1) ERIK NORLAND, SENIOR ECONOMIST AND EXECUTIVE DIRECTOR, CME GROUP 8 JANUARY 2016 China: Deceleration and Equities All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience. Chinese stocks opened 2016 with a tumble after a tumultuous Figure 1: Both Real and Nominal GDP Growth is Slowing. 2015, which saw the FTSE China A50 Index trade in a range China Real and Nominal GDP Growth Rate swinging from 8,450 to 15,100 points. Much of the volatility in China has to do with a changing macroeconomic environment: 25.0% China’s economy is slowing, export growth is weak, commodity prices are collapsing, the People’s Bank of China (PBOC) is lowering interest rates and the country’s currency 20.0% 15.0% policy is changing. We will look at each of these factors as well as various valuation measures and discuss what they might 10.0% Nominal mean for the Chinese equity market in 2016 and beyond. Real A Slowing Economy China’s economy grew “only” 6.9% in the quarter ended September 30, 2015. By the standards of most countries, this 5.0% 0.0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Bloomberg Professional, CNGDPYOY and CNNGPC$ is an enviable pace, but for China it represents a significant slowdown from the 10% pace that the country has enjoyed for much of the past few decades (Figure 1). We expect China’s growth to decelerate further to 5.5% during the second half of this decade before falling to around 3% annually in the 2020s. Not only has real GDP growth cooled, nominal GDP is also growing much more slowly than in the past. Nominal GDP, which doesn’t adjust for the rate of inflation, is a much underappreciated measure of economic health. It represents the sum total of cash flows available to service debt, equity shareholders and to fill government coffers. China’s nominal GDP has been decelerating even faster than its real GDP as a result of declining inflation (Figure 2). 1 

2) 8 JANUARY 2016 Figure 2: Inflation Has Been on a Downtrend Since 2011. Figure 3: China’s Private Sector More Highly Leveraged Than its Emerging Market Peers. Private and Public Sector Debt China: Inflation Year over Year 10.0% 250 Government 8.0% Private Debt as a % of GDP 200 6.0% 4.0% 150 100 Source: Bloomberg Professional, CNCPIYOY In many respects, declining inflation is a good thing. It permits Ru ss ia es ia M ex ic o In do n il di a In Br az d ke y an Tu r Po l tin a Af ric a th So u y Cz ec h -4.0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Ar ge n ila ga r Ch i un H -2.0% Re pu bl ic 0 Th a 0.0% nd 50 na 2.0% Source: "Deleveraging, What Deleveraging?" Buttiglione et al, International Center for Monetary and Banking Studies Figure 4: High Levels of Private Sector Debt are Manageable if Interest Rates are Very Low. the central bank to ease monetary policy. The combination of Private and Public Sector Debt lower inflation and slower real growth, however, can make life difficult for debtors. This is a problem because China’s private 450 sector is awash in debt. In fact, China’s private sector debt market countries and are more akin to those seen in Western Europe, U.S, Canada and Japan (Figures 3 and 4). Having high levels of private sector debt isn’t necessarily a problem if one of the following two conditions is present: Government Private 350 Debt as a % of GDP levels are much higher than those in most other emerging 400 300 250 200 150 100 50 0 1) Nominal (and preferably real) GDP is growing quickly: there will always be more money to service interest and principal repayments on existing debt. 2) Interest rates are extremely low: this is the case in Western Europe, Canada, Japan and U.S. but not (yet) the case in China, where the cost of borrowing is still relatively high. Sweden Korea Canada United Kingdom Australia China Japan Eurozone United States Source: "Deleveraging, What Deleveraging?" Buttiglione et al, International Center for Monetary and Banking Studies China’s equity market appears to be especially sensitive to credit concerns. This is probably because financial stocks represent 69% of the weighting of the index, dwarfing any other sector. Financial stocks have a similar weighting in the Hang Seng Index, which correlates highly with the FTSE China A50. By contrast, financial stocks have a much lower weighting in the tech-heavy S&P 500® and in the FTSE 100 (Figure 5). Any development that calls into question the credit worthiness of China’s private sector is likely to upset the equity market. 2 

3) 8 JANUARY 2016 Figure 5: The FTSE China A50 is Heavily Weighted to Financials. Figure 6: Euro (EUR) and Yen (JPY) Have Fallen Sharply Against the Renminbi and Dollar (USD). USD, EUR and JPY versus Renminbi 120 110 USD January 1, 2011 = 100 100 EUR 80 70 JPY 60 Currency 50 High debt levels are probably contributing to slower growth in China but are not the only one. Another major factor is an overvalued currency. For many years China has tied its 90 40 2011 2012 2013 2014 2015 2016 Source: Bloomberg Professional: CNH, EUR, and JPY currency to the value of the U.S. dollar (USD). When USD was weak during the period from 2002 to 2011, China allowed the Renminbi (RMB) to appreciate by roughly one third. This made sense at the time as it allowed China to contain inflationary Figure 7: Emerging Market Currencies Have Plunged Versus the Renminbi. pressures while not damaging competitiveness. Since 2011, Real, Rupee and Rouble versus Renminbi however, a stronger USD has lifted the RMB along with it, 120 degrading China’s competitiveness (Figures 6 and 7). 100 dependent on exports and has relatively weak internal demand, especially on the consumer side. In fact, much of China’s expansion was driven by investment, both private and public, that transformed the country into a global export powerhouse. Now, however, export growth is stagnating (Figure 8) and China is beginning a delicate transition to a January 1, 2011 = 100 This is a big problem for China since its economy is strongly 80 60 BRL INR RUB 40 20 more consumer-led economy. We expect that the equity market will be very sensitive to export growth as well as to information that indicates how the transition from an 0 2011 2012 2013 2014 2015 2016 Source: Bloomberg Professional: CNH, BRL, INR and RUB investment and export-led economy to a consumer-led economy is proceeding. Now that the RMB has become a global reserve currency with International Monetary Fund (IMF) special drawing rights, China is moving to a currency basket and is expected to loosen controls on RMB trading. If RMB weakens, it will likely boost the equity market. 3 

4) 8 JANUARY 2016 Figure 8: Exports are Stagnant but Imports are Plunging, Which Adds Back to GDP. China Trade In the face of an overvalued currency and high levels of private sector debt, the PBOC has been steadily reducing interest 3000 In USD Billions over Rolling 12 Month Period Interest Rates rates (Figure 9). On balance, lower interest rates should be supportive for Chinese stocks as they will make debt burdens 2500 Exports 2000 more manageable while encouraging growth in consumer spending and stability in investment spending. Higher rates Imports 1500 in the U.S. won’t necessarily be bad for Chinese stocks either, especially if higher U.S. rates coincide with a weaker exchange rate for the RMB. 1000 Figure 9: PBOC is Likely to Ease Policy Further and Focus More on Rates than Reserve Requirements. 500 5 20 14 PBOC monetary policy tools 20 1 2 20 13 1 20 1 20 1 9 20 10 8 20 0 20 07 20 0 5 6 20 0 20 0 20 03 20 04 1 20 02 20 0 20 0 0 0 Source: Bloomberg Professional, CNFRIMP$ and CNFREXP$ Commodities Given the breadth and scale of the collapse in commodity prices and the perceived role of China in bringing that about, some have even questioned if China’s economy might be in a much steeper slowdown than the official GDP numbers suggest. We don’t think so, for two reasons: 25 20 Reserve Requirement Ratio 15 10 5 Lending Rate 1) The collapse in commodity prices isn’t explained entirely energy and metals. 2015 2013 2014 2011 2012 2010 2009 2007 2008 2005 2006 2003 2004 2001 2002 1999 2000 1997 1998 of a wide range of products, including agricultural goods, 1996 by China. To a large extent, it reflects the boom in supplies Deposit Rate 0 Source: Bloomberg Professional: CNDR1Y, CHLR12M and CHRRDEP 2) GDP is the sum of government, consumer and investment spending plus exports less imports. While China’s China announced on the first business day of 2016 that it investments and exports have been slowing, imports are would be moving away from using the reserve requirement collapsing (Figure 8) and this adds back to GDP. In fact, ratio as its main monetary policy tool. Rather, reserve the collapse in energy prices alone probably added about requirements will be used mainly to ensure the stability and 1% to GDP. The collapse in imports is mainly a price effect solvency of the banking system while interest rates will gain a related to lower commodity prices and not primarily a more prominent role in the management of monetary policy. reflection on the weakness of Chinese domestic demand. We expect that China’s rates will most likely fall. The effect of lower commodity prices on Chinese equities is somewhat counterintuitive: while many people blame softer growth in China for the collapse in commodity prices, lower energy prices in particular, is actually good news for China and probably, on balance, good news for Chinese equities. To some extent, weaker demand for Chinese goods in commodity-producing countries will be bad for China’s growth, but this should be outweighed by domestic gains as well as gains in other commodity-importing markets that buy Chinese goods such as the United States, European Union and Japan. Valuations At the start of 2016, Chinese equities don’t look particularly expensive compared to their international counterparts. While there is no perfect measure of valuation, using a variety of measures such as price earnings, price/sales, price/book, and dividend yields shows Chinese stocks have valuation levels that appear to be fairly unexceptional when viewed against both emerging market and developed market indices (Figure 9). By most measures China’s stocks fall in the middle of the range for valuations (Figure 10). 4 

5) 8 JANUARY 2016 Figure 10: Regression Model A simple and admittedly not very sophisticated regression model largely confirms our intuitions regarding what influences Chinese stocks. Our model seeks to explain the monthly return of the FTSE China A50 Index from December 2010 to December 2015 using six variables: changes in the S&P 500®, West Texas Intermediate oil prices, Fed Funds, Copper prices, JPYUSD and the PBOC’s policy lending rate. In short, there is nothing to suggest that Chinese stocks are in Together, these inputs explain only about 29% of the variation a bubble. Even when Chinese stocks peaked in May and June in the index – leaving the rest unexplained (Figure 12). of 2015, they didn’t look alarmingly expensive. If there was a Figure 12: bubble in Chinese stocks it was probably back in 2007 and early 2008, not in 2015 and 2016 (Figure 11). As such, while we fully expect Chinese stocks to remain volatile and cannot rule out substantial further downside, we think that if Chinese stocks sell off a great deal further they will eventually be seen as a bargain. Overall, we suspect that the bearishness expressed by many commentators regarding Chinese stocks has probably gone too far and that over the next five to ten years Chinese stocks are likely to achieve average or perhaps somewhat above average returns. This, of course, doesn’t rule out the short-to-intermediate term possibility of a retest of the August low of around 8,500 points on the FTSE China A50 or A few things here are of interest: during the five-year period even a retest of its 2014 lows around 6,300 points. in question, Chinese stocks tended to benefit from lower oil Figure 11: prices. Copper prices and Chinese equities moved in line, but this is likely Chinese equities moving copper rather than the FTSE China A50 and the S&P 500 ® 25000 other way around. The same can be said of the FTSE China 2500 A50 future and the Japanese Yen future. Lower Chinese stocks 20000 may put further downward pressure on the Japanese currency. 2000 15000 Chinese interest rates are only after-the-fact moves in policy 1500 10000 1000 5000 500 S&P 500® FTSE China A50 Index U.S. and Chinese interest rates exert a weak influence BUT rates and do not reflect market expectations. Going forward, we expect that a weaker Chinese currency will most likely be positive for stocks as will any further easing of monetary policy. FTSE China A50 0 2006 S&P 500® 2007 2008 2009 2010 Source: Bloomberg Professional: XIN9I and SPX 2011 2012 2013 2014 2015 0 2016 Lastly, what is most interesting and perhaps ultimately most important to equity investors both in China and elsewhere is the lack of correlation between the S&P 500® and the FTSE China A50 Index. What this implies is that Chinese stocks are potentially a very good diversifier for investors in the U.S. and elsewhere and that Chinese investors would also likely benefit from diversifying abroad. 5