anti-globalisation, but many American profit margins depend on the outsourcing and foreign

manufacture that globalisation has brought in the last 10 years. This from our highly regarded Head of TMT

Neil Campling; “…Apple (for example) is a poster-child for globalised manufacturing and distribution. It has

fragmented production parts, outsourced manufacturing and diversified operations across numerous

countries to generate maximum possible benefits of internationalisation and globalisation. Such a strategy –

in which Apple is far from alone – leverages favourable manufacturing conditions wherever in the world they

may be found as a means to generate more profit – lower costs of production, greater economies of scale,

more bargaining power through concentrated procurement, etc. Geographical dispersion enables

multinationals to take advantage of lower local input costs. Apple’s value chain loops in investment-friendly

government policies in Ireland all the way to cheap and highly productive labour in China. It is a tangible

example of an internationalised company.”

Given, for example, Bloomberg Intelligence’s estimates that Foxconn produced iPhones in the U.S. could

easily cost 30% more than current production we feel the risks for the Apple supply chain in Asia over 2017

could significantly outweigh recent excitement surrounding cash repatriation.

NTAC:3NS-20 37

24. IMPLICATIONS OF THE DISSOLUTION OF THE TRANS

PACIFIC PARTNERSHIP (TPP)

Trump has confirmed he is to quit the Trans Pacific Partnership on his first day of office. Withdrawal of the

TPP was the very first item on Trump’s new list in fact (link) and importantly, does not require congressional

approval to be scrapped . The 12 countries in the TPP cover 40% of the world’s trade economy (BBC) and

are; US, Japan, Australia, Malaysia, Vietnam, Singapore, Brunei, New Zealand, Canada, Mexico, Chile and

Peru. There are some substantial stock implication of this event in our opinion, but importantly (although the

TPP was never a surety and was used mainly as a blocking mechanism for Chinese regional influence) the

confirmation it is to be scrapped is already having a significant impact to the diplomatic power base in the

region.

TEXTILE MANUFACTURING AND VIETNAM

As part of the TPP, Some 18,000 tariffs were due to be removed; immediately for some including textiles and

clothing. According to a study from the Petersen Institute (link), Vietnam was due to be the biggest

beneficiary of the TPP, due to strong trade with the US, high protection abroad against apparel and footwear

(Vietnam’s principle exports) and increasing competitive advantage from China’s traditional low value

manufacturing. The TPP was expected to provide a 10% boost to Vietnam’s economy by 2025.

Sell Li & Fung (494 HK) (the world’s largest sourcing firm) has recently been moving manufacturing to

Vietnam which now accounts for c.7% of their sourcing base (their second largest behind China) and the shift

to Vietnam has been a key part of Li & Fung’s future strategy, particularly as China reaches their economic

Lewis point and has now begun to export inflation. Continual earnings downgrades of the last 4 years have

stalled in the last three months, but we believe the downward trend will continue putting the company’s

current 12X PE (in line with its three year average vs a trough of 10X) under further pressure.

“…we are the biggest exporter out of Vietnam” Li & Fung’s Spencer Fung - Q4 2015 Earnings transcript

when describing the benefit of the TPP to Li&Fung.

Other manufacturers with high exposure to Vietnam include Yue Yuen (551 HK), Stella (1836 HK), Pacific

Textiles (1382 HK) and Shenzhou (2313 HK).

CARMAKERS AND JAPAN

Carmakers may also be under pressure on the scrapping to the TPP as some of the world’s largest car

makers are based in Japan (Toyota and Honda) and would no longer attain cheap access to their largest

market (the US). This at the same time as they are facing the largest disruptive threat the industry has ever

known (AV) and the largest marginal growth market (China - at 70% of global auto sales growth each year

since 2008 and 28% of global auto sales in 2015) is leading the race for the full roll out of AV aiming for 10-

20% of cars to be AV by 2025 (China’s Auto Industry commission link). The scrapping of the TPP could

directly accelerate the demise of the world’s largest car makers and with Sino/Japanese relations poor at

best, the consequential shift of regional economic power back to China could be particularly damaging for

Japan. Sell Aisin Seiki (7259 JP) / Buy Denso (6902 JP)

AGRICULTURE, WINE AND AUSTRALIA

According to the Office of US Trade (link) the five largest import categories for the US from Australia are:

Meat (beef, sheep) (USD 1.5 billion), Precious Stones/metals (USD 93.8 million), Optic and Medical

Instruments (USD 695 million), and Ores, Slag, Ash (uranium, titanium) (USD 613 million) and wine and beer

(USD 499m). Under the TPP 98% of the taxes on dairy, sugar, wine, rice and seafood would have been

eliminated.

With 45% of revenue coming from the US (their largest region) and 47% of assets residing in the US, it may

be worth flexing your assumptions on Treasury Wines (TWE AU), particularly as at 28X they remain very

close to their valuation peak as earnings upgrade momentum has waned in recent months.

NTAC:3NS-20 38

A SHIFT IN REGIONAL INFRASTRUCTURE AND CHINA

The biggest winner of the scrapping of the TPP would seem to be China with both its regional trade deal

alternative, the Regional Comprehensive Economic Partnership (RCEP) (which received renewed focus at

the Asian Economic Cooperation summit in Peru last weekend), and its massive and expansive One Belt

One Road (OBOR) initiative. According to Reuters yesterday China, Japan and South Korea are already in

the initial stages of discussing a trilateral trade deal, and Beijing has been pushing its own limited Asian

regional trade pact that excludes Washington for the past five years supported particularly through The Asian

Investment Bank (AIIB) (see prior notes). The AIIB commenced lending this year with China’s OBOR

programme being funded by 3 separate financial; the AIIB, the NDB and the Silk Road Fund. Taken together

these institutions will have USD 240bn in capital giving them a funding ability close to USD 800bn. This

amount of capital makes only the IMF a larger global financial institution with USD 300bn in capital (the

World Bank has USD 223 and The Asian Development Bank has USD 165bn). Buy Zhuzhou CRRC (3898

HK) and China Communications Construction (1800 HK)

NTAC:3NS-20 39

CHINESE REFORM MOMENTUM BUILDS DESPITE THE

APPROACHING CONGRESS.

The 19th National Congress of the Communist Party of China will be held in the Autumn of 2017 during

which the new leadership of the party will be elected. The approach of this political event should focus the

Chinese policy makers towards a period of stability over the course of 2017 (one of the reasons we think

recent tightening biases may be relaxed over the year as supply side factors begin to roll off and some

surprise marginal loosening may become apparent over the year – see ‘China has begun to export

inflation’ above). Given the current age of many Committee members however, Xi Jinping’s appointments

should give a strong indication of his ability to consolidate his power further and so give some insight as to

the pace of reforms to come. The new appointments made in the weeks following the politically important

Beidaihe summit last year, certainly indicate this consolidation of Xi’s political power has some further

momentum currently.

Xi is currently regarded as China’s strongest leader in 40 years (since Deng Xiaoping) with a grip that

extends from political to military and civil control, particularly following the political purges and consolidations

of recent years. With this in mind it is important to understand Xi’s focus on the policy front. The power

struggle between the State Council (responsible for the day to day running of China and headed by Premier

Li Keqiang) and the Standing Committee seems to be reaching a zenith with large implications for reform

momentum to come in our opinion. Historically it has been the State Council that has fuelled the debt led

growth of recent years and they have been strong proponents of the now defunct policy of targeting the

equity market as a positive feedback for the economy as a whole. In recent months, frustration has grown

from the Xi led Standing Committee over the management of the economy however with an article in the

People’s Daily in May said to have been directly authorised by Xi and warning of the dangers of Chinese

debt fuelled growth.

With this renewed political focus it is important to note the increased reform momentum of recent months

despite the approaching Congress (particularly in the areas of the derisking of credit (CSD market instigation,

fiscal bond expansion, Shenzhen Connect and NPL collateralisations), the opening up of the Chinese capital

markets (not least through the Chinese Insurance liberalisation of recent months) SOE reform, capacity

consolidation and mixed ownership reforms). We believe this recent focus is a strong signal for reform

momentum to come in the year ahead. Particularly on SOE and mixed ownership reform, Energy reform,

Social Security reform and the potential final clearing of Chinese credit risk.

25. MIXED OWNERSHIP REFORM AND THE CONSOLIDATION

OF CHINESE XCOMMERCE

China Unicom surged >11% in just 2 days in December following unconfirmed reports from Chinese news

outlet The Paper that they are to be the subject of a new round of mixed ownership reform involving Tencent,

Alibaba and Baidu. By way of context, it was reports of mixed ownership reform wrt Sinopec that saw

PetroChina (the most liquid stock in Asia) rally 33% in 1 month in 2014 and back in March China announced

10 Trials for SOE reform including M&A, restructuring of SOEs and mixed ownership reform (Xinhua citing

SASAC deputy director Zhang Xiwu) with most likely candidates alongside China Unicom (762 HK) being

Petrochina (857 HK), CNBM (3323 HK), Bank Of China (3988 HK), Zhuzhou CRRC (3898 HK) and China

Agri (606 HK).

While details are yet to be announced, different from past rounds of mixed ownership reform there may well

be significant synergies from this strategic tie up. Unicom is already collaborating with Alibaba, Tencent and

Baidu on mobile internet, AI, Autonomous vehicles, big data, IoT, security, credit referencing, IDC services

and cloud computing and as we have long discussed, these are the absolute backbone of Chinese

rebalancing. China is already ahead of western markets in this regard with Tencent (for example) already

owning the entire xCommerce environment (with the launch of the “little program” not even applications are

controlled by third parties). Any tie up with Unicom would only streamline that control, further lowering the

hurdles to China’s emergence as the first fully connected economy. While hard to value currently with few

NTAC:3NS-20 40

details as yet, the implications must surely be profound in our opinion, not least for Unicom that should enjoy

the benefit of enriched mobile Internet service data demand.

China Unicom’s net subscribers are finally building momentum towards 4G

Source: Bloomberg

We have long been highlighting the importance of China Unicom to the ongoing rebalance of China and their

continued leadership in their fully integrated xCommerce strategy (Continued Chinese rebalancing –

eCommerce is only just beginning Jan 2016 and China is leading the world in omni-channel retail (according

to most global retailers), their importance in China’s strategic move to autonomous vehicles (Unicom has

been a member of both our peak car and connecting china basket since 2015) and their credentials within

SOE reform (Unicom have the most to benefit from last year’s tower consolidation (The first mover in SOE

reform Buy Unicom) and particularly mixed ownership reform. Having been sellers of Unicom in Aug 2014

(Chinese Telco competition is telling), we admittedly moved buyers too early during 2015 as the company’s’

obvious SOE reform credentials were subsumed by their failure to shift their subscriber base quickly enough

to 4G (one of the reasons the company traded on a discount to the sector – China mobile remains 4G

dominant – unsustainable and priced in). Although this discount has (over the course of this year) declined,

on just 4X EV/EBITDA, China Unicom remains one of the cheapest telcos in the world and momentum is

beginning to build with their shift to 4G (likely supported by this tie up).

China’s shift to consumerism will likely be driven by a handful of consolidators who already have dominant

positions. More importantly however, it also means China’s technological advancement is likely to be far

faster (and cheaper) than will be seen in Western nations. This tie up alongside already present

collaborations puts Unicom firmly in this club in our opinion. Aside from the collaborations mentioned above,

Unicom recently joined with Internet-of-Things specialist Jasper to target the connected car market,

promising a rapid time to market for automakers. The two are launching China Unicom Smart Connection, a

venture that will provide for auto manufacturers to have a single provider to enter China’s connected car

market. The solution (available today) is an end-to-end service and operations platform built on Jasper’s

China Unicom Control Centre.

2017 should provide further catalysts for the company also with China Tower’s Chairman last month

confirming he is keen to pursue a separate listing by the end of 2017 in an IPO that is widely believed to

benefit China Unicom the most (see prior notes). The company is estimated to fetch between RMB 215b and

RMB 350b on listing with Unicom having a 28% stake.

Buy China Unicom (762 HK), Tencent (700 HK) and Baidu (BIDU US)

NTAC:3NS-20 41

26. MIXED OWNERSHIP MOMENTUM BEGINNING TO RE-

CATALYSE ENERGY REFORM IN 2017

As mixed ownership reform begins to gain momentum once more SinoPec (one of the largest original mixed

ownership candidates) announced mid-December it is to sell half their natural gas pipelines linking Sichuan

province to central and eastern China for 22.8b RMB. Trials announced through Xinhua last year for SOE

reform including M&A, restructuring and mixed ownership included Petrochina as a likely candidate and (as

such) 2017 may see renewed momentum in the consolidation and improved efficiency of China’s energy

value chain. By way of context, it was reports of mixed ownership reform wrt Sinopec that saw PetroChina

(the most liquid stock in Asia) rally 33% in one month in 2014 and similar stories of pipeline sales caused

significant outperformance on numerous occasions over the past two years.

The implications for any confirmation of pipeline sales are far more significant for PetroChina than for

Sinopec with an asset value close to USD 87b, 66% of its H-share market cap. The PetroChina Pipelines

Company (created at year end 2015 of which PetroChina owns 72%) has an appraised value of Rmb281B

(USD 41B), 32% of its current market cap leading to our belief that the market is giving PetroChina’s

pipelines essentially no value. A large deleveraging though a pipeline divestiture should unlock substantial

shareholder value, helping to re-focus PetroChina’s balance sheet that has struggled with inefficient

investment over recent years and paying down project debt (set to become more expensive as the US yield

curve steepens further – Energy is by far the largest USD debt holding sector in China currently). With a

steepening USv yield curve, balance sheet efficiency will likely become increasingly pressing over

the course of 2017.

Additionally, Petrochina’s correlation to Oil remains among the highest in the region and although concerns

persist on their ability to retain production given recent capex constraints, on the impact of high cost imported

gas and the ongoing inefficiencies of their asset base, the fact is that the stock trades on an all-time wide PB

discount to SinoPec. Many of the negatives would seem in the price and as such, PetroChina should benefit

fully on any recovery in the oil price from here, let alone on any further confirmation of SOE reform.

Petrochina remains at a historically wide PB discount to SinoPec that we believe is unjustified

currently.

As mixed ownership reform is currently connecting to energy reform, so too energy reform is connecting to

Insurance and Pensions reform as China Life Insurance is set to buy 43.86% of Sinopec’s pipeline helping

to utilise their own excessive cash balances into higher yielding annuity type assets.

NTAC:3NS-20 42

27. INSURANCE AND PENSIONS REFORM – UTILISING CASH

DEPOSITS DOMESTICALLY – A PROFOUND SHIFT

Historically China has effectively ‘exported’ their vast domestic deposits to the US consequently holding the

RMB cheap, supporting their physical exports and underwriting globalisation. In a post Brexit, post Trump

environment in which globalisation is targeted to reverse and in which trade may become significantly less

stable, China’s focus towards domestically driven demand and the better utilisation of their own cash

reserves will likely heighten still further over the course of 2017. The impetus for China to rebalance has

only increased in the last six months.

The renewed reform momentum of recent months suggests China may be aware of this shift and it is with

great interest that we have watched numerous Insurance Industry reforms enacted in the 4Q 2016. In

November, unconfirmed Bloomberg reports sourced from “a CIRC official” spoke of the potential imminent

launch of tax deferred policies that could cause “explosive growth” according to the source. This as

mainlanders were already buying a record amount of insurance products.

These reports came just months following the announcement from the CIRC (China Insurance Regulatory

Commission) that a new channel had been opened for insurers to invest in the H share market through the

Shanghai link to help boost investment returns. New route for mainland flows announced. Regulatory news

flow would seem to us to be suggesting increasing focus towards attaining appropriate yields for

underperforming Chinese assets and the deepening of Chinese capital markets, both of which have profound

implications for an insurance sector that is trading at PB levels that (until this year) had not been seen since

2005.

As we discussed at the time, during 2015’s Plenary sessions, the reform of China’s Insurance and Pension’s

industry were of prime importance with no less than 2 sessions focusing on the proper utilisation of China’s

truly vast (yet inefficient) cash balances in order to increase investment yields to cover the looming liabilities

presented by the fastest aging population on the planet (and a peaking workforce). The implications of this

potentially huge reallocation of Institutional resource cannot be overstated, particularly in a period where

expectations of investment returns are so low and the investment options available are so limited (foreign

outflows are being constrained, the property market is being tightened and the government is encouraging

the deepening of the capital market and private participation in infrastructure funding). See Chinese domestic

Institutional demand primed to increase. and The link between financial reform and SOE reform – putting

China’s shift to social security into perspective.

While many assume a steeper US yield curve may have underwritten recent strength in the secto, the reality

is that neither the US yield curve nor the Chinese yield curve tend to have as much influence on the sector

as is the case in more developed markets. China is, after all, a supply side economy with an equity market

less driven by interest rates than broad moves in government policy. What tends to move the Insurers is

expectations of an improvement in their investment book (the stock market), particularly if reform driven

(SOE reform and the deepening of the stock market) and a change in the outlook for new business wins.

At a time when the government is trying to encourage the participation in social security and the

improvement of investment yields while (as discussed above) the range investment options available is

NTAC:3NS-20 43

continuing to shrink (potentially underwriting equity demand in 2017) the real drivers of historic Insurance

sector outperformance may have shifted profoundly for the year ahead.

At 1.73X PB China Life (2628 HK) remains below its 2014 trough valuations, let alone anywhere near its 3X

peak. With a potential step change in the demand for policies and a shifting outlook on potential investment

returns we would advise investor to buy.

28. 2017 COULD PRESENT THE ULTIMATE SOLUTION TO CHINA’S

CREDIT PROBLEM.

Although the ever present argument of Chinese asset quality remains, the fact is that (alongside the above

developments) China has also been making inroads into the proper pricing and insurance of credit as part of

their deepening capital market efforts (Chinese CDS market begins – insuring credit risk) potentially

underwriting the demand for NPL sales and better pricing risk for the proper allocation of future capital. This

at the same time as Chinese Bank NPL pressure has waned (Chinese Bank NPLs flat on the quarter). As

mentioned above (Chinese reform momentum builds despite the approaching Congress), credit risk

remains a key concern of Xi Jinping and as his political power continues to build into this year’s congress and

the control of the State Council (responsible for the credit fuelled growth of the past) becomes diluted, 2017

may see a step change in the already begun process of NPL clearance in China.

Indeed, the next financial work conference (1Q 2017) may well confirm the same NPL collateralisation

solution that ultimately cleared the NPL balance during the last cycle (currently almost identical in value),

while also defining the bottom for equity valuations (significantly higher than current levels). Given that NPL

collateralisations have already begun and more freely flowing capital markets are lowering investment

hurdles for NPL sales and fiscal credit solutions, 2017 may well be the year that this solution is ultimately

enacted.

Securitisation of NPLs was the solution to the last NPL crisis removing 705b RMB of NPLs and

defined the bottom in valuations despite significant capital raisings.

Source : Bloomberg

Although this potential is gaining in likelihood, the Chinese Banks remain some of the largest and most under

owned exposures in the region a situation that only increased over 2H of last year (see Is this the final

‘taper tantrum’? EM implications) and they also continue to express some of the best dividend yields in the

region (c.6%).

NTAC:3NS-20 44

The next question then becomes one of potential capital issuance (as the balancing factor to China’s NPL

strategies) and on this (in our opinion) China has multiple options including the issuance of non dilutive pref

shares or further NPL coverage reductions to mitigate any undue pressure. In fact, even in a worst case

scenario should NPLs spike from their current 1.6% to 4.1% in a single year there will be no further

requirement for capital raisings should provision ratios fall to 100%. Given current bank valuations imply NPL

ratios between 10-15% it is interesting to note that the capital required should NPLs spike to these levels in a

single year (3-7tn RMB) is still a very small percentage of current SOE cash balances, let alone should

coverage ratios be allowed to fall further than 100%.

To put this capital flexibility into further context; even with coverage ratios falling to 100% China would

remain a market with among the highest coverage in the world. EU member states with NPL ratios of 15%

only have coverage in the region of 50%.

Within a debt/equity swap programme also the capital pressure is less than many assume given the fact that

China ascribes differing risk weights to different loan qualities (in excess of Basel requirements) a fact that

can be seen with Chinese Banks having among the highest RWA/Total Assets in the world (65-70% vs 51%

in Asia, 58% in the US and 36% in the EU).

Having said this, should further capital raisings become apparent it is our opinion that these should be

relatively easy to digest (as was the case during the large capital raisings at the end of the last NPL cycle)

particularly given the large cash balances of Chinese SOEs (currently being encouraged to seek higher

yielding assets). Demand for equity was high at the resolution of the last NPL cycle once the demand for

Chinese NPL securitisations had been established. In this instance, the development of a functioning CDS

market is likely to make any potential securitisations significantly easier to swallow than in 2008.

The resolution of one of the largest global tail risks in recent memory coupled with potential policies that

could see one of the most liquid sectors in Emerging Markets double their profits should make buying this

sector compelling over the course of 2017, particularly at valuations below the GFC trough. Buy Bank of

China (3988 HK).

NTAC:3NS-20 45

29. SOME CONTEXT TO THE OFTEN QUOTED 15-19%

UNDERLYING NPL RATIOS

Depending on the environment, sector analysts periodically dust off their headline grabbing notes warning of

10-15% underlying NPL ratios in China. While there are various ways these figures can be derived, it is worth

highlighting exactly what assumptions are required to reach this conclusion and bearing in mind that (even

should underlying NPLs be at these levels) in our opinion, they will never be realised in China. Reforms will

be enacted well before the NPL ratios currently being priced by Chinese Bank valuations ever become reality

in our opinion.

In any case, the reality of 10-15% NPLs are as follows:

• The 15-20% NPL ratios are based on interest coverage ratios and assume the implicit guarantees of

SOEs are entirely removed. Chinese Banks adhere to Basel regulations and in fact have a more

conservative risk adjustment than Western Banks when taking into account the guarantees of SOEs.

So the difference between 1.6% NPL and 15-20% NPL is purely down to implied guarantees

• The majority of cash is held by relatively few SOEs, while systematic credit stress is with a large

number of small inefficient loss making companies that need to be closed down. 10-15% NPL ratios are

derived utilising interest coverage ratio averages which overweights the liabilities of the many while

underweighting the assets of the few

• Should all of the 15-20% NPL ratios hit at once it would imply a cost of 6.8-10.6tn RMB (vs SOE cash

balances (that underwrite the economy) of between 50-100t RMB depending on the economic

estimates you use). The large Chinese Banks alone have cash balances .in excess of 30t RMB (due to

the highest RRRs ratios in the world, no longer required due to likely shifts in the USD/RMB dynamic

(see RMB devaluation is a function of USD strength) and a rebalancing economy)

• Should NPLs rise sharply to 5% in just 1 year, if the banks lower their coverage ratios to 100% and

utilise their current capital buffers there will be minimal requirement to raise new capital

• The majority of NPLs on the above analysis come from small property developers (property market is

stabilising at the margin) and inefficient, small non profitable steel and coal companies that the

government is keen to close. Property has seen a large bull run in the last 12 months and steel and

coal are seeing a large supply driven recovery currently

• Chinese NPL growth is currently the lowest it has been since 2011. last week’s note)

Our view remains that current marginal credit stress has a greater impact on likely reform announcements

than the imminent beginning of an uncontrolled credit event.

Buy Bank of China (3988 HK)

NTAC:3NS-20 46

CHINA – FISCAL VS FINANCIAL

Despite the fact that China’s monetary stance may loosen throughout 2017 due to the rolling off of some

supply side factors that have caused economic figures to look robust (as explained above in ‘China has

begun to export inflation’), the reality is that the PBOC are likely to keep the monetary environment stable

and prudent in the year ahead. That being said, as the tightening of property policies begin to weigh on a

sector that accounts for some 30% of GDP and who’s service industry has accounted for the majority of

China’s shift to tertiary industry as part of their ‘economic rebalancing’, the need to stimulate will remain high

in 2017. Fiscal and particularly infrastructure investment growth is therefore likely to be of prime importance

over the year, most particularly (in our opinion) within the railway sector. The ‘Pledged Supplementary

Lending’ (PSL) facility will likely be utilised to manage liquidity, consequently directing yet more money

directly into infrastructure projects. Chinese fiscal stimulation – buy infrastructure, sell property. Focusing

exposures to those companies primed to benefit from fiscal stimulation of infrastructure construction while

avoiding those exposed to an increasingly difficult property market, rising USD funding risks (see ‘USD

tightness – the new tail risk’ above) and rising working capital pressure should present significant

opportunity for alpha generation over 2017.

30. THE CASE FOR RAIL INVESTMENT – REBALANCING AND

R&D – ‘MADE IN CHINA’ MEETS OBOR

We have often highlighted the often missed precedent of China’s current situation to that of the ‘Great US

Urbanisation” between 1800-1900 and how (at similar stages of economic development (GDP per capita of

USD 9K USD pp in 2009 dollars)) the US had the same length of rail as China has currently (despite

significantly smaller land mass), before doubling it in 10 years from 1878 as GDP per capita rose by 50%

(please call or see prior notes for full context). Within this backdrop, as China approaches her economic

‘Lewis Point’ (becoming more service led with higher wages), continues to climb her value chain (now the

world leader in High Speed Rail) and rebalances her economy towards domestic consumption Chinese

domestic rail freight growth is currently at six year highs.

Chinese domestic rail freight growth is at 6 year highs.

Source: Bloomberg

NTAC:3NS-20 47

Following last year’s Plenum, China’s commitment to climbing the technological value chain through their

‘Made in China’ plan became more apparent and rail (particularly High Speed Rail) is an area in which Chia

is truly a global leader. Towards the end of October state media (People’s Daily link) reported that CRRC is

in R&D to develop ‘super’ high speed trains that would run at 600km per hour (as fast as test runs of Japan’s

(and the world’s) fastest maglev train) cutting travel time between Shanghai and Beijing down to just 2 hours.

At this speed London to Paris would take just 34 minutes. CRRC are also in development for high speed

cross border trains that will also support China’s ‘One Belt One Road’ plan while supporting steel demand as

China rebalances to domestic consumption. The momentum behind OBOR is only likely to increase over the

course of 2017, particularly following Trump’s win (see ‘Asian Trumpenomics’). China is also focusing on

the expansion of metro rail (particularly positive for the likes of Zhuzhou) with the 4Q approval of a USD 36

billion rail plan for cities around Beijing.

R&D (a strong area of government support currently) has also become a key feature in our highest conviction

rail infrastructure trade Zhuzhou CRRC (3898 HK), and this has caused the reality of their competitive

position to become somewhat misrepresented in their margins in the short term. This particularly as ZZCRRC

will benefit in the year ahead from the launch of standard electric MUs (new generation multiple units for

electric high speed rail).

In our opinion, recent weakness in this stock is a buying opportunity as China forges ahead with inevitable

rail investment in line their ‘Made in China’, ‘Going out’ and ‘One Belt One Road’ plans. Zhuzhou is investing

in the future with R&D expenditure (they have a history of profitable R&D over the past 10 years), are highly

cash generative with a strong balance sheet and are exceptionally well placed to capture the opportunity of

China’s future policy.

Additionally, Zhuzhou’s 1H 16 results were masked by currency related one offs (61m RMB) that (when

normalised) would have seen Zhuzhou’s profit come in +16% higher than the prior year for the seasonally

weaker 1H and in line with seasonally adjusted consensus expectations for the full year (accounting for 45%

of FY expectations). The 3Q has seen currency one offs roll off and (adjusting for the 1H), 65% of FY

expectations reached. This improvement in gross profitability and growth in core profit has come despite the

fact that in the 1H Zhuzhou spent 100m RMB more on R&D YoY, as they develop standard MU product

development for former CNR products that should prove a significant competitive advantage for Zhuzhou in

the medium term. The 2Q has seen similar inflated R&D expenditure that should provide a windfall in both

volumes and profitability in the year ahead as China’s plans to launch standard electric MUs (new generation

multiple units for electric high speed rail) in the months ahead. The instigation of this could see a doubling of

sales for MU and locomotive parts for ZZCRRC in our opinion, as it penetrates further into CNR sales as they

themselves shift towards electric HSR.

Even aside from ZCRRC’s potential market share win on the standard MU roll out, current MU density is

around 0.13 MU units per km of track in China (source: MoR). With the current rail expansion this would

imply around 1,500 new sets required at a run rate of 358pa over the next four years. Should MU density

trend towards the European average of 2X or 3X in Japan, the potential for growth could be greater still

however.

Buy Zhuzhou CRRC (3898 HK)

Another favourite stock for 2017, exposed to construction and rail is China Communications Construction

(1800 HK). CCC is mainly exposed to transportation infrastructure construction (increasingly rail). What real

estate exposure it does have is focused towards affordable housing. CCC may also be a primary beneficiary

of increased SOE reform momentum given they have been chosen as one of seven companies to trial state

capital investment company reforms. Back in November, CCC was linked with the construction of the

Malaysian East Coast Rail Link (costing USD 13b) further underlining CCC’ credentials as a beneficiary of

‘One Belt, One Road’ policy. With potential asset injections, CCC also have the added advantage of

competitive positioning in municipal rail investment going forward, an area we believe of primary focus for the

government and one that may highlight it as a unique asset for mainland investment. At 7.8X FY1 PE CCC is

among the cheapest of the construction companies despite having by far the best RoA and ROE profile and

at 0.87X, remains far below its 3X PB long term average. With by far the most diverse revenue stream of all

the construction companies and significant potential opening for them within the rail segment, we believe

(alongside Zhuzhou), CCC will represent a unique asset for mainland investor demand over the course of

2017.

Buy China Communications Construction (1800 HK)

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31. CEMENTING CHINESE GROWTH

As one of the poster children of Chinese excess capacity sectors, the Cement industry has shown good

strides in curbing that capacity over the course of 2016 with national average cement prices now beginning

to rise for the first time in over five years over the 4Q 2016. Cement inventories too are at trough levels last

seen in December 2013 and with renewed focus on infrastructure investment, SOE reform and capacity

consolidation, we expect the positive trends to continue.

North China is showing the strongest price momentum currently and as such BBMG (2009 HK) looks

interesting as the cheapest stock in the sector (5.6X PE) but with the greatest exposure to North China.

Anhui Conch (914 HK) should benefit most from a generally strong cement environment as the national cost

leader (16.5X PE) while CNBM (3323 HK) has a potential added catalyst of SOE reform and asset injections.

32. FISCAL EXPOSURE WHILE AVOIDING PROPERTY AND

FINANCIAL RISK

As mentioned above, focusing exposures to those companies primed to benefit from fiscal stimulation of

infrastructure construction while avoiding those exposed to an increasingly difficult property market, rising

USD funding risks (see ‘USD tightness – the new tail risk’ above) and rising working capital pressure

should present significant opportunity for alpha generation over 2017.

Buy Lonking (3339 HK) is one such company that is beginning to see the benefits of an unexpectedly early

cyclical recovery in wheel loaders (81% of sales and a highly consolidated market within China), which are

particularly exposed to infrastructure and mining rather than property construction. The recovery had been

partially delayed by the early cycle substitution of excavators that should reverse as the recovery takes hold

and their positive profit alert at the beginning of December could see significant upgrades come through for

the 2H. Loader sales are now beginning to turn from six months of YoY contraction and should the

substitution reverse, momentum could rise still further over 2017. Despite the challenging environment of

recent years, Lonking have managed to maintain a strong balance sheet and generate impressive operating

cashflows with healthy trends in working capital (unlike their peers). Also, unlike peers, Lonking has failed to

see a build-up in accounts receivable despite also seeing a high correlation to real estate construction over

the past 10 years, meaning funding and default risk is low should the property market correct. This sets it

apart from its peers. The cyclical recovery in infrastructure construction seems to be coming sooner than

many expect and could see Lonking gain significant market share as the recovery gains speed. Despite the

recent rally, at 1X PB Lonking still remains at the trough valuations of the prior cycle (2008/09) and far from

its 1.9X long term average. This is a company that should not only benefit from domestic fiscal policy, but

also from China’s OBOR plans that could get a further boost from Trump’s regional policies (see ‘Asian

Trumpenomics’). Buy

Sell Zoomlion (1157 HK) – Komatsu’s KOMTRAX index continues to imply resilience in the recovery for

Chinese construction machinery (strong all last year). Having said this, Chinese property tightening is now

beginning to show signs of taking effect as (although October showed still rampant price appreciation) the

NBS for the first time in history commented on the current month’s property environment, stating new home

prices have fallen 3.7% MoM in Beijing and that the broad market had “apparently cooled”. As discussed

above, efforts to cool the property market may converge with tightening of USD funding as the US yield curve

steepens and USD liquidity begins to bite (see ‘USD tightness – the new tail risk’) and nowhere is that risk

more apparent than in the Chinese Property developers (see ‘Is a strong USD posing a global risk’).

Zoomlion itself is heavily exposed to Chinese residential construction and we expect tightening here to

continue further exposing Zoomlion’s vastly inflated payable days vs peers and bringing real estate

developer default risk to the fore, potentially diluting 83% of Zoomlion’s current book equity. (Zoomlion – the

penny drops). Recent results from major global E&E players (such as Schindler) highlight the cash pressure

Chinese property developers are feeling already (link) and Caxin reported in the 4Q 2016 of the government

mandated removal of funding channels for this sector both nationally and internationally (link). Zoomlion is

also exposed to the risks of a weaker RMB (see ‘RMB devaluation is a function of USD strength – a risk

to funding not one of trade’ above).

NTAC:3NS-20 49

AV, BIG DATA AND XCOMMERCE

33. AUTONOMOUS VEHICLES – THE ROUTE TO CHINA’S

REBALANCE?

Autonomous vehicles may well be the elephant in the room for the ultimate rebalancing of China and recent

company collaborations (including but not limited to the mixed ownership reform between Unicom, Tencent,

Baidu and Alibaba detailed above (see ‘Mixed ownership reform and the consolidation of Chinese

xCommerce’)), suggests China is well aware of the opportunity not just within domestic manufacture, but

also in the ultimate rollout of fully connected xCommerce and subsequent opportunities from ‘big data’.

Indeed, nowhere globally are the competitive hurdles to provide multiple services so low (eg Tencent already

owns their entire online and social media environment vs the fragmented yet highly competitive service

offerings of the FANG companied in the West). IoT investment for example has been specifically targeted

within government policy as an area for support and in which China targets to lead the world by the end of

this Five Year term. Furthermore, the potential pressure on exports and funding that China may feel as a

result of Trump’s policies may even strengthen China’s resolve in utilising the global AV mega trend to bring

the Chinese economy more swiftly towards a domestic focus (as was seen with the solar industry following

the GFC). China has a history of fully committing to technological advancements more quickly than any other

nation if it is in their interests. Following the GFC for example, China targeted the solar industry coming from

nowhere in 2006 to having the same capacity as the rest of the world combined in solar wafers within just

three years, doubling this capacity again just one year later (PV News). In High Speed Rail, Japan was the

technological and capacity leader in 2007 but was matched by China within 1 year and by 2012 had the

same capacity as the rest of the world combined (International Union of Railways and FT). Currently, in HSR,

Chinese capacity is 1.6X that of the rest of the world combined and 7X larger than the next largest country

(Spain). China has now moved from reverse engineering to be a technological leader, beginning now to win

international contracts in competitive tenders. China also moved from the world’s smallest to largest

consumer of semiconductors within the space of two years, driven mainly by Integrated Circuit design

(PWC).

In an effort to move more swiftly up their value curve and avoid the middle income trap as they approach

their economic ‘Lewis Point’, China have to date announced an unprecedented USD 207b worth of M&A in

the last 12 months. They are also spending a similar amount on R&D as the US for the first time in history

and have recently changed their accounting rules to encourage R&D to minimise the impact to short term

profitability.

NTAC:3NS-20 50

It is for this reason (among many others) that we continue to expect full integration of IoT, AV, mobile

consumption and big data to happen first in China.

In our opinion, China has by far the most to gain from the full roll out of AV and the lowest hurdles. Nowhere

else are the environmental, political and economic benefits larger and nowhere else are the infrastructure

and corporate hurdles smaller with such large potential consumer synergies through ‘big data’. China has a

history of total commitment to large scale technological advancement and in 2017, we expect this to only

accelerate.

Buy Tencent (700 HK), Baidu (BIDU US), DeNA (2432 JP), Jiangsu Protruly (600074 CH), Mando

(204320 KS), Nexteer (1316 HK), Renesas (6723 JP), Sunny Optical (2382 HK) Tung Thih Electronics

(3552 TT) and Buy Denso (6902 JP) / Sell Aisin Seiki (7259 JP)

34. AV – THE FINAL STEP IN CHINA’S ‘BIG DATA’ CONSUMER

REVOLUTION AND A RISK TO GLOBAL OEMS

The car is not a car. The car is a platform, a hub, a service, an app, a captive audience. So says Lynk & Co

back in a company presentation from October and we could not agree more.

At the end of October Geely (175 HK) (which owns the Volvo brand) announced the first offering from Lynk &

Co, the O1, an SUV but what is most remarkable about it, and other future Lynk & Co models – is that ride-

sharing is baked into it. From the touchscreen inside, owners can opt to make the car available for sharing, to

be driven by random strangers who will access the service via an app and then gain entry to the car using a

unique digital key. Basically you get paid for letting other people drive it while you're at work. Why own, when

you can share for a fraction of the cost?

Ultimately if car-ownership is to fall in China, the impact to global OEMs would be significant. China made up

28% of global auto sales in 2015, by far the biggest country, and 70% of the growth in auto sales globally

since 2008 has been due to China. Surprisingly, at 80 vehicles per thousand people, China already has car

ownership similar to both HK and Singapore despite having significantly lower GDP per capita (according to

Tsinghua University) and multiple times higher than the car ownership seen in other countries at a similar

stage of development. This and tax incentives are set to roll off in December 2017, meaning YoY impacts will

be diluting from now.

NTAC:3NS-20 51

For Geely specifically, the upside (in our opinion) remains one of valuation unfortunately. Recent gains in the

share price have been due to capacity additions with commensurate earnings upgrades. Many of the cost

synergies have already happened, in our opinion, meaning further margin expansion may be difficult and

despite recent performance, the stock trades on average sector multiples. While this recent move from the

company should attract a premium valuation, there remain better exposures to this theme in our opinion, as

the sector approaches the zenith of supportive tax incentives.

What is most stark to us however is the fact that (as Lynk & Co allude) the shift to AV has multiple avenues

for economic growth made particularly valuable in a country with few competitive hurdles for platform

convergence and that is in the process of (and has a fundamental need to) rebalance to a domestically

driven consumption model. According to Intel, self driving cars will generate over 4,000GB of data per day,

each. In other words, one million connected cars will generate the same amount of data as 3B people. As we

continue to discuss, the competitive value right now remains with the data generators the business which

owns the relationship with the customer will be the ultimate winner. There’s probably only room for two or

three (as in mobile). FT "driverless cars will change everything" link.

As alluded to above, China remains significantly further ahead than the rest of the world when it comes to

consolidating and owning the customer relationship across platforms and nowhere is that more obvious than

with Tencent (700 HK). Tencent owns 55% of all time spent on mobile phones in China at 110 mins per user

per day vs just 33 mins for Facebook (as the longest in the US).

Source : KPCB Global internet trends

Visits per user per day average 10X vs Facebook at c.1X and total impressions per year are already 2X

those of Facebook and a whopping 20X those of Instagram. Despite this, currently Tencent’s ARPU in the

advertising division remains at just USD 1.30 vs Instagram’s advertising ARPU expected to grow to USD

8.56 by 2020 (Forbes) (Facebook’s current Advertising ARPU is USD 13.37 (10X higher than Tencent’s)

despite having half the impressions, 3X less time spent per user per day and 10X fewer visits per user per

day than Tencent). Even should advertising ARPU hit levels expected to be hit by Instagram, the implied

valuation of this division would be >4.5X higher than current consensus expects in our SOTP valuation

analysis (details of which can be found here: Tencent – the path to becoming the largest company in the

world.)

NTAC:3NS-20 52

While Facebook connects users to external content, what is so different is that Tencent owns the ecosystem.

Indeed with the launch of Tencent’s ‘Little Program’ consumers do not even circumvent Tencent when

purchasing their apps… they are all effectively owned by Tencent. Add to this the fact that Tencent’s WeChat

accounts for a whopping 55% of all eCommerce transactions in China with monthly transactions per user

more than 2X higher than for Debit Cards in the US and the opportunity should be obvious. 31% of all

WeChat users make purchases through the app (having doubled from last year) and according to the

company more than 50% of their nearly 1b users (as at 1H 16) have uploaded their card details. Wechat and

Tencent truly own the ecosystem, involving themselves in every aspect of people’s lives. For a better idea of

how this works in practice, see the following Economist article; Why China and Tencent are leading the

global consumer revolution .

Tencent have divisions in eGaming, eCommerce, ePayment, investments in Autonomous vehicles and AI,

have recently been linked to SOE reform through the value chain with Unicom and have a hugely

underpenetrated position in advertising. Tencent is the ONLY global stock we have in our three of our TMT

related baskets; eGaming, Autonomous Vehicles, and Quality Cash Compounders and is at the forefront of

not just one, but multiple disruptive forces globally (autonomous vehicles, ride sharing, eGaming, mobile

advertising, click to buy and crucially big data). With exposure to China consumerism, high growth, an app

led economy and eGaming we feel Tencent has the platform, services and technology to win. BUY Tencent

(700 HK)

35. OEM “EXTINCTION” IMMINENT? CAPACITY VS R&D

“AUTOMAKERS RISK EXTINCTION” is the headline from a report by McKinsey from December (link). “It’s

time for car makers to partner with software makers, or risk extinction”. The problem is that car makers want

to keep the software development in house. But their engineer ratios are skewed the wrong way, 8.5%

software, 91.5% non-software whereas in technology companies, 62% of engineers are software engineers.

Furthermore the key to AV is artificial intelligence technology and actually it’s about moving from mere

learning to inference which is a whole leap forward and here in AI technology companies have 28x more AI

engineers than the auto players.

NTAC:3NS-20 53

Source : McKinsey

The problem for OEMs and their value chain is the fact that they have considerably more physical capacity

than R&D and nowhere is this dichotomy more apparent than between Denso (6902 JP) and Aisin Seiki

(7259 JP) (See Technology vs Capacity – Buy Denso/Sell Aisin Seiki). Both companies predominantly

service Toyota (7203 JP), although one produces parts for their hybrid technology while the other produces

combustion and transmission parts that will largely be made obsolete should AV become a reality.

Furthermore, Toyota themselves have begun to see the merits of investing in AV, having been married to

real world driving and hybrid technology previously and Denso (Toyota’s primary supplier of electronic and

hybrid technology) has begun to invest accordingly (See Denso diverges from Aisin) particularly as Toyota

(much like the other OEMs) want to keep their software development “in house” by utilising Denso. (See

Toyota announces connected car strategy and Toyota moving to EV by 2020). In the last few months alone

Denso have announced collaborations in R&D in AV and AI technologies, announcing joint research with

Imagination Technologies (IMG LN) on multithreaded CPU cores to enhance the development of

processors for future in-vehicle electronic systems (link) and an investment agreement with THINCI Inc. in

deep-learning and vision processing, the announcement of a large leap forward in V2V (vehicle to vehicle)

and V2I (vehicle to infrastructure ) communications systems by Renesas (used within Denso’s in vehicle ITS

units), a tie up with Toshiba in AI development (Deep Neural Network-Intellectual Property (DNN-IP)) and an

announcement by Toyota (7203 JP) themselves of step changes in both AV and EV strategies utilising

existing partnerships.

While Denso are fully committing to the future of AV through R&D, Aisin continue to invest in capacity

expansion that could arguably be obsolete within five to ten years.

Denso (left) has 2X the proportional investment in R&D than Aisin (right) and is investing more in

R&D than in capacity

Source : S&P Cap IQ, NTS

NTAC:3NS-20 54

The outlook for both companies is therefore looking increasingly divergent and yet on c.13X FY1 PE Aisin is

trading at half its historic average valuation discount to Denso despite the fact that for the last 10 years the

two companies have been almost operationally identical on nearly every single metric including historic sales

trends, margin levels and trends, cumulative FCF generation, cash conversion, working capital and dividend

distribution. All that is, except in two crucial areas; Denso has 26% of its market cap in cash while Aisin is

Net Debt (thus the historic discount) and secondly Denso has actively been investing in technology while

Aisin invests in capacity.

As traditional OEM capacity becomes redundant and more and more USDs are spent on disruptive

technology, the outlook for these tow companies could not be more different in our opinion.

Buy Denso (6902 JP) / Sell Aisin Seiki (7259 JP)

36. THE NEXT STEP FOR AV, SMARTPHONES AND ECOMMERCE

IS AI – SPEED OF DEVELOPMENT COULD BE EXPONENTIAL

Without deep learning techniques (an Artificial Intelligence technology) driverless car were to remain on the

fringes, but if Xilinx's CEO is to be believed (alongside our highly rated Head of Global TMT Neil Campling),

the dawn for AI is now. After some 50 years in development, it is ready to leave the research lab and enter

mainstream industry. Without AI it would be almost impossible to write software able to anticipate every

scenario and permutation a self-driving car will need to cope with. However, a sufficiently powerful AV with

embed AI will be able to learn as it drives, store new situations and ‘remember’ how to cope with them.

Indeed these networks could be joined together to learn from each other in real time. The first truly

commercial real time ‘big data’ event.

It is in AI that most players with AV aspirations are investing (see Denso above, but also Tencent, Baidu,

Google, Nvidia and many others (including most global OEMs). Of these, probably the most

underappreciated my well be Baidu (BIDU US).

AutoBrain is the core of Baidu’s autonomous driving technology and includes highly automated driving (HAD)

maps, positioning, detection, and smart decision-making and control. Baidu and Nvidia have a complete end-

to-end solution for autonomous vehicles which will deliver a cloud-to-car architecture platform. Significantly

this is a completely open platform which enables other companies to move onto the platform (shades of

Android, and Linux). Such collaboration could help accelerate AI and AV technology).

This open platform approach may be the very thing that accelerates the demise of global OEMs stubbornly

trying to keep their R&D in house as it proliferates the number of operators, floods the market with capital

and drives returns (especially for incumbents) much lower. The vision of the disruptors is to put ‘more people

into fewer cars’. ‘Riding’ becomes a mobile advertising opportunity and the car becomes a bit-part in the

utility of transport. The value of which will lies in services, like advertising, and in the applications. The

business which owns the relationship with the customer will be the ultimate winner, of which there’s probably

only room for two or three. (see Tencent above)

As though to make the point, BMW and Baidu ended collaboration after what Wiertschafts Woche quoted

‘unbridgeable disagreements’ ironically the day after Baidu showcased a fleet of eighteen ‘Level 4’

autonomous vehicles in Wuzhen. TechRepublic defines Level 4 as what is meant by ‘fully autonomous.’

Baidu is currently working with over 60 auto manufacturers, although given recent signals from the Chinese

on R&D and AV focus we wouldn't be surprised to see Baidu leaning towards Chinese OEMs in the future.

Indeed Baidu signed a partnership with domestic OEM BYD in January 2016 to develop its self-driving

technologies and then signed a strategic intelligent car cooperation with State-Owned OEM Changan which

in turn has JVs with Ford, Peugeot, Mazda and Suzuki. Then in May, Baidu established a solid cooperation

with the local government Wuhu city of Anhui province to jointly build an exclusive pilot area for driverless

vehicle in the city, two models of electric cars developed jointly by Baidu and another domestic OEM Chery

for road tests. Baidu has also invested USD 150M alongside Ford in LIDAR leader Velodyne and has set up

a USD 200M early stage investment venture to back artificial intelligence projects.

Ultimately the competitive advantage will lie with those that own the customer relationship (Tencent), but in

the meantime the power lies with the enablers in technology (e.g. Baidu) and those determined to create

NTAC:3NS-20 55

their own software, their own platforms, insist on their own proprietary technology will likely fail (incumbent

OEMs) and auto's scramble for auto tech partnerships, and there have been many, could actually lead to

their own downfall.

Source: CB Insights

Additionally, if this is truly the beginning of ‘big data’ the demand for silicon content could potentially rise

exponentially. TSMC (2330 TT), the world’s largest foundry owner and therefore best qualified to comment,

believes demand for silicon content to support AI applications will be huge - “...we forecast total wafer

revenue opportunities excluding memory in this market could reach more than USD 15 billion in five years...”

That is just for wafers. Many of the disruptive technologies in use today are on 16-nanometer technologies.

TSMC themselves note strong adoption of 16nm for video games, augmented reality, virtual reality, deep

learning and artificial intelligence. In fact TSMC’s 16-nm technology in 2016 is likely to have grown from the

levels in 2015. TSMC would seem also to be an excellent exposure t the looming AI trend in our opinion.

Elsewhere in AI, we expect excitement to build around the potential of a more fully AI savvy smart phone

release over the course of 2017, particularly in the area of ‘perception’ with further development of tactile and

vision functionality. Apple have already begun down the road of ‘haptics’ (feeling) with ‘Force Touch’ in the

iPhone 6s in 2015 and have been aggressively buying relevant companies (particularly in the last 12

months). We expect AI capabilities to be expanded further in the coming years with potential 3D functionality

(enabling phones to better ‘perceive’ their environment, particularly useful for Augmented reality gaming for

example) and giving users the ability to perceive the feel of products (such as roughness). When humans

touch object, tactile sensations are relayed to the brain as vibrations, even complex textures. As such many

haptic sensations may soon be able to be mimicked by smartphones, particularly useful when it comes to

online shopping. Best positioned for this thematic would seem to us to be AAC Technology (2018 HK).

Companies: Denso, Tencent, Baidu, TSMC and AAC Technology.

NTAC:3NS-20 56

37. E-GAMING LONGEVITY TO SHOW THROUGH IN 2017

(By NTS Head of Global TMT Neil Campling). One unexpected consequence of growth in the use of digital

channels to purchase gaming is volatility as traditional methods of data collection and retail information

become less meaningful. That notwithstanding, we do know demand appetite for the sector remains strong

given that PS4 and Xbox One were respectively the first and second highest selling items on Cyber Monday

according to the Adobe Digital Insight survey. While the sector is still perceived as hit-driven and cyclical, the

future may well look different and provide more predictable revenues streams.

Global direct consumer spending on apps is expected to have reached USD 44.8 billion in 2016 and,

incredibly, 82% (almost USD 37 billion) of this app revenue is generated by games. NewZoo estimates direct

app revenues are expected to grow to USD 80.2 billion by 2020. We see Tencent, DeNA and Nintendo

positioned well to benefit from that trend.

Source : NewZoo

China is now the largest gaming market with the largest vertical being mobile gaming - consultancy NewZoo

reports both are enjoying double-digit growth. In 2020, China gaming app revenues alone are expected to

have reached USD 14.9 billion, more than 80% larger than the forecast for U.S. game app spending.

Source : NewZoo

NTAC:3NS-20 57

Within the more traditional eGaming environments, we see evidence of Gaming as a Service (“GaaS”)

beginning to emerge. Sony has announced its PlayStationNow subscription service is available on the PC.

The proposal is a PC-compatible version of its PlayStationNow gaming services, which boasts a catalogue of

more than 300 PS3 games priced at USD 20/month in the U.S. No PlayStation console is required; all a user

needs to do is download a simple PC app. The next evolution - due shortly - is to offer PS3 games as a

subscription service across Smart TV, PlayStation 3, 4, or Vita and PCs. The company’s plans for PS Now

don’t end there, with Eric Lempel, Sony’s Head of PlayStation Network explaining “...we’ll continue to explore

other options in the future. Alternative devices, alternative content, all of that is possible...” We see this move

as a precursor for rolling out the same to PS4 games, to multi-dimensional, multi-published, subscription

gaming in the future.

Sony’s move follows Microsoft’s expanded Xbox strategy, where they are ramping the Xbox Play Anywhere

initiative which unifies PC/Console gaming. Microsoft will also launch more games on digital distribution

platform Steam as part of the initiative. The ability to buy a digital game once on Xbox and get a free PC

version (and vice versa) can only help to fuel cross platform harmonisation, in our view.

We see all these efforts as further signs of the new path in which gaming is developing – a shift towards

GaaS. - ‘Gaming as a Service’.

THE EVOLUTION REVOLUTION

This current eGaming revolution is combining the elements of:

• New media consumption (#1 form for Gen Z, source: Sparks & Honey)

• Social media interaction (social multi-player gaming)

• Bew age celebrities (YouTube’s Pew Die Pie), and

• Creating new Sports (USD 20M prize pot for the Dota2 Championship)

It is also the latest industry to take advantage of technology deflation. Simply put, the various components

installed in powerful gaming systems continue to get cheaper and that matters to consumers and users.

Digital game downloads and streaming multi playing gaming requires sizable hard drives and/or data

connections. Here’s a somewhat imaginary example but it helps understand the context – if they existed in

1980, modern 2TB hard drive which are standard in the latest consoles, would in theory have cost USD 3.86

billion each (yes, that’s right billion dollars each!) Buffalo-based software engineer Mkomo calculates that

hardware storage costs have dropped from USD 193,000 per GB in 1980 to less than USD 0.03 per GB

today.

Another impact is the way in which digital service based models afford high multiples. Pure SAAS valuations

are well known:

• Salesforce.com trades on 60x 12 month forward consensus P/E (Source: Bloomberg, as at 15 Dec

2016)

• ServiceNow is on 84x

• Workday (NTCM Sell) on 421x (that is not a typo)

• Adobe has transformed from a disk-led business to a subscription service model – the result is a

business that has re-rated from c.12/13x consensus P/E to 30X

Generally, SaaS is a subscription to a hosting and infrastructure service bundled with the rights to use the

software. SaaS providers maintain the hardware, perform upgrades, backup, and otherwise perform all of the

utility services and activities required to keep the software running.

Gaming could evolve the same way. Imagine the potential for GaaS companies in the future? For the

companies exposed we see a path where digital-led consumption generates substantially higher margins,

relative to both history and market expectations.

Companies: Square Enix, Nintendo, DeNA and Tencent.

NTAC:3NS-20 58

38. THE RETURN OF THE CHINESE CONSUMER

Higher inflation in China is chipping away at the country’s recently rising savings rate (the real deposit rate

has been negative for nearly all of 2016). Given that the phenomenal wage inflation of the past three years

has not yet flowed through to consumption (as the savings rate has only risen) what this may do is catalyse a

significant catch up trade in China’s impetus to consume (already being signalled by global luxury retailers in

China) and with few other viable options available to investors (as the property market is cooled, wealth

management products constrained and off shore flows capped) this could bring renewed flows into both

Chinese consumer products and into domestic equities during 2017.

"It seems that the Chinese government's intent to promote growth through consumption rather than just

investment is bearing fruit," Johann Rupert, chairman of Compagnie Financiere Richemont, told investors in

November. Rebalancing in China is well underway and there is even improvement in Luxury demand. As

highlighted already a number of Luxury companies have been reporting good numbers in China. In

December Reuters carried an article titled ‘No price like home; big spenders reappear in China.’ It's worth a

read. "China's rich make up almost a third of the world's luxury shoppers, up from only 2% around the turn of

the millennium. They are a driving force for global luxury, even after a slight dip this year when fewer

travelled abroad, in part due to militant attacks in Europe. For the past three years, a crackdown on

corruption and ostentation by President Xi Jinping dampened sales, however (as explained above in

‘Chinese reform momentum builds despite the approaching Congress.’) the approaching Congress may

mark a relaxation in the anti-corruption momentum that has defined the past few years as President Xi

confirms the consolidation of power. This combined with the passing of the Japanese gambling bill as the

Tokyo Olympics approach, the recovery in Chinese tourist growth to Macau and GGRs hitting their best

monthly gain since February 2014 in November as new capacity is added keeps us buyers of Sands China

in the year ahead. Sands is a high quality cash compounding company that was a member of our QCC

basket last year alongside other consumer names such as Anta which we also remain buyers of over 2017.

Additionally, as an indication of current Chinese domestic demand, domestic Chinese rail freight volume

growth remains at six year highs YoY.

Source : Bloomberg

Companies : Sands China (1928 HK), Anta (2020 HK)

NTAC:3NS-20 59

39. E-FINANCE – CATALYSTS LOOM IN 2017

As big data consumerism looms in China (far ahead of the rest of the world) the implications for not only

eCommerce, but targeted advertising and risk adjusted credit pricing rise, freeing up the potential for a vast

shift in the velocity of money in China. Within this sphere e-Finance is an area attracting significant attention

from Internet companies looking for new routes to leverage their customer relationships. 2017 will see a

number of e-finance IPOs coming to market (eg Ant Financial, Lufax, Beijing Happy Times, Zhongan Online

P&C Insurance and JD is planning a spin off of JD Finance according to media reports). Look through

valuations should provide catalysts for the likes of Tencent, Alibaba and JD but with some brokers

expecting Ant Financial to be worth as much as USD100b in 2 years it may also be worth taking a closer look

at Fosun.

According to local reports, Fosun (656 HK) has spun off its tourism and hotel assets into its newly

established subsidiary in preparation for a future listing (in 2 -3 years) with an asset value in excess of 200b

RMB. A prime example that Fosun is continuing down the asset restructure route following their recent

balance sheet improvements. Currently consensus expect just HKD43b in blue sky upside should all of

Fosuns’ unlisted assets IPO this year which seems particularly conservative, particularly when we consider

their 25% holding in Ant Financial. As at the last round of financing (Apr 2016 WSJ) Ant Financial was

ascribed a USD 60b value giving an implicit valuation c. 15X EV/sales. At current growth rates and on a

similar multiple this would (on our numbers) imply a potential listing price in 2017 at c. USD 72b. With

Fosun’s 25% ownership this could add a further 140b HKD to Fosun’s NAV (on our back of the envelope

numbers), currently not in consensus forecasts. This potential uplift could add 80% to current group NAV and

accounts for 140% of Fosun’s current market Cap. This for a stock that already trades at a 43% discount to

NAV even without any value for Ant.

Companies : Tencent, Alibaba, JD and Fosun

NTAC:3NS-20 60

AUSTRALIAN EQUITY STRATEGY

BULLISH:

• US infrastructure and global reflation; financials over commodities

• Bond yields, borrowing costs

• Gold and volatility

• Oil

BEARISH:

• Premium commercial and Residential property

• Building materials

• Coal

• Consumer discretionary

Longs Shorts

ACX NCM ABC GPT SGP

BHP NST CSR LLC WHC

ILU STO CTD MGR WOR

IOF WOW DOW QAN

MQG DXS RIO

NTAC:3NS-20 61

KEY THEMES FOR 2017

EFFECTIVE TIGHTENING OF MONETARY POLICY;

INDEPENDENT OF THE RBA

• We expect a continuation of the November/December theme of higher bond yields and subsequent

higher lending rates for Australian consumers and Australians with variable and fixed rate mortgages.

Higher discount rates (yields) lead to lower asset values in the absence of changing assumptions on

earnings growth. What we know from recent macro data is that there is no case, unlike the US, to

assume wage growth and better business conditions. As such, asset values will fall and we view the

REIT Index as a preferable short, particularly following the bounce in December. In addition, the

fundamentals do not exist, in our view, for Australian Residential; where historically price growth has

been muted in times of increasing lending rates. Risks to the downside for price is compounded by the

unprecedented level of building starts; in particular apartments; the impact of Chinese macro prudential

controls and changing APRA lending standards at a time when household debt to income is at a record

high and wage growth at a record low

• In summary, there is a higher probability priced in of a rate hike in 2017 than a rate cut; all bank and

non-bank lenders have been increasing lending rates, independent of the RBA, and therefore when the

RBA does lift rates (timing) we would expect significant pain in the property space

� Long: IOF

� Short AS51PROP, DXS, LLC, MGR, SGP, ABC, CSR

STAY LONG OIL NAMES

• Our contention is that supply and demand will rebalance more quickly with the agreed OPEC

production cut; but fundamentally will happen given the significant underinvestment of the last few

years. We expect an unwillingness for E&P’s to make major multi-billion investment decisions and see

a scenario where the current supply/demand imbalance flips and upward pressure resumes for the oil

price

� Long: BHP, STO

COMMODITY HYPE

• There is a fair amount of global growth optimism priced into commodities. For most commodities we

feel one needs to be more bullish on China property than US infrastructure; which is tempered by our

view that China is actively trying to cool her property market. 34% of global copper demand is attributed

to China (vs the next most important country, the US, at just 4% of global demand) and 60% of this is

attributed to the property market. While Trump’s infrastructure plans are certainly a driver of sentiment,

their impact to sustainable demand seem questionable in the short term, particularly given lead times

and the fact that China that consumes 40-50% of most industrial commodities. For example copper has

far more uses in construction of property etc than roads, bridges and tunnels. Coal’s 2016 gains are

also unlikely to repeat, in our view.

� Short: RIO, WHC, DOW

� We prefer to play the pair Long BHP Short RIO

NTAC:3NS-20 62

FEBRUARY REPORTING SEASON LIKELY TO SORT THE SHEEP

FROM THE GOATS

• Is likely to be volatile amid what appears to be a large rotation out of gold names into base metal

names and into commodity derivatives such as some mining services companies (DOW is a stand out)

• We have witnessed something similar in oil, but we believe there are better fundamentals for the price

of oil than the price of commodities and prefer exposure to the oil price (not oil EPCM relying on mega-

projects like WOR)

• If commodity prices / stocks are as the result of repositioning, not future earnings prospects; it is

worthwhile asking the question of whether 2016’s out-of-consensus is 2017’s consensus and how that

positioning may impact on stock prices

Gold Money Managed Long / Short contracts

Source: Bloomberg

• Short Australian residential property

• US growth plays – infrastructure theme via finance and construction

• Oil – bullish price, but not activity

• Gold – why we like the gold miners and ALS Global

• Commodities / Miners – when do supply / demand dynamics takeover from asset rotation?

• Expectations (share price) way ahead of reality (earnings forecasts): DOW

• Trading pairs

• Out of consensus basket

NTAC:3NS-20 63

AUSTRALIA RESIDENTIAL

1. INCREASING BORROWING COSTS

a. One hypothesis we had believed it logical for the big four banks to increase borrowing costs at a faster

rate than the RBA, as well as tightening liquidity and lifting serviceability thresholds. This is now

happening, so there may be less debate than before. All four banks have increased fixed rates

(predictable) and all banks are raising investor borrowing costs at faster rate than owner-occupier loans

and interest-only loans at a faster rate than P&I; indicating that our hypothesis has merit. As such, it is

logical, in our view, that when the RBA does increase interest rates that borrowing costs may escalate

reasonably quickly.

b. How does this affect serviceability? According to the Real Estate Institute of Australia, the proportion of

the median family income required to meet average monthly loan repayments was 29.5% at the

September-quarter. If you take the average loan size for a first home buyer in NSW ($397,000),

household income of $150,000, 5% borrowing cost and a 20% tax rate; that implies for every 100bps

increase in borrowing cost there is a 400bps reduction in disposable income. Another area of concern

is that while borrowing costs have been declining (from March 2012) the average first home owner loan

in NSW is up 38%

c. There is a significant negative carry on residential property: Sydney/Melbourne apartment gross yield is

~4.0% and houses is ~2.8%. As such, one must question investor appetite for increases in borrowing

costs when macroeconomic data suggests it is difficult to get rental growth

d. Genworth at its Q3 result reported worrying delinquency rates, in our view. Most concerning is

delinquency rates being higher for premiums written more recently, despite the growth in house prices.

This may suggest that asset buyers have entered the market at highly elevated prices with little

financial buffer. Genworth specifically called out regional markets, Perth and Brisbane. The lessons

learned here from delinquencies when prices are plateauing or falling gradually is insightful when

considering the increase in median house prices in Sydney and Melbourne and the fact that underlying

conditions (tighter lending standards, end of interest rate cycle, muted wage growth) are getting worse.

Australian Residential Property metrics

Source: Bloomberg

NTAC:3NS-20 64

2. MACRO

a. Australia has five very poor macro reads recently: GDP, capex, building approvals, housing finance and

wages. None of these factors are constructive for the residential housing market

b. What if we get inflation? It is interesting, in our view, to consider that China has begun to generate ‘cost

push’ rather than ‘demand pull’ inflation and what impact this might have on the Australian economy

and inflation, independent of the lack of ‘demand pull’ inflation drivers Australia is currently

experiencing. China is Australia’s biggest import partner and around twice the size of the next biggest

trading partner (USA). It is also useful to consider that OPEC just exported a significant amount of

inflation to the world with higher oil prices. Interestingly, Petrol (refined and crude) is Australia’s biggest

import by product; being twice the size of the next market (cars)

3. PRICE

c. A lot of debate on issues like settlement risk has largely been a non-issue given price appreciation.

Residential property prices rose 3.5% through at 30 September 2016, the weakest growth since March

quarter 2013. Despite recent weak macro data and borrowing costs increasing in November/December;

the September quarter price growth of apartments in Sydney, for example, was the weakest in four

years. With borrowing costs up since, tighter lending conditions, a wave of supply coming in 2017/18

there is likely significant pressure on price. Another consideration on settlement is the willingness of

FIRB buyers to settle in the event of price depreciation coupled with the ~10% deprecation in the Yuan.

d. The owner-occupier home loan market is around 1.5x the size of the investor market (60:40). The

majority of owner-occupiers (~75%) pay P&I, however the majority of investors (~65%) pay interest-

only loans. This is likely where the price pressure comes from.

e. Increasing the denominator (risk free rate / 10-year bond rate) and keeping the numerator (rental

growth) static, implies value goes down. We have been preaching the Ben Graham quote: “Price is

what you pay, value is what you get” and acknowledge the difference between price and value; but

sooner or later there will be convergence.

4. APARTMENT SUPPLY PEAK / SETTLEMENT RISK

a. Peak Apartment has been discussed widely and is well known. Of concern to us is the correlation

between high-rise apartment approvals and FIRB approvals and how this might impact on price.

Approvals of apartments > four stories – is up 127% in NSW since FY13 and 102% in Victoria

b. Chinese capital controls are presently dampening ability to settle (introduced January 2016) and

Australian banks are no longer lending to FIRB buyers (March / April). Put into perspective on the rapid

increase in Chinese and FIRB investment in Australian property:

� In 2010, total FIRB investment approvals in Real Estate was ~$20b and Chinese was ~$2b.

� In 2015, total FIRB investment approvals in Real Estate was ~$88b and Chinese was ~$24b

► That’s a 5x FIRB increase and a 10x Chinese increase

c. This is very much a self-fulfilling prophecy; so it should serve as no surprise that listed and unlisted

companies have been reluctant to be vocal on the topic.

5. STOCK POSITIONING:

Short: LLC, MGR, SGP, ABC, CSR or AS51REIT

NTAC:3NS-20 65

ASX200 REIT Index has corrected too much to the upside

Source: Bloomberg

SELL PREMIUM OFFICE NAMES: DXS, GPT, LLC

An interesting fact on LLC is that commercial profits have been a key driver of its results over the last few

years. In fact, the 10-year bond rate falling from ~4% to 2% was the key driver. This also enabled the

company to generate significant trading and revaluation (non-cash) profits; which are clearly more difficult to

replicate in a rising bond yield environment. This has been a key driver for statutory profits from FY13.

REITs can perform well (generate higher returns) amid RBA tightening and higher bond yields, but only when

there are improving economic conditions. On a macro basis, we do not see this and from a micro perspective

there are several headwinds on the premium-end of the market including high vacancy in Sydney and

Melbourne in the premium end of the market and supply coming. In our view, there is likely to contribute to

continued pressure on rents and incentives. On the flip side, we like exposure to A and B grade office, which

currently exhibits low vacancy and significant net negative absorption.

With reference to previous times the 10-year traded ~3%, it also appears that the REIT Index is significantly

overvalued; again with reference to the outlook this is amplified.

If you cross-reference a 3% yield in 2012/13 we observe the premium cap rate for Sydney CBD of ~7.0%, A-

grade of ~7.5% and B-grade of ~8.5%. This compares, for example, to Dexus’ last blended office cap rate of

5.95% and as an example 30 The Bond at a 5.63% cap rate. These appear very tight in our view with the

recent movement in bond yields and lack of evidence on

NTAC:3NS-20 66

10-year ~3% could push REIT Index down ~20%

Source: Bloomberg

NTAC:3NS-20 67

US GROWTH

OUR PREFERRED POSITIONING FOR US INFLATION AND INFRASTRUCTURE IS MQG AND

ACX

ACONEX

The stock has significantly underperformed on a thesis of the potential use of rebates propping up short term

revenue; a reasonably high receivable balance and the recent resignation of the CFO. That said, there are

two relationships we like, Bechtel and AECOM, when contemplating US infrastructure spend.

AECOM should be a major beneficiary of US infrastructure spend; the stock is up ~35% post-Trump. Even in

the absence of Trump; infrastructure projects backed by state ballot initiatives and higher gasoline taxes will

drive a surge in domestic spending regardless of the new administration’s spending pledge. CEO recently

said: “I don’t think we’ve ever been more bullish on the future of infrastructure in North America”.

Bechtel is the biggest contractor in the US with turnover of >$30b. Recently, the Europeans have had a lot of

major success in projects like the California High Speed Rail and Champlain Bridge; however we see Bechtel

as an integral player in the market with respect to privately financed infrastructure competing against the

Europeans with their own financing arms (e.g. ACS/Iridium, Ferrovial/Cintra). Bechtel also has a strong

relationship with the US government and if you take the view that American companies may be favored;

Bechtel has a good outlook. Aconex also has agreements with Fluor and Salini which offers US infrastructure

exposure and also offers exposure to Australian infrastructure via John Holland and CIMIC; who will likely

win a good share of the infrastructure pipeline.

Bechtel is also a major pipeline constructor and the biggest LNG contractor in the world, delivering 1/3 of

global LNG capacity; and we view Trump and his appointments as positive for this space.

MACQUARIE

MQG has exposure to US infrastructure through advisory and financing in an immature privately financed

market. As such we see significant room for growth. We also prefer financials to commodities to play global

reflation and the potential for a lower AUD. MQG generates the majority of its revenue offshore, with ~25%

from Americas, ~25% from EMEA and ~10% from Asia Pacific.

MQG vs peers

Source: Bloomberg

NTAC:3NS-20 68

OIL

Our contention is that supply and demand will rebalance more quickly with the agreed OPEC production cut;

but fundamentally will happen given the significant underinvestment of the last few years. We are uncertain

about a time frame, but given the project pipeline and our contention of an unwillingness for E&P’s to make

major multi-billion investment decisions; we see a scenario where the current supply/demand imbalance flips

and upward pressure resumes for the oil price.

We agree with the IEA’s assessment that “says "OPEC also appears to be signalling that high-cost

producers should not take for granted that they will receive a free ride to higher production… These high-cost

producers, who assume that the cuts at the very least guarantee a floor under prices, might think twice

before taking the risk of sanctioning new investments."

Capex for E&P’s continue to be revised down and consensus forecasts 2017 capex flat on 2016. We believe

it is important to acknowledge that because of price deflation in the services industry; a flat $ value may

indicate more activity / production.

On the flip side, we are bullish North America. ALQ was a preferred play, but now it is selling its Oil & gas

business; we prefer to play the theme via BHP. There is likely to be a significant supply response from North

America; however in the medium-term will unlikely be enough to replace natural depletion rates.

We pushed a long on WOR after OPEC, simply because of the 20% short base at the time and the lack of

options in the Australian market to play an oil derivative. The stock has since seen a significant amount of

short covering (-7% to 13%) and the stock has rallied through $10. This is now a clear short in our view and

will likely correct to the downside at February and August results.

STOCK POSITIONING:

Long: Santos, BHP

Short: WorleyParsons

2017 capex forecasts (USDb)

Source: Bloomberg

SHORT QAN

We see risks to FY18 earnings, with consensus seeing flat EBITDA on FY17. FY18 will likely see material

higher fuel price and a lower AUDUSD. As such, it appears that airfares need to lift and with borrowing costs

for Australian consumers on the rise, combined with record low wage growth and a low AUD, there is a

question as to the propensity of consumers to absorb higher prices. We also believe the combination of

factors above leads to a material downgrade to free cash low forecasts in FY18.

50

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North America (RHS)

NTAC:3NS-20 69

Correlation of jet fuel (AUD) and QAN breaking apart

Source: Bloomberg

NTAC:3NS-20 70

GOLD

We believe the gold theme is intact and offers an attractive entry point following the post-Trump risk-on trade

that has seen a global rotation out of the precious metal. In the medium-term:

• Index volatility - ASX 200 and S&P500 one year implied vols are >16% pricing both to move by at least

1% every day for the next year

• First signs of some pickup in inflation with a number of recent price gauges exceeding forecasts - China

Sept CPI, UK Sept CPI, AUS Q3 CPI, US ISM prices paid, US Sept PPI. China factory gate prices

rising for first time in nearly five years

• Central bankers (eg Yellen) are toying with idea of letting the economy run hot for a period to allow

higher inflation by design

• Positioning is lighter with Gold net long almost halved since peak

• Gold exploration capex is down over 50% from peak in 2012, exploration is not replacing natural

production declines

• Outlook for fiscal policy is highly expansionary globally

Buy NCM and NST

Buy ALQ on weakness (<$6.00) – A higher gold price is positive for exploration and although we saw a slight

slowing of capital raisings through December there is likely enough momentum to set up revenue gains for

the peak season in April / May.

AUD and CAD gold price still relatively strong on a 5-year basis

Source: Bloomberg

NTAC:3NS-20 71

COMMODITIES

The run-up in commodity prices through 2016 was a key driver of the market and in most part; it appeared

an out-of-consensus outcome. Post the Trump rally we feel a key question to ask is whether the run-up in

commodity prices and the subsequent strength in resource stocks is justified relative to the supply / demand

outlook. It is also worth asking the question of whether long / bullish resources is now a consensus call and

what may happen should commodity prices correct to the downside.

IRON ORE

Consensus has played catch-up over the last 12-months leading to significant earnings upgrades for the

major iron ore miners. This continues into 2017 with consensus forecasting iron ore at $56 for Q1 vs spot of

$77.25. It is reasonable to ask if supply / demand dynamics return; how sustainable this earnings upgrade

cycle is. In addition, to the extent speculation is driving contract prices in the short term needs to be taken

into consideration; for example, volumes of iron ore derivatives traded on the Singapore Exchange jumped to

a record 1.7 billion tons last year, 58% higher than in 2015.

Is the iron price fuelled by speculation? Will supply / demand balance return?

Source: Bloomberg

COAL

A combination of Chinese supply controls and wet weather impacting supply led to material coking/thermal

price increases in 2016. In reaction to higher prices there has been a supply response; so we would expect

coal-related stocks to have a heavy skew of risk to the downside. Stocks we like on the short-side are

Whitehaven Coal (WHC AU) and Downer EDI (DOW AU); the former a pure play thermal coal producer and

the latter a stock that has been a major (share price, but not earnings) beneficiary of the commodity rally.

NTAC:3NS-20 72

Coal price v WHC and DOW

Source: Bloomberg

Mining stock we like: Iluka

We believe BHP moves ahead with South Flank (~80mt per annum) in Mining Area C to replace tonnes from

Yandi. We think this equates to ~$5-6b spend by BHP on new mine infrastructure including rail. This could

represent ~$100m EBITDA or >30% upgrade to ILU’s earnings / there is the potential for this royalty stream

to be divested.

Mining Area C

Source: BHP

NTAC:3NS-20 73

SELL DOW AU

The last time DOW traded >$6.00 forward NPAT forecast was ~$220m vs $167m for FY18. This values the

stock at 16.8x FY17 EPS or 16.3x FY18 EPS. Juxtaposing the share price performance over the past 12

months with its business performance: it lost its biggest mining contract (FMG) and was relatively

unsuccessful in its “infrastructure” push. As such, we see the stock pricing in earnings upgrades in the order

of 30-40%. There is significant risk to this assumption; consequently we see material share price downside.

The FY16 result, -14% on pcp ($180.6m) also appeared assisted by a $20.5m goodwill write-up relating to

the acquisition of Tenix and VEC. It is difficult to see how Tenix was worth more at 30th June 2016 than at

acquisition following the Queensland election and the Ausgrid sale to IFM and Australian super as opposed

to China’s State Grid; where we assume DOW would have had a far more lucrative role.

In addition, there is a school of thought around DOW being a major beneficiary of the potential Adani mine.

In our view, it is more unlikely than likely Adani’s mine and infrastructure is built. DOW received multiple

contract awards in 2014 should the Carmichael Project go ahead. Despite the Queensland Government

recently awarding the project “critical” status (Government announcement), The AFR reported on 21

September 2016 (citing Adani Australia’s CEO) that Adani has scaled down Carmichael mine project from

USD 16b to USD 4b; marking down the production target from 60mtpa to 25mtpa. The new “target” sees

construction to start in late 2017 and ship coal to its plants in India by 2019, instead of selling it in Asia,

according to the original plan. Contracts were initially signed for a US$16b project, which Adani now sees at

USD 4b (if the project goes ahead); so one might ask the question whether the original contracts sign are

still applicable anyway…. Adani Enterprises has ~USD 1.7b of debt outstanding and has a current market

capitalisation of ~USD 1.1b. Despite the strength in Thermal coal price, it is likely drawing a long bow to

suggest Adani moves ahead with its project let alone it will contribute to DOW’s earnings.

RCR at 9.5x FY18 earnings is a far more attractive entry point and exposure to infrastructure / utilities.

DOW share price vs consensus earnings

Source: Bloomberg

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2.50

3.00

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g-1

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-12

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Share Price (LHS)

NPAT ($m) (RHS)

NTAC:3NS-20 74

PAIRS

LONG E&P (SANTOS, BHP) SHORT SERVICES (WOR) AND

QAN

Short Qantas on higher fuel, capex and lower AUD; There is also a solid medium-term case for a short

driven by: lower demand from the inevitable price rise that will come from the higher fuel cost; lower AUD;

low wage growth; borrowing costs going up impacting demand.

LONG A/B GRADE OFFICE; SHORT PREMIUM

To hedge out bond rate risk and long A/B grade, short premium; based on the thesis that new supply is

largely Premium/A-grade and Sydney in particular is seeing significant A/B-grade withdrawals for Resi

conversions and Sydney Metro. .This was ratified recently with Sydney and Melbourne rents up 5.5% and

5.7% respectively for the September-quarter and Sydney up 19.7% annually according to JLL. In addition,

vacancy rates are significantly lower in IOF’s predominantly Eastern-seaboard exposure vs premium.

In Sydney for example where there are numerous withdrawals scheduled (~70ksqm A Grade, ~240k

Secondary) over the next few years with a reasonable amount of supply coming in Premium and yet to be

filled.

Long IOF short DXS

Vacancy by Stock (Sydney and Melbourne)

Source: JLL

0

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NTAC:3NS-20 75

OUT-OF-CONSENSUS

2016 saw a number of stocks severely de-rated on the back of downgrades or where the outlook for

medium-term earnings have seen material deterioration including Crown, Sirtex, TPG, Vocus, Bellamy’s,

Ardent (on the way down and on the way up). There have also been a few consensus. Sells that have

significantly outperformed: Orica, Fortescue, ALS Global, Monadelphous feature.

• Corporate Travel – Sell

• Star Entertainment – Sell

• Lendlease – Sell

• Mirvac – Sell

• Qantas – Sell

• Woolworths – Buy

CONSENSUS RECOMMENDATIONS

Source: Bloomberg / NTS

SGR,NXT,REA,RSG

ALL

JBH,RHC,SKIECX,MQA,SAR

CAR

BSL

ORE,WEB,FXL,HGG

IPL,LLC,SUL

BEN

ARB,TME

FMG

WOW

CHC,EHE

CQR,CMW

ASX

MND

BWP

1

3

5

7

9

11

-20 -15 -10 -5 0 5 10 15 20

#

of

Re

cs

Level of Conviction

Sell Buy

NTAC:3NS-20 76

CORPORATE TRAVEL

We see as significantly overvalued (compared to Flight Centre), a serial acquirer in a structurally challenged

market and after making a large acquisition (relative to its size) now has a large integration task.

Contemplating the beating high PE stocks have had when they have disappointed, the floor in the share

price is very low if these earnings expectations are not met. In addition, it appears a key risk to TTV that the

appetite for corporate travel when airlines ultimately have to lift ticket prices due to higher fuel costs

combined with benign profitability growth for corporate Australia.

• 5 buys, 2 Holds,.0 Sells (Bloomberg)

STAR ENTERTAINMENT

In our view the stock has been a beneficiary of a number of tailwinds through 2016 including benefitting from

Macau-related VIP crackdown a favourable competitive and macro environment. We believe the company

now faces more difficult comps through 2017 and potentially a more difficult macro environment.

From a micro perspective, the company is now closer to a major capex bill and as Crown moves closer to

developing its offering in Sydney; we see a more difficult environment that the 8 Buys, 1 Hold and 1 Sell on

the stock.

WOOLWORTHS

We believe Woolworths has legs with respect to a turnaround story. Our thesis remains WOW is the biggest

restructuring and turnaround story in Australia. They have cut the financial haemorrhage that was Masters,

cut the CEO, and now seeing reward for the new focus and investment in Supermarkets.

The Q1 Sales result end October showed growth returned to Supermarkets for first time since 2015, 0.7%

LFL sales growth in the Food division with an acceleration in the last six weeks to 1.2-1.3% growth given the

first eight weeks were +0.3%. The gap to Coles has narrowed from 560bps in Q1 FY16 to 100bps now, it’s

taken significant price investment which has impacted EBIT growth but they had to lift turnover. Short

interest started the year at 132m shares, now sits down at 75m but still 39 days turnover. It is a long dated

recovery but the end of the Master bleed and Supermarkets back executing have taken out the downside

now. Sell side is still split 8 Sells, 5 Neutrals and 2 buys that we can see on Bloomberg.

NTAC:3NS-20 77

REVIEW OF LAST YEAR’S STRATEGY REPORT (2016)

OVER THE COURSE OF 2016 - MXAP CLOSE UP +5%.

Below is the summary section that topped our strategy note last year (see attached for full note) with a

review of how our views played out, particularly with respect to the connected stocks

KEY UNDERSTANDINGS FOR THE BEGINNING OF THE YEAR - SUMMARY

1. Same way positioning is stark – look for USD correction - January saw the largest USD correction

seen in seven years

2. Chinese slowdown may surprisingly ‘snap’ back driven by Oil in particular – This categorically

happened. BUY PetroChina (+16% over the year), Bank of China (+9%) and look to BUY commodity

exposures such as Angang steel (Maanshan/Angang pair highlighted in the note and numerous times

subsequently +40% in two months with subsequent vanilla long +77%).

3. Capacity consolidation will encourage both defaults and loosening – Renewed focus on capacity

consolidation will see further defaults but further loosening (particularly through PSL and more broadly

through RRR cuts) will continue through 2016 – BUY Property (Country Garden / Evergrande pair

highlighted in the note gained >20% in Jan sell off and closed the year +65%) and Banks (Bank of

China (+9%))

4. RMB will not weaken significantly - we think the market is overly concerned about RMB depreciation.

A weaker RMB is not in China’s interests and despite a 30% relative appreciation vs its Asian

competitors, they are winning global market share in areas that support their economic rebalancing

(high value manufacture). – while depreciation continued this was USD centric and not trade weighted,

so not directly due to Chinese action. The concern at the time was for devaluation which did not

eventuate. BUY Tencent (+22%), Baidu (-8%), ZTE (-31%), Unicom (+3%)

5. Global concerns have hidden significant reform strides - Concerns on the USD and the RMB (along

with the impact of lower oil) have hidden the reform strides China has made – BUY PetroChina

(+16%), Bank of China (+9%)

6. Rebalancing is gaining momentum - The Chinese slowdown is a function of a rebalancing economy.

Tertiary focussed companies are not only seeing divergent growth, but earnings upgrades. Stocks with

EPS growth in a weak economy include Alibaba and Tencent (accelerating monetisation and GMV

sustainability) (+22%), COLI (improving cash generation) (-17%), CCC (new order growth, OBOR and

SOE reform) (+17%).

7. The drivers of rebalancing are converging - The avoidance of the middle income trap, the

engagement of China’s large rural savings pool, the Chinese Lewis point and China’s ambitions to climb

the technological value chain are all now inextricably linked – the infrastructure of consumption. BUY

Tencent, Baidu, ZTE, Unicom – this theme is still ongoing and although ZTE proved a terrible call as

political risk overwhelmed the stock in 2016 Tencent continues to be a great exposure and Unicom has

just now confirmed our contention for 2016, albeit late in the year.

8. China has a chance to lead the global technology curve - Surprisingly China finds itself at the

forefront of the technological curve with the ability to roll out advancements far faster than Western

peers, with a lack of sunk cost, more aligned company structures and a greater ‘bang for buck’ value

attributed to marginal technological advancements (e.g. currently utilise 2x the energy per USD of GDP

and remains one of the least productive countries on the planet). China already is at the forefront of ‘big

data’ for example ‘smart malls’ giving them the opportunity to capture every point on the demand curve

at a time when the stimulation of consumption is fundamental to China’s future. – this contention

continued to gain momentum through the year and continues to be a strong driver for 2017.

NTAC:3NS-20 78


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