VOLUME 6.3 • MAY 2016 China: Mounting Macro Paradox · capacity in many parts of the country –...

VOLUME 6.3 • MAY 2016

China: Mounting Macro Paradox

INSIGHTSGLOBAL MACRO TRENDS

2 KKR INSIGHTS: GLOBAL MACRO TRENDS

China: Mounting Macro ParadoxA recent visit to China gives us more assurance that there is a base rate of economic growth that the government — using a variety of monetary and fiscal tools — will work hard to achieve in 2016. As such, we have boosted our 2016 GDP forecast for China to 6.5% from 6.3%. However, our bigger picture conclusion remains that the Chinese economy is structurally slowing, driven by disinflation, declining incremental returns, demographic headwinds, and the law of large numbers. If we are right, then China needs not only to bring nominal lending growth more in line with nominal GDP, but it also needs to start to shift its existing debt load away from the corporate sector and towards the consumer sector. How these transitions unfold have major implications not only for China, but also for a world economy that now relies on one country, China, for almost one-third of total global GDP growth.

KKR GLOBAL MACRO & ASSET ALLOCATION TEAM

HENRY H. MCVEY Head of Global Macro & Asset Allocation +1 (212) 519.1628 [email protected]

DAVID R. MCNELLIS +1 (212) 519.1629 [email protected]

FRANCES B. LIM +61 (2) 8298.5553 [email protected]

REBECCA J. RAMSEY +1 (212) 519.1631 [email protected]

JAIME VILLA +1 (212) 401.0379 [email protected]

AIDAN T. CORCORAN + (353) 151.1045.1 [email protected]

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“ If you do not change direction, you may end up where you are

heading. ”

LAO TZU 6TH CENTURY B.C. PHILOSOPHER

3KKR INSIGHTS: GLOBAL MACRO TRENDS

When my colleague Frances Lim and I arrived in Beijing in late April, it just felt different than recent visits to China. Sentiment was gener-ally upbeat, corporate executives talked constructively about their business outlooks, and even the smog overhang had subsided.

Without question, this positive backdrop stood in stark contrast to the downbeat and somewhat overwhelming experience I had with some of my KKR colleagues in the country’s capital at year-end 2015. Dur-ing that visit both investors and CEOs talked begrudgingly about their business prospects, and one needed a heavy duty environmental mask to even walk out of the hotel to fight the dense smog and winds afflicting China’s capital city before the holidays.

Overall, our most recent time in both Beijing and Hong Kong was well spent, and we walked away with what we believe are important short-term and long-term investment conclusions. They are as follows:

1. As it relates to the short term, we are lifting our 2016 GDP forecast for China to 6.5% from 6.3%. This change represents our first uptick in forecasted Chinese GDP growth since we ar-rived at KKR in 2011. The primary catalyst for the increase is the government’s renewed commitment to achieving its 6.5% growth target for 2016 via robust liquidity injections into the economy. As one might sense, the recent decision to substantially boost more credit creation appears to run counter to the government’s origi-nal reform agenda of targeting a less levered, more market-based economy. Meanwhile, our inflation forecast for 2016 in China moves to 2.0% from 1.7%. The primary driver of the change is the aforementioned slightly higher growth, which results in slightly higher core inflation.

2. Longer-term, however, we do not think that the recent stimulus can help the Chinese economy to re-establish a higher sus-tained growth rate. In fact, growth in residential property and infrastructure – both areas that are already suffering from excess capacity in many parts of the country – were the two primary stimulants of growth during 1Q16 (Exhibit 1). Including liquidity added to these two areas, a total of RMB 7.5 trillion (U.S.$1.2 trillion) of stimulus was injected into the economy during the first quarter, which fully equates to 47% of total GDP on an annual-ized basis, according to work done by Goldman Sachs in April of this year. Not surprisingly, we view these types of stimulus initia-tives as unsustainable for an economy that already has a total debt to GDP ratio of 245%.

3. Corporate credit growth remains outsized relative to GDP, which has implications for – among others – the country’s banks, insurers, and brokers. Investors hoping for a “big bang” write-off in the banking sector, however, are likely to be disap-pointed in the near-term. From what we can tell, it’s not coming. Rather, during our visit there was a lot of discussion amongst bank executives, investors, and CEOs around more measured approaches. For example, there was quite a “buzz” about the proposed introduction of debt to equity swaps for corporations with large loans outstanding, which should theoretically provide some form of equity capital relief for banks. Another big initiative to improve the situation in the banking sector is a program that allows debt from local government funding vehicles (LGFVs) held by banks to be refinanced through the municipal bond market at

lower rates and capital charges as well as for longer durations. Unfortunately, we view both the debt for equity swap strategy and the replacement of LGFV debt with municipal debt somewhat more cautiously than the consensus because neither actually represents a true injection of external equity. Moreover, we still wrestle with the fact that credit is growing more than 13% year-over-year, which is nearly twice the pace of nominal GDP (Exhibit 24). If current trends persist, my colleague Frances Lim forecasts that debt to GDP will reach 300% or greater by 2020.

4. There is no “One China” anymore, as the country’s economy is undergoing a massive transition. Importantly, though, we are not talking purely about the transition from manufacturing towards services. In our view, this economic “hand-off” has been somewhat overhyped. The reality is that fixed investment as a percentage of GDP is now higher than any period in recent memory – largely the compliment of outsized government stimulus in recent years. Rather, we are talking about the significant transition that China’s millennials, many of whom are quite Internet savvy, are driving across the economy, particularly in the country’s retail, travel and leisure, consumer finance, sports, and healthcare/wellness sectors.

5. To offset the slowdown in global trade and flows, China is also repositioning its export economy to take market share in higher value-added services. Some of this transition is linked to internally building a “fast follower” strategy in certain sectors, but the lion’s share of executives with whom we spoke indicated that the number one priority was to acquire overseas firms with customer knowledge, global supply chains, distribution networks, and superior intellectual property. If we are right, then we should expect more outbound global M&A by China in the near-term as well as more global pricing cuts in the long-term.

6. China Inc.: Coming to a theater near you. Without question, this trip’s dominant view centered on the desire by many Chinese business leaders to acquire companies, properties, and experiences outside of China. Getting assets outside of China is clearly a major focus after the August devaluation. There is also some sound industrial logic too. For example, there is clearly a growing desire to shift excess capacity from the country’s domestic economy to new markets, the U.S. in particular. In addition, some CEOs with whom we spoke wanted to acquire high-end expertise across technology and healthcare. Finally, some Chinese businesses want to learn more about consumer behavior in developed mar-kets, so that they can bring that expertise back home or be more prepared when the local Chinese market becomes more mature.

Over time, we see really only one path forward for China’s long-term prospects: It must shift some of its credit creation away from the local government and corporations towards consumers and the central gov-ernment. This process has started, but – as with any process – there are lots of vested interests and roadblocks along the way. However, if this strategy is not pursued more vigorously, then we believe it will be nearly impossible for China to achieve 6.0-6.5% growth over the next five years due to ongoing misallocation of resources. Simply stated, investing more in loss-making businesses creates a notable drag on productivity, and as labor force growth slows further in China, produc-tivity improvement will quickly become the only catalyst for boosting longer-term growth.


EXHIBIT 1

Recent Monetary Stimulus Has Certainly Worked to Bolster Animal Spirits…

Mar-16160

107102

90

100

110

120

130

140

150

160

170

10 11 12 13 14 15 16

China: Existing House Price Index: January 2010=100

Tier 1 Tier 2 Tier 3+

Data as at March 31, 2016. Source: China National Bureau of Statistics, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

EXHIBIT 2

…But There is Now a Bigger Issue in China: As Credit as a Percentage of GDP Rises, Real GDP Growth Falls

2007

2015

1995

5

6

7

8

9

10

11

12

13

14

15

100 120 140 160 180 200 220 240

Chin

a: R

eal G

DP Y

/y, %

China: Credit as a % of GDP

Data as at 3Q15. Source: BIS, China National Bureau of Statistics, Haver Analytics.

EXHIBIT 3

China’s GDP Growth Will Rise and Fall With Stimulus, but the Trend Is Downward Sloping

Dec-156.0%

Mar-167.1%

4%

6%

8%

10%

12%

12 13 14 15 16

China: Nominal GDP Growth Y/y, %

Growth stronger than expected providing some

support for reform

Growth weaker than expected resulting in

stimulative policy response

Data as at March 31, 2016. Source: China National Bureau of Statistics, Haver Analytics.

EXHIBIT 4

China Has Already Had a Hard Landing In Nominal Terms, We Believe

9.9%

19.6%

6.7% 7.1%

China: Real GDP Y/y China: Nominal GDP Y/y

China Real vs. Nominal GDP Growth, Y/y, %

2Q11 1Q16

-64%-32%

Data as March 31, 2016. Source: China National Bureau of Statistics, Haver Analytics.

So, despite our decision to boost our 2016 GDP forecast, our bigger picture conclusion remains that the Chinese economy is structur-ally slowing, driven by disinflation, declining incremental returns, demographic headwinds, and the law of large numbers. Importantly, though, whenever China’s growth trajectory falls too far below trend, the government periodically re-embraces its well documented “playbook” of stimulating fixed investment to smooth growth and improve confidence. Our growing concern with this strategy is that the incremental return on credit is falling each time the government re-stimulates the economy via rapid credit creation (Exhibits 2 and 6). We also think the ongoing decline in returns and growth in credit is inconsistent with a currency that is being asked to trade in a nar-row band (estimates during our trip were from one to three percent depreciation during the next 12 months).

“ Corporate credit growth remains outsized relative to GDP, which has implications for – among others – the country’s banks,

insurers, and brokers. “


EXHIBIT 5

Credit Has Increased by More Than 100 Percentage Points of GDP Since 2000

134148

245

80

100

120

140

160

180

200

220

240

260

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Other Credit % GDP

China: Bank Loans & GDP

China: Total Social Financing % GDP

%

Data as at 3Q2015. Source: BIS, PBoC, China Bureau of National Statistics, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

EXHIBIT 6

Diminishing Returns: Credit per Unit of GDP Growth in China Remains on an Upward Trajectory

2.5

1.2 1.2 1.31.1

1.4

4.7

2.1

1.6

3.1 3.2 3.33.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

03 04 05 06 07 08 09 10 11 12 13 14 15

China: Credit per Unit GDP

Data as at December 31, 2015. Source: China National Bureau of Statistics, Bloomberg.

Beyond the credit overhang, China “bears” will also argue that the country is now caught between ceding the low-end manufacturing activity to its Southeast Asia and African peers without the neces-sary increases in high-end manufacturing market share to create a smooth transition. We certainly saw examples of this “squeeze” happening, but we think this perspective ignores that China is making huge inroads in terms of profitability and growth in some of the more value-added segments of the global economy (see Exhibit 8). Regard-less of where one comes down on the China debate, this bull versus bear script will still take time to play out, and in the interim, we think the economy will give both sides enough food for thought to keep things quite volatile well into 2017.

EXHIBIT 7

China’s Overall Manufacturing and Export Machine Has Slowed…

-10

0

10

20

30

40

11 12 13 14 15 16

China: LTM Fixed Asset Invt Y/y, %

China: LTM Exports Y/y, %

China: LTM Retail Sales Y/y, %

Data as at March 31, 2016. Source: China National Bureau of Statistics, China Customs, Haver Analytics.

EXHIBIT 8

…But Within Its Export/Industrial Sector, Profitability Is Surging in Its Higher Value Industries

-234

-186

-111

-19

10

12

13

15

15

35

Petroleum & Natural Gas

Petro, Coking & Nuclear Fuels

Coal Mining

Ferrous Metals Mining

Medical & Pharma Products

Beverage Manufacturing

Special Purpose Equip

Food Manufacturing

Agricultural & Food Processing

Waste/Materials Recovery

China Industrial Profits, Y/y, %

Data as at February 29, 2016. Source: China National Bureau of Statistics, Haver Analytics.

In terms of investment opportunities, we left with similar takeaways as from our prior trips. Specifically, we continue to eschew the Chinese public equity markets, which are heavily skewed towards large banks (Exhibit 9). By comparison, in the private markets we still continue to see more interesting opportunities, albeit we believe one has to be more valuation disciplined than in the past. In particular, we continue to favor the high value-added segments of the market that are direct plays on rising GDP-per-capita, not just rising GDP (which is what we think the public markets in aggregate represent). This opportunity set includes healthcare, consumer finance, food safety,


and mobile/Internet penetration. We also continue to see grow-ing opportunities in sports and wellness. On the other hand, while environmental investment “plays” appear theoretically attractive, the space now feels overcrowded, including increased government participation.

EXHIBIT 9

Financials Continue to Represent a Large Percentage of the MSCI China Index; By Comparison, Consumer Is Quite Small

MKT CAP CONSENSUS EPS GROWTH

CHINA WEIGHT % 2016 2017

TOTAL MARKET 100.0 2.9 14.0

CONS DISCR 7.3 6.0 26.7

CONS STAPLES 2.7 8.7 8.5

ENERGY 7.0 -44.6 147.9

FINANCIALS 31.7 -1.7 5.8

HEALTH CARE 1.9 9.7 16.2

INDUSTRIALS 6.7 15.2 12.3

INFO TECH 29.0 35.3 29.0

MATERIALS 1.3 67.4 29.4

TELCO 9.1 2.5 10.3

UTILITIES 3.3 8.6 4.1

Data as at April 28, 2016. Source: JPM Research “Emerging Markets Strategy Dashboards” dated April 28, 2016.

EXHIBIT 10

Revisions In China Continue to Be on a Downward Trajectory

Jun-15

Apr-16-12.4

-30

-25

-20

-15

-10

-5

0

5

10

15

10 11 12 13 14 15 16

China: FY2 Earnings Revision, %

Data as at April 30, 2016. Source: Factset.

Separately, we spent a lot of time on the non-performing loan (NPL) opportunity this trip. On the surface, the opportunity appears significant, as NPLs have increased for 17 consecutive quarters, and in the last year total non-performing assets on bank balance sheets in China increased to 1.3 trillion RMB, a full 51% increase year-over-year (Exhibits 27 and 28). We are by no means experts in this area, but our base conclusion is that this opportunity could take more time to ramp up than the current consensus now thinks. True, the government is cracking down on off-balance sheet lending structures that shield NPLs, as well as increasingly pushing banks to dispose of problem assets. However, we did not sense that we are on the cusp of a crisis moment, nor did we leave Beijing under the impres-sion that there would be a policy change that dramatically favored foreign capital players in terms of loan workouts. Also (and some-what ironically), the government’s recent decision to boost liquidity has actually helped many weak corporations and property players to stay the course, not restructure the way they potentially should. Finally, returns across many deals we discussed were not as high as one might think, particularly relative to what we are now seeing in regions like Europe.

Looking at the bigger picture, we still think that the global capital markets remain in “Adult Swim Only” mode. As we saw with the Bank of Japan’s recent decision to refrain from more stimulus, there is a lot of confusion and anxiety around negative interest rates. Meanwhile, aggregate global EPS growth continues to disappoint, as nominal revenues are falling amidst higher debt expenses. This combination is somewhat worrisome, though we are sticking to our team’s base view that the next global recession likely occurs in late 2017/early 2018.

Against this backdrop, our major macro and asset allocation themes remain largely unchanged. Specifically, we continue to favor an overweight positon in private credit, including direct lending, mez-zanine, and asset-based lending. Year-to-date, these markets have represented some of the best risk-adjusted returns, we believe. Importantly, our work shows that private equity tends to outperform public equities at this point in the cycle. Within private equity, we favor consumer facing businesses more than industrial/export related franchises. Key to our thinking is that 1) globally, we just shifted $2.7 trillion in value from commodity producing nations to consumer-ori-ented ones and 2) global trade and global flows continue to disap-point, which we view as a secular, not cyclical, phenomenon. Finally, within real assets, we remain bullish on our Yield and Growth thesis, which leads us to infrastructure, broken energy stories with upside optionality, and dislocated real estate credit.

DETAILS

GDP Update/Putting China in Perspective

As we indicated above, we have boosted our 2016 GDP forecast for China to 6.5% from 6.3%. This increase is important for all global investors because, as we show in Exhibit 11, China accounts for about one-third of total incremental global growth in nominal USD terms. If we are using purchasing power parity as a measuring stick, then Chi-na’s contribution is even larger. That said, as Exhibit 12 shows, strong absolute growth in China has not led to strong growth in profits and/or returns on shareholder equity. We link this “disconnect” between


strong GDP growth but weak profits to the reality that nominal GDP as well as nominal revenues in China have fallen sharply at the same time that corporate debt service burdens have increased dramatical-ly. In addition, some of this GDP growth has come from loss making industries with excess capacity.

EXHIBIT 11

In 2016, the U.S. and China Will Be the Major Contributors to Global Growth in U.S.$ Terms

0.6

1.0

0.6

1.0 3.2

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

U.S. China Other EM Other World

Contribution to 2016 Global Real GDP GrowthWeighted by Nominal U.S.$ GDP, %

Data as at April 12, 2016. Source: IMF, Haver Analytics, KKR Global Macro & Asset Allocation.

EXHIBIT 12

Despite Strong GDP Growth, Corporate Returns Remain Lackluster in China

Apr-1613.5

12.8

10

11

12

13

14

15

16

17

18

6

8

10

12

14

16

18

20

06 07 08 09 10 11 12 13 14 15 16

LTM Trailing ROE

U.S. China

Data as at April 30, 2016. Source: MSCI, Factset.

Despite our increasing concern about the trajectory of debt levels in China as well as the ability of this economy to translate GDP growth into profits, we see three important, positive economic trends from our trip that we think are worth highlighting. First, China has been using its growing strength in high-end exports to drive increased market share, despite an overall slowing export environment. In fact, China has actually been gaining share in total net exports in recent years (Exhibit 13) at the time it has been ceding the low-end of the

market to players like Vietnam, Africa, and Mexico (Exhibit 15). All told, China’s proportion of global exports rose to 13.8 percent last year from 12.3 percent in 2014, the highest share any country has enjoyed since the United States in 1968.

A heightened focus in recent years on value-added growth markets such as high-speed rail, nuclear reactors, and new energy vehicles has been instrumental to growing overall market share, we believe. Meanwhile, on the low-end, the country has thoughtfully and willingly forfeited share in areas where Chinese wages are no longer competi-tive (e.g., toys, leather, and shoes) and/or competitive devaluations by other EM peers have affected China’s long-term market position. The other key change that the country has made to help its overall export initiative is to insource the production of more immediate goods. One can see this in Exhibit 14. Besides improving cost and supply chain management, insourcing has boosted the country’s cur-rent account, which is ultimately a much needed potential tailwind for its currency.

EXHIBIT 13

As China Rebalances Towards Higher Value-Added Exports, It Continues to Grow Its Share of Global Exports at the Expense of Japan, Germany, and the U.S.

0

2

4

6

8

10

12

14

82 86 90 94 98 02 06 10 14

Share of World Exports, 12mma, %

Korea China JapanGermany U.S.

Data as at December 31, 2015. Source: IMF, Haver Analytics.

“ Our bigger picture conclusion

remains that the Chinese economy is structurally slowing, driven by

disinflation, declining incremental returns, demographic headwinds,

and the law of large numbers. “


EXHIBIT 14

China Is Maintaining Share by Exporting More High-End Goods. However, It Is Also Importing Less as It Builds Local Competitive Advantages

9.5

Dec-1513.8

0

2

4

6

8

10

12

14

90 92 94 96 98 00 02 04 06 08 10 12 14

China Share of World Trade, 12mma, %

China Imports China Exports

Data as at December 31, 2015. Source: IMF, Haver Analytics.

Second, the country has also done a solid job of building out its ser-vices platform, which has been important to offset the ongoing slow-down in the country’s manufacturing and construction industries. One can see elements of this transition in Exhibit 16. All told, services now accounts for 56.9% of Chinese GDP, compared to just 37.5% for manufacturing and construction. Growth in healthcare, travel, and financial offerings are representative of key drivers of this significant shift in the country’s economy.

EXHIBIT 15

The Traditional “Made in China” Export Economy Is in Secular Decline…

Mar-1653.9

Mar-1634.5

30

35

40

45

50

55

60

06 07 08 09 10 11 12 13 14 15 16

China % Total Exports, 12mma

Ordinary Trade (Higher Value Add)

Reexports (Lower Value Add)


EXHIBIT 16

…But Services Are Now Growing Nicely

37.5

Mar-1656.9

20

25

30

35

40

45

50

55

60

70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15

China GDP Composition (as a % of GDP)

Secondary Industry (Manufacturing & Construction)

Tertiary Industry (Services)


EXHIBIT 17

Private Consumption Is Growing Rapidly in China, a Trend We Expect to Continue

CONSUMPTION U.S.$ TRILLIONS

2015 2020 % CHG

U.S. 12.3 15.0 22%

CHINA 4.1 6.1 47%

JAPAN 2.5 2.9 16%

GERMANY 1.8 2.2 18%

UK 1.8 2.1 14%

FRANCE 1.3 1.6 16%

INDIA 1.2 1.9 59%

ITALY 1.1 1.2 13%

BRAZIL 1.1 1.1 -1%

CANADA 0.9 1.0 12%

CONSERVATIVE ASSUMPTIONS STILL LEAD TO NEARLY 50% GROWTH. IF CONSUMPTION AS A % OF GDP GREW BY JUST 100BP A YEAR, 2020

CONSUMPTION WOULD RISE TO $7.3 TRILLION OR A 70% INCREASE

Data as at April 12, 2016. Using 2014 ratio of Consumption % GDP against IMF estimate of nominal GDP. Source: IMF, Haver Analytics.


EXHIBIT 18

China’s Tech Sector Is Now Bigger Than Europe’s

486 399 502

3,753

Alibaba + Tencent + Baidu

+ JD.com

MSCI Europe Information Technology

Sector

MSCI China Information Technology

Sector

S&P 500 Information Technology

Sector

Market Cap in U.S.$ Billions

Data as at April 27, 2016. Source: Bloomberg.

Third, China has become a major force in advancing technology change. To review, in 2006 the government set a goal of turning China into a science powerhouse by 2020 by raising R&D spend-ing to 2.5% of GDP, compared to 1.4% at the time. Already, R&D has increased to 2.0% of GDP, while the number of local researchers in China has increased 32% to 1.5 million from 1.1 million in 2005 (Exhibit 19). Not surprisingly, there has been a surge of patent applica-tions by China, increasing 5.4 fold to 928,000 in 2014 (latest data) from 173,000 in 2005 and now 60% more than the U.S. (Exhibit 20). Meanwhile, as we show in Exhibit 18, Chinese companies have been translating this technological innovation into market capitalization growth. Just consider that four Chinese technology companies have a greater market capitalization than the entire European technology sector. This successful transition from private start-ups to large, profitable public companies is important, because these companies can use their highly valued equity currencies to acquire early-stage companies both inside and outside of the Chinese mainland. As a re-sult, we believe that China is now in a much better position than other countries against which it competes for talent and ideas to create a virtuous cycle of technological advancement.

EXHIBIT 19

China Has More Researchers Than the U.S….

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

96 98 00 02 04 06 08 10 12 14

Number of Researchers in R&D, Millions

China U.S. Euro Area

Data as at December 31, 2013. Source: World Bank, Haver Analytics.

EXHIBIT 20

…And Now Files 60% More Patents Than the U.S.

928

579

105

0

100

200

300

400

500

600

700

800

900

1,000

96 98 00 02 04 06 08 10 12 14

Patent Applications, Thousands

China U.S. Euro Area

Data as at December 31, 2013. Source: World Bank, Haver Analytics.

“ To offset the slowdown in global trade and flows, China is also

repositioning its export economy to take market share in higher

value-added services. “


EXHIBIT 21

The 25-34 Year Old Age Bracket Is Driving Online Spending Growth in China

6.2

24

37.9

23.9

8.1

4.2

0%

5%

10%

15%

20%

25%

30%

35%

40%

0

5

10

15

20

25

30

35

40

6-14 15-24 25-34 35-44 45-54 55+

Online Spending per Month by Age Group,RMB Millions and % of Total

Online Spending % of Total Online Spending

Data as at June 30, 2015. Source: China Internet Network Information Center (CNNIC), Credit Suisse Live and Breathe the Internet 2015 Investment Guide.

EXHIBIT 22

World Internet Penetration: China Stands at a 49% Penetration Rate, Suggesting More Running Room

3%31%

46%49%49%49%

58%68%68%

71%82%

87%91%92%92%

95%

0% 50% 100%

IndiaIndonesiaAverageMexicoChina

South AfricaBrazil

PolandMalaysia

RussiaSingapore

U.S.Japan

South KoreaU.K.

Canada

Global Internet Penetration

By 1H15, the number of Internet users in China grew to 668m (49% penetration). IDC projects this number to reach 70% by 2017 (53% rural, 73% urban)

Data as at June 30, 2015. Source: Internet World Stats, Credit Suisse Live and Breathe the Internet 2015 Investment Guide.

Against this backdrop of accelerating technological change, industries are being redefined – and in some instances at an alarming pace. For example, online sales in China are now growing around 40% year-over-year, compared to just six to seven percent for bricks and mortar offerings1. As such, online sales as a percentage of total sales are expected to be 15.4% in 2017, compared to just 10.4% in 20142. Driving significant growth in online sales are both the rising number of online millennial shoppers as well as rising income within this demographic. One can see this in Exhibit 21. Rough estimates are that millennials account for one-third of the China’s total population, but now account for two-thirds of total e-commerce.

…But Still More Balance Is Needed

Beyond the changes we described above in exports, services, and technology, the Chinese government is also making a significant push towards reforming its state-owned enterprises (SOEs). Indeed, as Premier Li Keqiang stated in a December 2015 meeting with top ad-visors “We must summon our determination and set to work, for those ‘zombie enterprises’ with absolute overcapacity, we must ruthlessly bring down the knife.3”

While we applaud Premier Li’s recent “call to arms,” we think that there are at least three other strategies the government should consider to promote more stable long-term growth. For starters, we would argue that the aforementioned SOE reform can’t achieve its desired effect unless weakened competitors across industries with excess capacity are allowed to fail. To do so, however, credit creation growth must trend down below nominal GDP growth. To date, how-ever, the exact opposite has been true, as nominal lending growth is now running more than six hundred basis points above nominal GDP, one of the widest gaps ever (Exhibit 24). As such, while China is “ruthlessly bring(ing) down capacity” in some areas, excess credit is allowing “absolute overcapacity” in other areas of the economy.

1 Data as at June 30, 2015. Source: China Internet Network Information Center (CNNIC), Credit Suisse Live and Breathe the Internet 2015 Investment Guide.

2 Data as at January 15, 2016. Source: Credit Suisse, iResearch.

3 Data as at February 29, 2016. Source: FT, China’s State-Owned Zombie Economy.

“ The country has thoughtfully

and willingly forfeited share in areas where Chinese wages are no longer competitive and/or

competitive devaluations by other EM peers have affected China’s

long-term market position. “


EXHIBIT 23

Loss-Makers Form an Increasing Share of SOEs

-2,000

-1,000

0

1,000

2,000

3,000

4,000

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Profit and Loss-making SOEs, RMB Billions

Profits of Profit-makingLosses of Loss-making

Data as at December 31, 2013. Source: China Finance Ministry, Ibid. 1.

EXHIBIT 24

Nominal Credit Growth Is Still Running Way Above Nominal GDP; Reform Can’t Happen Unless This Relationship Changes, We Believe

Mar-1613.4

Mar-167.1

0

5

10

15

20

25

30

35

05 07 09 11 13 15

Total Social Financing Y/yChina: Nominal GDP Growth Y/y %

Credit growth growing in line with nominalGDP growth

Debt to GDP still climbing

Data as at March 31, 2016. Source: People’s Bank of China, China National Bureau of Statistics, Bloomberg, Haver Analytics.

Another option for the government to consider is to facilitate more credit creation from the consumer segment of the market versus the existing strategy of re-stimulating an already over-leveraged corpo-rate sector. If done properly, we believe this strategy would help to make China less reliant on its old economy sectors, manufacturing in

particular. In addition, by providing access to a segment of the market that has traditionally had an extremely high savings rate, it would further drive consumption at the expense of fixed investment, which is what is really required to rebalance the economy. If there is good news, many of the banking executives and officials with whom we spoke seem supportive of this game plan. The bad news is that this rebalancing is moving slowly; in fact, consumer credit still now only accounts for about 25% of total loan growth4.

EXHIBIT 25

China Has Too Much Corporate Debt

3878 60 65

164 70 103 101

4393 91

210245 242 255

377

China US Euro Area Japan

Total Debt as a % of GDP

Government Corporate Household

Existing LGFV debt classified ascorporate will ultimately need to be transferred to the government sector

Data as at 3Q15. Source: Bank for International Settlements, Statistical Office of the European Communities, Cabinet Office of Japan, Bureau of Economic Analysis, China National Bureau of Statistics, Haver Analytics.

EXHIBIT 26

China Needs to Encourage More Consumer Borrowing, Not Savings, at This Point In Its Economic Cycle

46.0

23.225.3

18.7

31.4

6.52.2

5.0

05

101520253035404550

China Euro Area Japan U.S.

Gross National Savings Rate, % Household Savings Rate, %

Equivalent to $5 trillion of government, corporate, and household savings relativeto just $3.3 trillion in the U.S.

Data as at December 31, 2015. Source: IMF, OECD Net Household Savings Rate, Bureau of Economic Analysis, China National Bureau of Statistics, Haver Analytics.

4 Data as at December 31, 2015. Source: Bloomberg, Haver Analytics.


The final potential change that we think warrants consideration is an increasing focus on building out a credible bond market, one that is transparent enough to attract foreign capital on a sustained basis. We see several positives to this strategy. First, in a world of zero interest rates, we think that China’s bond market – if run properly – could act as an attractive destination for foreign capital seeking returns. Just consider that only 17% of the $48 trillion Barclays Multiverse Aggregate Index currently yields north of three percent5. By compari-son, there are hundreds of quality companies in China with corporate debt yielding five percent or more6. Second, in terms of balancing the capital account, we think a credible local bond market in China would potentially help to offset the ongoing desire by locals to remove capi-tal from the mainland. Given our view that capital flight is likely one of the biggest risks to the China story, we think ensuring a greater source of alternative inflows into the country warrants attention at this point in China’s capital markets liberalization strategy. Finally, we believe the development of a credible bond market, so early in China’s capital market development, could ultimately become a com-petitive advantage versus other markets like Japan and Europe, both of which still rely heavily on a concentrated bank market for credit creation.

China: The Ultimate Macro Paradox?

After enjoying its Golden Era of growth during the 2000-2010 pe-riod, the China macro narrative has become much more complicated, one today that is filled with a series of ongoing policy trade-offs that often end up being more intertwined – and sometimes conflict-ing – than one could ever imagine. Indeed, too many times on this trip it felt like we heard the refrain that “on the one hand…but on the other…” Just consider the following points:

• On the one hand, we heard continuously that the Chinese government has pledged more serious SOE reform, including more competitive and profitable global industries. On the other hand, the government is again boosting domestic credit growth to more than 13% year-over-year. At such a high level above nominal GDP, the recent pace of credit growth all but ensures that many of the country’s weakest corporate entities sidestep bankruptcy and/or avoid default, which is ultimately at odds with improving competitiveness and productivity.

• Amidst low inflation and bumpy growth, China has continued to lower rates further to ease financial conditions. Importantly, more easing is likely needed, as the country’s GDP deflator hov-ers near zero. On the one hand, if the People’s Bank of China does ease further, then it will certainly give a much needed boost to the corporate sector, which appears to be lumber-ing under the weight of excess debt service burdens. On the other hand, if the central bank does lower rates, it could have a negative impact on the currency, which could create significant capital markets volatility inside and outside of China.

• Meanwhile, a weaker currency could be good for exports, but it would undermine some of the credibility achieved by China gaining admission to the Special Drawing Right (SDR). A weaker

5 Data as at April 30, 2016. Source: Bloomberg.

6 Data as at April 21, 2016. Source: Citigroup.

currency would also make it more expensive for consumers to import things and for companies to acquire abroad, both of which appear to be strategic priorities for the country. On the other hand, if the currency were to re-adjust downward towards what we view as fair value, then the recent bout of capital flight might finally subside if locals felt that there was less downside risk to the local currency.

Why does it feel like there is a surge in Chinese macro-related incon-sistencies? We see at least three reasons, all of which are inter-re-lated. First, the current Chinese government is being forced to make some unnatural concessions as it attempts to fulfill the party’s origi-nal mandate to double GDP between 2010 and 2020. Given more challenging demographics and the recent slowing of global trade, the government now needs to run the economy even hotter than normal to achieve the annual growth it requires to fulfill its long-term GDP mandate. This mandate in turn leads to a need to boost credit growth towards double-digit levels to overcome the offsets linked to struc-turally slower growth. And because credit growth is so strong, the country is obliged to clamp down on its capital account to prevent this growth in capital from fleeing the system.

Second, while the government wants to boost productivity to drive growth, rapid credit growth to aid the old economy actually hurts long-term efficiency. The third challenge is that there appears to be somewhat of a conundrum between the government’s desire to sup-port growth and to consolidate power via anti-corruption initiatives. In fact, a number of local people we met thought that recent reform initiatives were only hurting, not helping, growth. While we agree that reform often requires painful adjustments, it also represents the most credible path forward to longer-term sustainable growth in China, in our view.

“ The recent pace of credit growth

all but ensures that many of the country’s weakest corporate

entities sidestep bankruptcy and/or avoid default, which is

ultimately at odds with improving competitiveness and productivity.

“


Our bottom line in assessing the China global macro landscape is that, if it feels a little confusing, it probably should. Why? Because there are so many crosscurrents at work. In our view, the good news is that the government appears to be working hard to communicate with folks both inside and outside of China. Central bank Governor Zhou Xiaochuan has certainly raised his profile with international investors, and we left Beijing with the distinct impression that the government seems more committed to more clearly articulating its strategy around growth, anti-corruption, and liberalization initiatives to both internal and external constituents. If we are right, then this could be an important positive relative to some of the misunderstand-ings we have seen around the Chinese stock market, currency, and reform initiatives during the past few quarters.

Banking: the Slow Burn

Every time I visit with a bank executive in China I am reminded of that famous Mark Twain quote that, “The reports of my death have been greatly exaggerated.” To be sure, with total debt as a percent-age of GDP at 245% and nominal lending growing nearly two times the pace of nominal GDP, investors have been theoretically right to approach the banking sector in China with caution (Exhibit 24). However, despite multiple apocalyptical predictions about the sec-tor’s demise in recent years, the average bank in China has continued to deliver both earnings growth and book value per share growth. A key reason is that actual stated NPLs are now at just 1.7%, on aver-age, for the sector, though they have started to increase in recent quarters. One can see this in Exhibit 27. Meanwhile capital ratios still appear solid, with the sector’s Capital Adequacy Ratio at 13.5% and Tier 1 ratio at 11.3%, respectively7.

EXHIBIT 27

The NPL Ratio Has Risen as GDP Growth Has Fallen…

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0

0.8

1.0

1.2

1.4

1.6

1.8

11 12 13 14 15 16

China: Commercial Bank: NPL Ratio (L)

China: Real GDP (R)

Data as at March 31, 2016. Source: China Banking Regulatory Commission, Haver Analytics.

7 Data as at March 31, 2016. Source: China Banking Regulatory Commission, Haver Analytics.

EXHIBIT 28

…But NPLs Have Not Kept Pace With Loan Growth

Jun-0934.4

Mar-1614.7

Sep-085.49 Dec-15

1.67

0

2

4

6

8

10

12

14

16

0

5

10

15

20

25

30

35

40

05 06 07 08 09 10 11 12 13 14 15 16

Non-

Perf

orm

ing

Loan

s Ra

tio, %

Loan

Gro

wth

, %

China: Major Commercial Banks

Loan Growth, Y/yNon-Performing Loan (NPL) Ratio

Data as at March 31, 2016. Source: China Banking Regulatory Commission, Haver Analytics.

EXHIBIT 29

And If China Keeps On Growing Credit At 13%, Then Credit to GDP Will Reach 300% By 2020

300

250

200

140160180200220240260280300320

06 08 10 12 14 16 18 20

China: Credit as a % of GDP

If TSF Grows at 13% and Nominal GDP at 9%



TSF = Total Social Financing. Data as at December 31, 2015. Source: BIS, China National Bureau of Statistics, Haver Analytics.

We can’t vouch for the loan books of the Chinese banking sector, but we do have some insights into why the capital ratios still appear robust, de-spite rising NPLs. First, our research shows that many LGFVs recently paid back their bank loans, then immediately began swapping their li-abilities into local municipal debt securities. This corporate finance “ba-ton hand-off” is significant because municipal debt tends to be longer in duration and has a capital charge of 20% versus 100% for LGFV loans/bonds. As such, banks enjoyed essentially an overnight re-equitization, though no actual capital has been injected into the banking system in some instances. Second, many banks are now on track to swap corpo-rate debt obligations into equity positions, which improves the capital structure of the business and prevents – in the near-term – what could


have been a significant impairment that a bank would have had to other-wise taken. Third, because loan growth remains so robust in China, it is actually hard for reported non-performing loans as a percentage of total bank assets to actually “catch-up.”

Even with these accounting tailwinds, certain banks, particularly the smaller ones, are seeing notable deterioration in their loan books. Moreover, a real NPL market is beginning to form. Indeed, using pub-licly available data, we believe that commercial banks in China have around RMB 1.3 trillion of official NPLs, while loans that “warrant special attention” now total RMB 2.9 trillion. Collectively, this RMB 4.2 trillion of souring assets (Exhibit 30) is now sufficiently larger than the RMB 1.6 trillion of asset management equity (note that RMB 200 bil-lion has been raised, but it can be levered 8:1 for RMB 1.6 trillion).

Moreover, these reference points do not tell the entire picture, as the aggregate loan market is actually about RMB 111 trillion (Exhibit 31). If we assume loss ratios of eight or nine percent (which many analysts believe is more realistic) versus the current reported number of one to two percent for normal commercial bank loans, then the total ca-pacity needed to digest NPLs across multiple asset classes is closer to RMB 10 trillion, or 15% of GDP in China.

EXHIBIT 30

Total NPLs in China Are Running at RMB 4.2 Trillion or an NPL Ratio of 5.5% After Including Special Mention Loans

0.6

0.50.2 1.3

2.9 4.2

Substandard Loans

Doubtful Loans

Loss Loans

Official NPLs1.7%

Special Mention Loans

Total NPLs5.5%

China: Commercial BanksNon-Performing Loans, RMB Trillion

Data as at 4Q15. Source: China Banking Regulatory Commission, Haver Analytics.

EXHIBIT 31

Including Non-Commercial Bank Financing, the Total Loans Outstanding Is Roughly RMB 111 Trillion

72.0 1.3 2.9 76

18

16 11113

10 133

China: Total Domestic Credit,RMB Trillion

NPL Ratio Implies NPLs Of:8% RMB 8.9 trillion9% RMB 10.0 trillion10% RMB 11.1 trillion

Normal Comm'cl

Bank Loans

Official NPLs

Special Mention Loans

Total Comm'cl

Bank Loans

Other Bank Loans

Trust & Entrusted

Loans

Total Loans

Other Financing

Claims on Govt

Total Domestic-

Credit

Data as at 4Q15. Source: China Banking Regulatory Commission, Haver Analytics.

Overall, we left Beijing with the impression that the banking sec-tor, including its asset management companies (AMCs), are likely to slowly bleed these losses out over time. As such, investors looking for a 2007/2008 shock to the system – similar to what happened to the U.S. banking sector – that leads to huge overnight asset sales are likely to be disappointed in the near-term. Rather, we believe we will see more of a Japanese bank style, sluggish unwind of NPL portfo-lios.

We also do not think the current NPL cycle in China will look any-thing like it did during the last NPL clean-up around the turn of the century. Key to our thinking is that the current macro environment is just less conducive than it was 15 years ago. For starters, GDP growth is now slowing, not increasing. Coupled with higher corporate debt levels, the environment gives banks less wiggle room to take write-offs and move on. Moreover, asset management companies no longer are buying the assets at book value because they have their own shareholders, not just the government (which was the case during the prior cycle). Finally, return profiles appear more muted in some instances than what was earned in the past.

So, our bottom line is that a significant opportunity for NPL restruc-turing has formed, but access to quality product, particularly for non-local players, is likely more challenging than the current consensus now thinks. It also requires boots on the ground to source the oppor-tunity, to directly deal with the major AMCs, the growing number of provincial AMCs, and the variety of large and small banks that define the financial services system in China. Finally, as we mentioned earlier, the recent shift back towards short-term economic growth strategies using outsized credit creation versus President Xi Jin-ping’s stated focus on reform could actually be a net negative for the China NPL story in the near-term, as it again delays the inevitable by temporarily revitalizing many of corporate sector’s weakest links.

“ China has become a major force in advancing technology change.

“


China Inc. Is Headed Overseas

When we go to China and do a series of meetings over a few days, there is always a lot of debate around key issues/topics. Will the government stimulate more, what is the direction of the currency, are the NPLs understated? Then there is a consensus that forms around one or two big ideas. Without question, this trip’s consensus view centered on the desire by many Chinese business leaders to acquire companies, properties, and experiences outside of China. Getting assets outside of China is clearly a major focus after the August devaluation. There is also some sound industrial logic too. For example, there is clearly a growing desire to shift excess capacity from the country’s domestic economy to new markets, the U.S. in particular. In addition, some CEOs with whom we spoke wanted to acquire high-end exper-tise across technology and healthcare. Finally, some Chinese busi-nesses want to learn more about consumer behavior in developed markets, so that they can bring that expertise back home or be more prepared when the local Chinese market becomes more mature.

Regardless of the reason, the demand side of the aforementioned equation is surging. One can see this in Exhibits 32 and 33. What does this mean for investors? It likely means that Chinese companies will now compete more aggressively against strategic and private equity investors on the acquiring side of deals, but could provide a logical buyer of choice on exits. Second, once a company has been acquired, investors should be wary if Chinese management competes aggressively on price. Beyond the impact at the company and the industry levels, increased price competition could likely add a defla-tionary backdrop to what is already a disinflationary global macro environment and add further downward pressure on interest rates. Finally, China will need to manage its currency base firmly in other areas (i.e., prevent further outflows) if M&A volumes do — in fact — tick up from current levels.

EXHIBIT 32

China’s Influence Has Risen to 25% of Global M&A, Exceeding That of the U.S.

Middle East3%

United States22%

Europe8%

Japan11%

Canada12%

Greater China25%

Other19%

2014 Cross-Border M&A by Purchaser U.S.$B

* Greater China = China + Hong Kong + Taiwan. Data as at December 31, 2014. Source: United Nations Conference on Trade and Development.

EXHIBIT 33

China Is on a Mega Buyout Spree

341

0

50

100

150

200

250

300

350

0

20

40

60

80

100

120

140

160

3 4 4 7 9 11 16 15 11 15 14 10 10 11 1552 5 10 13

25 16 2024 25

18 21 2031

122 23

10

85 12

1012

13 17 21

19

100

07

18 17

22 5523

4351

4549 43

79

88147

169

01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

>$1B500m-1B100m-500m<$100mAverage Deal Size (R)

China: Cross-border Announced M&A VolumesBy Deal Size

US$B US$m

2016 data is YTD; annualized deals in U.S.$ terms < 100m = 16, 100m to 500m = 36, 500m to 1B = 30, >1B = 263 totaling 345B with an average deal size of 1,023. Data as at May 2, 2016. Source: Dealogic, UBS.

“ Without question, this trip’s

consensus view centered on the desire by many Chinese business

leaders to acquire companies, properties, and experiences

outside of China. “


China’s Role in the Recent Commodity Spike

As has been well documented in the press, commodity prices have surged in recent months. For our nickel, we see the current price action as a cyclical bounce in what we still view as an ongoing structural bear market. However, given how far prices have fallen in absolute terms and for how long in duration (Exhibits 34 and 35), we think this bounce could potentially provide an investable opportunity.

EXHIBIT 34

Commodities Have Experienced, on Average, a 66% Price Correction in Recent Years…

Peak-to-Trough Correction to Date, %

Post 2009 High All Time High

-87-84

-79-79-77

-72-67-65

-58-57-56-55-52

-39

-100 -80 -60 -40 -20 0

Nat GasNickel

UraniumIron Ore

Crude OilCoal

SilverZinc

PlatinumTin

LeadCopper

AluminumGold Average correction

from all timehigh is 66%

Data as at March 31, 2016. Source: World Bank, IMF, Haver Analytics.

EXHIBIT 35

… Which Has Lasted Between Four and Ten Years

4.34.84.84.9

7.07.37.57.57.77.88.1

8.89.1

10.4

0 2 4 6 8 10 12

GoldSilver

TinCopper

UraniumAluminumCrude Oil

CoalPlatinumIron Ore

LeadNickel

ZincNat Gas

Duration of Correction to Date, Years

Start of Recent CorrectionNumber of Years Since All Time High

Data as at March 31, 2016. Source: World Bank, IMF, Haver Analytics.

We see several forces at work. First, as we show in Exhibits 36 and 37, respectively, research done by my colleague Frances Lim shows that major initial declines are subsequently followed by counter trend rallies that can produce returns of 41-110%. Second, we do think that Fed policy has changed in recent months towards being more accom-modative, which is dollar bearish and commodity bullish. Importantly, though, we think that the current dollar “pause” lasts only 12-18 months, which is consistent with our view that commodities are enjoying a cyclical bounce, not a fundamental, long-term resurgence in prices across the complex.

“ A significant opportunity for

NPL restructuring has formed, but access to quality product,

particularly for non-local players, is likely more challenging than

the current consensus now thinks. “


EXHIBIT 36

Real Prices Tend to Hit an Initial Trough After Five Years, But The Full Cycle Might Be As Long As 40+ Years

Commodity Price Peaks and Troughs

Sharp rally over a relatively

short period of a few years

60-75% correction in real prices over 5 years or so

Overall, commodity corrections tend to be very long tailed

Final trough could be as long as a few decades from the peak

Initial cyclical rally

First trough (Feb 2016)

Data as at March 22, 2016. Source: KKR Global Macro & Asset Allocation.

EXHIBIT 37

An Initial Rebound In Commodities Can Be Sizeable, Running Up 41-110% in Real Terms, Before Falling to New Lows Again

41%

55%61%

69% 72%

110%

0%

20%

40%

60%

80%

100%

120%

Oil: 1980 Iron Ore: 1880

Copper: 1916

Iron Ore: 1957

Copper: 1966

Oil: 1864

Real Price Rally Off the First Trough, %

Data as at March 22, 2016. Source: USGS, BP Statistical Review, Yale/Robert Shiller data, Statistical Abstract of the United States, History of the Great Lakes, Federal Reserve Bank of Minneapolis: Handbook of Labor Statistics, NBER, BLS, IMF, World Bank.

Third, our time in China leads us to conclude that many local Chinese investors, particularly those who have gained an appreciation for how much stimulus entered the system during 1Q16, have shifted significant investment profits out of stocks and real estate and into commodities. For example, as we show in Exhibits 38 and 39, respec-tively, iron ore trading volumes are up 106% in three months ending April 2016 and over 360% in the twelve months, while steel rebar futures trading volumes are up 142% and 197%, respectively, during the same periods.

To put this surge in trading volume in context, the current 30-day average daily trading volume in iron ore futures of 600 million tons per day is equal to 63% of China’s total iron ore imports of 950 mil-lion tons for all of calendar 20158. Taken together, the nascent iron ore and steel rebar markets have recent daily trading volume that on some days is equal to the notional U.S. dollar volume of the S&P 500 futures, the largest and most liquid global equity index future con-tract. Not surprisingly, the Dalian exchange just recently announced that it would be increasing margin requirements and transaction costs on iron ore futures.

EXHIBIT 38

Of Late, There Has Been a Surge in Both Prices and Trading Volumes of Iron Ore…

0

100

200

300

400

500

600

700

200

300

400

500

600

700

800

900

1,000No

v-13

Feb-

14

May

-14

Aug-

14

Nov-

14

Feb-

15

May

-15

Aug-

15

Nov-

15

Feb-

16

Iron Ore Price vs. Futures Volumes

Iron Ore Price (RMB/ton; LHS)Tons Traded 30D Avg. (MMs; RHS)

Iron Ore Prices Are Up 66% and Trading Volumes Up 106% in the Last Three Months (and 360% in 12 Months)

Data as at April 25, 2016. Source: Goldman Sachs Research, Bloomberg.

8 Data as at April 30, 2016. Source: Bloomberg.


EXHIBIT 39

…While Steel Rebar Futures Are Up 56% Over the Same Three Months

0

20

40

60

80

100

120

140

160

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Nov-

13

Feb-

14

May

-14

Aug-

14

Nov-

14

Feb-

15

May

-15

Aug-

15

Nov-

15

Feb-

16

Steel Rebar Price vs. Futures Volumes

Steel Rebar Price (RMB/ton; LHS)Tons Traded 30D Avg. (MMs; RHS)

Daily Trading Volume up 142% in Three Months

Data as at April 25, 2016. Source: Goldman Sachs Research , Bloomberg.

Given heightened levels of speculative trading on Chinese commodity exchanges and changing central bank policy in the U.S., we think that commodity prices could run further in the near-term. That said, our longer-term view is more cautious; in fact, we do not believe that we will actually see the final long-term trough in the commodity cycle until fundamentals are better aligned with inventories as well as ongoing supply trends. To date, however, our research indicates this realignment has not occurred. Indeed, as once can see in Exhibits 42 and 43, respectively, both crude oil and copper inventories continue to build on a global basis. As such, our base line remains that, after a sharp counter trend rally, prices could fall back – potentially further than where they were when this recent rally started. If we are right, then we think some of the recent speculation around commodity trading in China could endure a similar fate to what happened in the Chinese stock market after margin requirements were lifted further in 2014.

EXHIBIT 40

The Path Down Takes Much Longer Than the Path Upwards

9

15

8

18

26

46

0

5

10

15

20

25

30

35

40

45

50

Oil Copper Iron Ore

Duration of Cycles, Years

Boom: Trough to Peak Bust: Peak to Final Trough

The path down takes much longer than the path up


EXHIBIT 41

A Final Peak-to-Trough Real Price Correction Is Roughly 70-85%. However, the First Trough Normally Occurs After Five Years and a 60-75% Correction

(90%)(80%)(70%)(60%)(50%)(40%)(30%)(20%)(10%)

0%

Copper: 1916

Oil:1864

Oil:1980

Copper: 1966

Iron Ore: 1957

Iron Ore: 1880

Real Price Correction, %

Peak-to-First Trough Peak-to-Final Trough


“ We do not believe that we will actually see the final long-term trough in the commodity cycle until fundamentals are better

aligned with inventories as well as ongoing supply trends.

“


EXHIBIT 42

We Do Not Believe That Copper Inventories Have Yet Peaked…

0

200

400

600

800

1000

04 06 08 10 12 14 16

COMEX + LME + SFE Copper Inventories (‘000 mt)

COMEX = Commodity Exchange, LME = London Metals Exchange, SFE = Shanghai Futures Exchange. Data as at April 30, 2016. Source: Bloomberg.

EXHIBIT 43

… And Hard to Call a Peak in Oil Inventories When Global Production Is Currently Running at a 1.9% Surplus to Demand

1.9%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

-4 -3 -2 -1 0 1 2 3 4 5

3Q86 4Q98 1Q09 4Q15

# Quarters (Before)/After WTI Trough

Global Production Surplus/(Deficit)

Oil balance not expected to move into deficit until 3Q16

Dotted line represents KKR GMAA estimates based on IEA global demand growth estimates (+1.7 MM B/d in 2015e and +1.2 MM B/d in 2016e), IEA non-OPEC supply growth estimates (+1.4 MM B/d in 2015e and -0.6 MM B/d in 2016e), and assumption that OPEC supply has peaked at current level. Data as at January 22, 2016. Source: IEA, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

Conclusion

Our belief has never been higher that – to have conviction on the overall global macro landscape – one has to spend more time un-derstanding the big trends occurring in China. Importantly, it is not just the massive growth contribution that China makes to the global economy. The direction of China’s currency too has huge implications for global capital markets stability; in addition, its M&A and export strategies can also materially influence the pace and absolute rate of global trade and inflation.

The good news is that our most recent visit gives us assurance that there is a base rate of growth – likely around 6.5% in our view – that this government will work hard to achieve in 2016. As such, we believe investors should take comfort that some of the fundamental weaknesses that we saw in the Chinese economy during the last quarter of 2015 has stabilized – and potentially even reversed. We are also encouraged that it appears the government is reflecting more deeply about how it handled its involvement in the stock market and currency events that occurred in recent quarters.

The bad news is that near-term gains in growth come at the expense of long-term sustainability. At some point, a country, particularly an emerging one, can’t continue to run with nominal lending growth rates so far above nominal GDP for so long. Also, while the govern-ment has done a good job of plugging its capital account, this is not a long-term solution for a country that wants to move towards more of a markets-based environment.

Against this backdrop, we continue to expect more volatility, and amidst that volatility, we believe that equity investors should con-sider migrating their investment dollars towards high-value services, including healthcare, consumer services, travel, and leisure. The push towards the Internet, particularly by a dynamic millennial cohort, is also another important theme on which to focus for both offensive and defensive reasons.

“ The good news is that our most recent visit gives us assurance

that there is a base rate of growth – likely around 6.5% in our view – that this government will work

hard to achieve in 2016. “


On the debt side, we think now is the time to start to position oneself to take advantage of the significant transfer of credit assets that will ultimately occur from banks to private investors. However, this op-portunity is likely a walk, not run, one in the near-term unless there is a more blatant directive from the government that foreign capital has emerged as the most efficient solutions provider to the growing NPL issue (not our base view).

Overall, though, we believe that the higher risk premiums now required to invest in China are likely to persist. Key to our thinking is that nominal credit growth continues to grow too rapidly relative to nominal GDP, and much of this credit growth is still occurring in sectors of the economy where debt levels need to be reduced, not increased. Besides rising debt loads in many parts of the economy, investors now must also face a more challenging exit environment for their capital, particularly given the recent downdraft in reserves as well as the recent uptick in expansionary M&A. Finally, given that many other economies have stalled in the developed world, it feels like China has been asked to take on too much responsibility for driv-ing global growth amidst its own internal economic repositioning. In our view, this “burden” unfortunately is leading to excesses in several sectors of the Chinese economy, particularly if the mandate to double GDP between 2010 and 2020 is maintained. As such, then our base view remains that it is “Adult Swim Only” across the global capital markets, China in particular.

“ Regardless of where one comes down on the China debate, this bull versus bear script will still take time to play out, and in the interim, we think the economy

will give both sides enough food for thought to keep things quite

volatile well into 2017. “


Important Information

The views expressed in this publication are the personal views of Henry McVey of Kohlberg Kravis Roberts & Co. L.P. (together with its affiliates, “KKR”) and do not nec-essarily reflect the views of KKR itself or any investment professional at KKR. This document is not research and should not be treated as research. This document does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not repre-sent a formal or official view of KKR. This document is not intended to, and does not, relate specifically to any investment strategy or product that KKR offers. It is be-ing provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own views on the topic discussed herein.

References to “we”, “us,” and “our” refer to Mr. McVey and/or KKR’s Global Macro and Asset Allocation team, as context requires, and not of KKR. Opinions or statements regarding financial market trends are based on current market conditions and are subject to change without notice. References to a target portfolio and allocations of such a portfolio refer to a hypothetical allocation of assets and not an actual portfolio. The views expressed herein and discussion of any target portfolio or alloca-tions may not be reflected in the strategies and products that KKR offers or invests, including strategies and products to which Mr. McVey provides his professional investment advice to or on behalf of KKR’s Balance Sheet or KKR as a whole. It should not be assumed that Mr. McVey has made or will make investment recom-mendations in his professional capacity that are consis-tent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client or proprietary accounts. Further, Mr. McVey, in his professional capacity, may make invest-ment recommendations and KKR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this document.

The views expressed reflect the current views of Mr. McVey as of the date hereof and neither Mr. McVey nor KKR undertakes to advise you of any changes in the views expressed herein. Opinions or statements regarding financial market trends are based on current market conditions and are subject to change without notice. The views expressed herein may not be reflected in the strategies and products that KKR offers, including strategies and products to which Mr. McVey provides investment advice on behalf of KKR. It should not be assumed that Mr. McVey has made or will make invest-ment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. Further, Mr. McVey may make investment recommendations and KKR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this document.

This publication has been prepared solely for information-al purposes. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this document has been devel-oped internally and/or obtained from sources believed to be reliable; however, neither KKR nor Mr. McVey guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.

There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future per-formance of any particular investment which may differ materially, and should not be relied upon as such. Target allocations contained herein are subject to change. There is no assurance that the target allocations will be achieved, and actual allocations may be significantly different than that shown here. This publication should not be viewed as a current or past recommendation or a

solicitation of an offer to buy or sell any securities or to adopt any investment strategy.

The information in this publication may contain projec-tions or other forward‐looking statements regarding future events, targets, forecasts or expectations regard-ing the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be signifi-cantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subse-quent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. The indices do not include any expenses, fees or charges and are unmanaged and should not be considered investments.

The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Please note that changes in the rate of exchange of a currency may af-fect the value, price or income of an investment adversely.

Neither KKR nor Mr. McVey assumes any duty to, nor undertakes to update forward looking statements. No representation or warranty, express or implied, is made or given by or on behalf of KKR, Mr. McVey or any other person as to the accuracy and completeness or fairness of the information contained in this publication and no responsibility or liability is accepted for any such information. By accepting this document, the recipient acknowledges its understanding and acceptance of the foregoing statement.

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VOLUME 6.3 • MAY 2016 China: Mounting Macro Paradox · capacity in many parts of the country –...

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