China Insights. Monthly update on Chinese markets. August Hot topic: How should investors interpret RMB depreciation?

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1 China Insights Monthly update on Chinese markets August 2018 Summary The pace of RMB depreciation over the past couple of months has been remarkable. However, in our opinion, this recent spate of RMB weakness does not imply that the turmoil experienced in 2015 will be repeated again The government is more proactive in countering uncertainties and managing investor sentiment by providing more liquidity and fiscal boosts, underpinning investment growth in the near future Bond Connect will now offer real-time delivery versus settlement service to investors, resolving a key issue that barred many regulated funds from investing in the onshore bond market previously Hot topic: How should investors interpret RMB depreciation? The pace of RMB depreciation over the past couple of months has been remarkable, dropping faster than it did in However, in our opinion, this recent spate of RMB weakness does not imply that the turmoil experienced back then will be repeated again. The sharp weakening of RMB against both the USD and its peer basket since mid-june can be attributed to four key reasons: a strong US dollar, widening interest rate differential amidst US-China monetary policy divergence, concerns over trade tensions, and signs of slowing growth momentum in China. Moreover, the current RMB weakness comes after a nearly year long appreciation in the currency. To illustrate, the CNY CFETS index fell by slightly over 5% from its June high to 23 August, after rising by nearly 7% in one year before the sharp fall. In light of rising speculation around RMB weakness, the Chinese officials have pledged not to use currency devaluation as retaliatory tool and have jumped in to prevent the adverse feedback loop that triggered massive capital outflows in The government s efforts seem to be paying off as the 12-month forward points in the onshore CNY (CNH) reversed course amidst the new measures. Steep pace of RMB depreciation reversed /15 2/16 8/16 2/17 8/17 2/18 8/18 CFETS CNY USDCNY (RHS) Source: Bloomberg, data as of August 2018 This commentary provides a high level overview of the recent economic environment, and is for information purposes only. It is a marketing communication and does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management accepts no liability for any failure to meet such forecast, projection or target.

2 Little evidence of significant capital outflows Compared to the outflows seen in , cross border outflows in the past two months have been moderate. FX spot demand by onshore banks clients has been muted compared with the H period, as indicated by FX settlement and sales, although they have bought more FX forwards. We think Chinese corporates are now much better hedged against RMB depreciation. Foreign portfolio flows for onshore equities and bonds have remained robust despite the market volatility. Net foreign direct investment inflows also improved compared to mainly due to controls on outward direct investment by Chinese corporates since Corporates also repatriated offshore USD, some of which were in the form of external debt raised in recent quarters As such, PBoC FX assets have been largely stable this year, indicating no action from PBoC to sell FX reserves on the spot market to protect RMB. What is the outlook for RMB in the medium term? Sharp RMB devaluation or sale of US Treasury holdings as retaliatory tools remain off the table, given the potential adverse consequences to the Chinese economy. If trade tensions escalate further, China s export growth will likely slow and policy easing could be ramped up even more to boost domestic demand, leading to higher import growth and decline in the trade surplus. This will not only reduce fundamental support from the trade/current account surplus, but also put the financial/ investment flows under pressure, especially if external financing conditions tighten further. China recorded a current account deficit of -0.4% of GDP in 1H18, compared with a surplus of 1.3% in 2017, and has shown a deteriorating trend since While relatively large net FDI inflows have provided a good cushion for the Chinese currency so far, a weaker current account balance means the RMB will be more sensitive to capital flows, and the movements of the DXY index and major currencies. On the flip side, any eventual constructive outcomes from the US-China trade talks could potentially provide a boost to China s export outlook and the RMB. We also expect monetary policy easing to increasingly focus on credit transmission to ensure reasonable credit growth, but not aggressive liquidity injection, which had recently pushed short-term market rates downwards and driven bond yields lower. Just the right amount of monetary policy easing, along with a more supportive fiscal policy in 2H18, should limit the downside on China rates and prevent the rate differentials from narrowing too quickly. Signs of stabilising Chinese economic momentum would also support investor sentiment. Policy to manage risks, not drive the direction After tolerating sharp RMB depreciation in June-y, the PBoC recently stepped in to manage the risk of an adverse feedback loop from investors or corporate herd behaviour (echoing the experience). The PBoC reinstated the 20% reserve requirement for banks selling FX forward to clients, raising the cost for corporates purchasing FX via forward transactions and making it more expensive to short the RMB. PBoC s Shanghai branch has also reportedly temporarily stopped offshore banks from borrowing RMB through the Free Trade Accounting Unit business. USD- CNH forward points rose notably as a result. The PBoC has re-introduced the countercyclical adjustment factor in the CNY daily fixing mechanism to mitigate the pro-cyclical CNY sentiment. Other measures may be introduced to manage expectations and curb speculation. With little indication of capital flight, Chinese authorities have been relatively hands-off, and haven t shown any signs of changing their existing macro-prudential measures. We think recent moves help contain the risk of triggering market panic and large-scale capital outflows, which would have added an extra layer of complexity in the bilateral trade negotiations. However, we do not expect aggressive FX intervention, given the long-term goal of allowing market forces (demand & supply) to play a major role in setting the RMB exchange rates and eventually moving toward a clean/free float FX regime as China continues to open up its economy and liberalise its capital markets in the longer term. Greater RMB flexibility in an uncertain external environment will allow monetary policy to focus more on domestic economic trends and policy agenda. Little evidence of significant capital outflows or PBoC selling FX reserves for intervention USD USD trn Banks clients net spot FX purchases remained small; FX reserves have been quite stable Net FX settlement by banks on behalf of clients (LHS) FX-related net payments by banks on behalf of clients (LHS) FX reserves (RHS) % GDP Overall balance of payments remained in a small surplus, despite a narrowing current account surplus Q07 1Q09 1Q11 1Q13 1Q15 1Q17 Errors & omissions Non-FDI financial account Net FDI Current account Overall balance Source: Bloomberg, CEIC, HSBC Global Asset Management, data as of August 2018 Investment involves risks. Past performance is not indicative of future performance 2

3 Equity market The government has turned more proactive in countering uncertainties and managing investor sentiment by providing more liquidity and fiscal boosts in 2H18 The MSCI China Index and the CSI 300 Index were down by 5.6% and 6.9% month-to-date (as of 21 August), respectively. Over the past three months, 24% of stocks have hit their three- and five- year lows. Utilities (-7.3%) and healthcare (-6%), best performing sectors year-to-date, have seen the largest correction month-to-date On 23 August, the US effectively implemented a 25% tariff on USD16 billion worth of Chinese goods. We expect prolonged volatility given another 10%-25% tariff may be applied on USD200 billion of wider range of goods. While there are signs that both US and China are open to further negotiations, we think the positive impact should be limited given the involved parties are not as influential as those who attended the first round of negotiations We think the government has turned more proactive in countering uncertainties and managing investor sentiment by providing more liquidity and fiscal boosts in 2H18, underpinning the investment growth in the near future. Some reassurance is also provided by the government to prevent RMB/USD from breaching the psychological level of 7.0. These are all supportive factors for equities in near term Valuations continue to be attractive, with MSCI China now trading at 11.2x forward P/E and 1.7x P/B, which are around their long term averages. Earnings growth estimates have edged down slightly to 18%, as continued uncertainties have prompted the market to reassess the earnings outlook Both higher HIBOR and capital outflows may weigh on Hong Kong equities, but we do not expect a sharp correction owing to these developments Net northbound inflows have climbed by another USD3.3 billion month-to-date, despite the volatility in the onshore market. Onshore investors continued to drain money from the Hong Kong market, with net southbound outflows reaching USD2.9 billion month-to-date. Large redemptions are made on the 2017 winners. Recent RMB weakness may attract some inflows from investors seeking a currency hedge. However, the still wide A/H premium, 26% on market-cap weighted basis, and asset diversification should remain the key drivers for southbound investments in longer run In Hong Kong, the Hong Kong Monetary Authority (HKMA) took action to curb capital outflows as the HIBOR-LIBOR spread widened and the US dollar strengthened. We think the gap will converge gradually to sustain the FX peg, thereby eliminating the arbitrage opportunity. Both higher HIBOR and capital outflows may weigh on Hong Kong equities, but we do not expect a sharp correction owing to these developments Overall, we think the correction in Chinese equities reflect the investors immediate concerns, but disregard the promising long term outlook for China. We remain positive on insurance stocks, which we think have bottomed out, as impact from regulatory tightening, fierce pricing from other wealth management products and high base effect have all been reflected. Overall, we think growth in new business value will pick up nicely as agency growth remains robust and as premium receivables stabilise with more regular first year premium (FYP) payers 3

4 Chinese equities have turned more attractive after recent correction 1-year cumulative total return 30% 20% 10% 0% -10% -20% 8/17 11/17 2/18 5/18 8/18 MSCI China CSI 300 Forward price to earnings ratio (x) /13 8/14 8/15 8/16 8/17 MSCI China CSI 300 Source: Bloomberg, HSBC Global Asset Management, as of 22 August Total return in local currency terms. Investment involves risks. Past performance is not indicative of future performance. Sector Consumer Discretionary Consumer Staples Energy Comment We are UW consumer discretionary sector. Policies such as tariff cut and relaxation of foreign ownership dent outlook of the auto sector. RMB weakness may negatively impact Macau gaming, HK retail and tourism industry in China. We still the education space as demand for high quality education service should be a secular story in China. We are overweight consumer staple sector as the trend of premiumisation on the back of rising income underpins higher pricing power and margin expansion capability of selected strong staple brand names We are overweight energy and in particular selected upstream players in light of their compelling valuations and attractive yields. Continued strength in oil price also underpins our positive view on these players Financials Healthcare Industrials Information Technology Materials We are overweight on Chinese banks as loan growth may pick up in 2H18 on the back of a more relaxed monetary policies and continued crackdown of shadow banking. We are selective on insurance. We are neutral on the healthcare space in light of unfavorable policy change such as import of Indian drugs. We only prefer players with a strong R&D capabilities and product pipeline Overall we are underweight the sector but overweight the capital good industry as favourable government policies suggest higher capex on industrial equipment We are selective on the IT sector, and mainly overweight leading players with well-established business model and secular earnings growth story. We are underweight on technology hardware as they could be victims of the US-China trade conflicts We are neutral on the sectors as positive effect from supply-side reform is offset by the recent softness in industrial activities Property We are underweight Chinese property. We only buy market leaders who have strong fund souring capabilities amid the current tightening credit environment. Telecommunication We are underweight telecoms, with concerns over increasing government intervention, fierce competition in the 4G market, and increasing capital expenditure in relation to 5G development Utilities We are overweight utilities sector in light of its defensive nature amid rising macro headwinds Source: Bloomberg, HSBC Global Asset Management, as of August 2018 For illustrative purposes only and does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies. The views and opinions expressed herein are subject to change at any time. 4

5 Fixed income After sustaining a rally for most of this year, onshore and offshore bonds have performed flat month-to-date (as of 21 August), delivering -0.3% and 0.1% in local currency term, respectively We think more calibrated actions will be taken by the government to ensure smooth credit transmission Onshore yields have rebounded slightly as investors see hope for further negotiation between US and China over trade tensions and as government pledged more fiscal spending in 2H18. However, we believe talks between the two countries will likely stretch on for months as they attempt to iron out their differences Consumer prices picked up modestly in y to 2.1% yoy, with subdued food prices growth and steady core prices. We continue to see more debt being brought back to the balance sheet as shadowing banking growth continues to shrink. Benign inflationary pressure allows the government to maintain its neutral-to-easing bias to facilitate credit transition, ensuring sufficient liquidity and reasonable cost of funding. We think more calibrated action will be taken by the government to ensure smooth credit transmission. Thus, we expect yield levels to stay stable in the near term. In the onshore space, long-dated government bonds are starting to look attractive from an entry point of view Starting from 23 August, Bond Connect will offer real-time delivery versus settlement service to investors The CNY has weakened against the USD and slightly rebounded against its currency basket month-to-date. The government reiterated that the currency would not be used as a retaliatory tool in trade tensions and rolled out several measures to support the currency, because a capital exodus would be a worse alternative to a very weak currency. While USD can become stronger if concerns over trade tensions continue to linger, Trump s administration does not want a one way strengthening of dollar. Hence, we do not think RMB will significantly weaken in longer term Starting from 23 August, Bond Connect will offer real-time delivery versus settlement service to investors, resolving a key issue that had barred many regulated funds from investing in the onshore bond market. This is also a prerequisite for JPMorgan to include onshore bonds to its widely tracked JPMorgan GBI-EM Index. So far, 395 institutional investors have registered for Bond Connect, and foreign ownership of onshore bond has reached a new high at USD220 billion. We believe foreign interest will continue to pickup against this backdrop and underpin onshore bond prices Yields picked up slightly on the back of optimism around trade talks 1-year cumulative return 6% 5% 4% 3% 2% 1% 0% -1% 8/17 11/17 2/18 5/18 8/18 ChinaBond New Composite Markit iboxx ALBI China Offshore Source: Bloomberg, data as of 22 August Total return in local currency terms. Investment involves risks. Past performance is not indicative of future performance. For illustrative purposes only and does not constitute any investment recommendation in the above mentioned asset classes, indices or currencies. The views and opinions expressed herein are subject to change at any time. % bps /13 2/14 8/14 2/15 8/15 2/16 8/16 2/17 8/17 2/18 8/18 CNH Yld - CNY Yld (RHS) CNH 10Y Govt Yld CNY 10Y Govt Yld

6 Data watch Indicator Industrial production (IP) Fixed Asset Investment (FAI) (ytd, yoy) Retail Sales Exports (USD) Imports (USD) Trade Balance (USD) CPI Inflation PPI Inflation Manufacturing PMI Official Nonmanufacturing PMI Official Total Social Financing (TSF) (RMB) New yuan loans (RMB) Data as of Actual Cons ensus Prior Analysis 6.0% 6.3% 6.0% 5.5% 6.0% 6.0% 8.8% 9.1% 9.0% 12.2% 10.0% 11.2% 27.3% 16.5% 14.1% % 2.0% 1.9% 4.6% 4.5% 4.7% ,040 1,450 1,100 1,275 1, ,840 y activity indicators showed economic momentum slowed further, with weakness particularly in infrastructure investment, likely reflecting the lagged impact of tightening of local government financing rules and ongoing unwind of shadow banking credit. However, policy has been eased since Q2, with a combination of monetary/credit easing, a slower pace of deleveraging and financial regulatory tightening, and a step-up in fiscal spending. Fiscal spending and local government bond issuance lags in H1, so fiscal policy can become expansionary without additional fiscal stimulus. Overall, recent policy easing may take some time to have any material impact on the real economy, and we should start see stabilising growth in the coming months. However, we do not expect major stimulus or a reversal in structural deleveraging/financial reform this year, as underlying growth still on course to meet the government s 2018 growth target of about 6.5% and barring any shocks to the economy. In terms of y IP data, slightly higher manufacturing IP growth was offset by weaker mining production and utility supply. Weak infrastructure investment remained the key drag, while real estate FAI growth picked up and manufacturing and private sector FAI showed further recovery. Local government bond issuance accelerated in y and policies on funding for infrastructure projects have been eased, but on-budget spending was weak and land sales revenue slowed in y. Local governments are required to issue over 80% of their 2018 special bond issuance quota (CNY1.35trn) by end- September (CNY533 issued as of y), with the rest to be issued in October. This coupled with a pickup in the execution of PPP projects (and more could be added) should help to drive a recovery in infrastructure FAI. Meanwhile, property sector activities held up well, with higher growth in real estate FAI, home sales, new housing starts and housing price inflation in y vs. June. As such, housing-market administrative measures are unlikely to be reversed. Real estate FAI growth may moderate in coming months, but likely only modestly, given much improved demand-supply conditions, lower inventory, strong land sales, and policy support for rental housing development. An expected scale-back in cash subsidies for shantytown redevelopment projects means less support for lower-tier cities. Solid earnings/profit growth, higher capacity utilisation and policy to reduce corporate financial/tax burden should help manufacturing capex. Weaker retail sales came on the back of a solid rebound in June, with auto sales and housingrelated items softening further. Despite import tariff cuts, the expiration of tax breaks likely has continued to weigh on auto sales this year. The risk is that the recent retail sales slowdown may be more than a short-term dip, due to slower (albeit still solid) household income growth and higher debt burden, although the household balance sheet in aggregate still looks healthy. The boost from cash subsidies of the shantytown redevelopment projects has subsided. However, the personal income tax reform, including raising the taxable income threshold and allowing various deductions, should help. Meanwhile, the rapid digitisation trend increases the share of services consumption, but the official retail sales data do not capture this rapid growth segment. The data indicated still sold global demand and showed little impact on shipments to the US despite an additional 25% import tariff on USD34 of Chinese goods coming into effect in y. Import growth was boosted by postponed shipments from June to y due to import tariff cuts on autos and some other consumer goods. China s exports face risks of slowing global growth and trade tensions with the US. The US and China moved ahead with 25% import tariffs on another USD16 of imports from each other on 23 August. The US could make a decision on tariffs on yet another USD200 of Chinese goods after the public consultation period ends on 5 September. However, the recent RMB depreciation could provide some relief. The resumption of China-US trade talks introduces risks of positive developments. Meanwhile. the government s pledge to increase imports and policy easing should help sustain import demand. The slightly higher headline CPI was driven by a modest uptick in food price inflation, summer tourism fares and fuel costs. Core inflation (ex. fresh food & energy) remained stable at 1.9%. Inflation in medicine and medical care continued a downward trend, while residence cost inflation steadily trended higher. Meanwhile, a further rise in mining and raw material prices was offset by lower manufacturing sector PPI (due to the base effect) and helped contain headline PPI inflation. Overall, inflation remains moderate and is unlikely a constraint for near-term policy, despite some risks, such as a recovery in infrastructure investment (for PPI), imported inflation as a result of a weaker RMB, higher import tariffs and higher oil prices. The composite index fell to 53.6 from 54.4, indicating further softening of growth momentum. For manufacturing PMI, output and new orders fell while new export orders stayed in contractionary territory (49.8). PMI for large enterprises (52.4) remained much higher than for medium (49.9) and small enterprise (49.3). Both services sector and construction activities weakened. The PBoC adjusted the definition of TSF in y to include asset-backed securities issued by banks and loan write-offs, but that does not change the slowing trend: the TSF stock rose 10.3% yoy, down from 10.5% in June, driven by further contraction in off-balance-sheet credit. Bond financing recovered steadily amid monetary easing, while bank loan growth picked up to 13.2% from 12.7% in June. Loans to infrastructure projects and medium- and long-term corporate loans increased. We expect credit growth to bottom out in coming months amid policy efforts to boost bank lending and a slower pace of financial deleveraging and shadow banking cleanup. Indicates improved data on month-on-month/quarter-on-quarter/year-on-year basis Indicates worsened data on month-on-month/quarter-on-quarter/year-on-year basis Indicates no change in data on month-on-month/quarter-on-quarter/year-on-year basis Source: Bloomberg, HSBC Global Asset Management, as of August

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