Dim Sum Express. A-Share Market. Hong Kong Market. Equity Research. Oct 17, 2016

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1 Equity Research Dim Sum Express Key index performance Chg (%) EPS (%) P/E Market 1D 1M YTD 16E 17E 16E 17E HSI HSCEI MXCN SHSZ SHCOMP SZCOMP INDU SPX CCMP UKX NKY Hong Kong ADRs HK ticker Company Local (HK$) Daily (%) ADR (US$) Daily (%) 700 TENCENT CHINA MOBILE ICBC PETROCHINA CCB HSBC BANK OF CHINA PING AN SINOPEC CHINA LIFE Source: Bloomberg A-Share Market Marco: Sept inflation data review Price growth data so far this year have confirmed the view we have had since the end of last year that the main theme running through 2016 will not be severe deflation but rather the narrowing of industrial deflation and re-inflation of consumer prices. At this point, we think we should pay attention to a potential peaking of global credit expansion amid rising inflation and how this might affect asset prices, particularly in view of the delayed inflation stemming from previous credit loosening and asset price volatility after the market has become used to an environment of liquidity easing. Electronics: VR/AR growth upside enlarged by hardware upgrades and technological innovation Hardware innovation has helped overcome the bottleneck created by VR sickness, laying the foundation for VR commercialization on a large scale. In AR development, tracking registration technology has made tracking & location possible, while machine learning has contributed to situation perception, both providing the conditions for virtuality-reality integration. VR/AR technology first became widely used in the gaming space, and has great potential to be integrated with livestreaming, tourism, education and engineering. Distribution platforms/channels are crucial for the formation of a closed-loop business model, of which offline experience stores and theme parks will also become a key part. Environmental: PPP still the biggest sector investment theme We continue to see PPP projects as the most important investment theme for the environmental sector. With the execution of the MoF s newly unveiled PPP pilot projects, the release of the Oct implementation report of the MoF s PPP project pool, and the announcements of 3Q16 results by listed environmental companies, various policy catalysts are set to continue to play out. The demand of environmental monitoring equipment and services, as well as relevant operation and maintenance demand, will grow substantially going forward with the popularization of vertical regulation and smart environmental protection systems, not to mention the derived value of environmental monitoring data. Hong Kong Market Macro: Strong economic data strengthen case for a Dec hike Figures released last Friday showed that the decline in US retail sales was merely temporary. We believe this will give the Fed confidence that US domestic demand remains strong. We expect US inflation to pick up significantly in Dec, supported by high energy price growth. Overall, both economic data and inflation expectations strengthen the probability of a Dec hike. We do not think Janet Yellen s speech last week signaled that the Fed is not ready for this hike, as Ms Yellen stated that an accommodative monetary stance, if maintained too long, could have costs that exceed the benefits. Alex Fan, CFA, Head of Research, SFC CE No. ADJ672 alexfan@gfgroup.com.hk Gao Yedong, Editor, SFC CE No. BAI002 yedonggao@gfgroup.com.hk

2 Marco: Sept inflation data review Sept CPI beating expectations Despite resumed market views earlier that inflation would come down given the relatively low CPI reading in Aug, we had expected the consumer price growth to rebound to around 1.7% in Sept and above 2.0% in Oct. However, the actual Sept CPI figure (+1.9% YoY) exceeded even our estimate. Non-food CPI: actual inflation underestimated Stronger-than-expected inflation was mainly attributable to a strong non-food CPI which rose to a 26-month high of 1.6% YoY. In particular, MoM service price growth accelerated mainly due to the recent surge in land and property prices. Rising oil prices was another factor pushing non-food CPI higher, a trend that we believe will continue beyond Sept. Housing-related price growth remained low at 1.5% YoY, with rental growth staying at 0.4% MoM and 2.7% YoY. However, this is at odds with our channel checks, which suggest that rental in firsttier cities rose by more than 20% during the month while more than half of the 40 key cities tracked also saw rental go up. As such, official CPI figures have very likely underestimated actual inflation levels, meaning real GDP growth might be lower than it appears. Food CPI: low base for pork prices in 4Q16 Among food CPI components, vegetable prices grew 10.7% MoM and 7.5% YoY, which was in line with expectations. Pork prices were weaker, declining 0.1% MoM and rising 5.8% YoY, which might be attributable to the recent surge in pork imports and the drop in corn prices. The impact of these short-term incidents should wear off from Oct onwards. In fact, pork prices are very likely to rebound at an accelerating pace in 4Q16 given the low comparable base last year. PPI uptrend to continue The YoY PPI reading unexpectedly rebounded 0.9pp from Aug to 0.1% in Sept, turning positive for the first time in 55 months. This was partly, but not entirely, due to the low base effect, as MoM PPI growth also rose to a four-month high of 0.5%. We believe the upward momentum for the PPI has come from strengthening commodity price growth during Aug-Oct, the acceleration in capacity reduction since the Politburo meeting held around mid-year, and the quickening pace of manufacturing sector growth after it came out of deflation. The PPI is likely to continue to rise based on the CRB Commodity Index, which is a leading indicator of the PPI. Sept PPI mainly reflected the rebound in the CRB during July-Aug, while the CRB demonstrated even stronger growth during Sept-Oct. Impact of peaking credit expansion on asset prices Price growth data so far this year have confirmed the view we have had since the end of last year that the main theme running through 2016 will not be severe deflation but rather the narrowing of industrial deflation and re-inflation of consumer prices. At this point, we think we should pay attention to a potential peaking of global credit expansion amid rising inflation and how this might affect asset prices, particularly in view of the delayed inflation stemming from previous credit loosening and asset price volatility after the market has become used to an environment of liquidity easing. Global inflationary cycle Although inflation in China is driven by various factors unique to the country, the high consistency between China and OECD countries in terms of inflationary patterns is often overlooked. During , most OECD countries will see the output gap narrow and inflation pick up, a process in which the US is leading the way by initiating an interest rate up cycle and most other countries with greater population pressure (e.g. European countries, Japan) have fallen slightly behind. Most countries increased credit supply during the just-ended global deflationary cycle, and this oversupply of credit will very likely push inflation upwards when the liquidity trap comes to an end. A similar process was observed in the aftermath of the Asian financial crisis, Russian financial crisis and dot com bubble during : monetary policy remained loose for some time as the world economy went through economic pressure and low price levels ( ), which was followed by an observable liquidity oversupply and rising inflation ( ). Electronics: VR/AR growth upside enlarged by hardware upgrades and technological innovation Hardware upgrade helping to overcome VR bottleneck AMOLED has solved the delay in VR (virtual reality) display, while customized VR processors have enhanced computers performance; ATW (asynchronous time warp) has increased frame rates, while eye tracking technology along with blurry backgrounds have created a depth of field. Hardware innovation has helped overcome Page 2

3 the bottleneck created by VR sickness, laying the foundation for VR commercialization on a large scale. PC-based immersive VR offers the best user experience at present, with three leading players having emerged in the global VR scene. Meanwhile, mobile VR equipment tends to be highly cost effective, and is likely to become popular in the near term. Virtuality-reality integration brought by technological innovation Accurate environmental perception and information presentation are currently the main bottlenecks for AR (augmented reality) development given the importance of integrating the real and virtual worlds and achieving real-time interaction. Tracking registration technology such as SLAM (simultaneous localization and mapping) has made tracking & location possible, while machine learning has contributed to situation perception, both providing the conditions for virtuality-reality integration. Offline experience crucial for business model development VR/AR technology first became widely used in the gaming space, and it has great potential to be integrated with the live-streaming, tourism, education and engineering industries. Distribution platforms/channels are crucial for the formation of a closed-loop business model. In addition, offline experience stores and theme parks will also become a key part of this business model. Our stock picks We believe that VR/AR is likely to replace smartphones as the next generation of mainstream computing platforms. We are positive on companies with core technological strengths and those with exposure to applications that can give rise to new business fields when integrated with traditional industries. We suggest watching IRTOUCH Systems ( CH), Sunwoda Electronic ( CH), SVG Optronics ( CH), Crystal Optech ( CH), Castech ( CH), Leyard Optoelectronic ( CH), All Winner Technology ( CH), GoerTek ( CH), Thunder Software Technology ( CH), Sunway Communication ( CH) and LianChuang Electronic Technology ( CH). Environmental: PPP still the biggest sector investment theme PPP still the biggest sector investment theme The MoF released its third batch of pilot PPP projects on Oct 13, with total investment of Rmb1.17trn. We continue to see PPP projects as the most important investment theme for the environmental sector. With the execution of these pilot projects, the release of the Oct implementation report of the MoF s PPP project pool, and the announcements of 3Q16 results by listed environmental companies, various policy catalysts are set to continue to play out. Environmental monitoring demand to surge Last week the Ministry of Environmental Protection released a report regarding the enforcement of the Environmental Law during 8M16. The number of penalties imposed increased significantly on a YoY basis as law enforcement strengthened. In addition, the ministry aims to complete a vertical regulation reform by mid The demand of environmental monitoring equipment and services, as well as relevant operation and maintenance demand, will grow substantially going forward with the popularization of vertical regulation and smart environmental protection systems, not to mention the derived value of environmental monitoring data. YTD air pollution report Last week the Ministry of Environmental Protection also issued a report on the air quality in key regions and cities during Sept/9M16, which shows that during 9M16 the average number of days with good air quality in 338 cities increased by 2.6% YoY, and that PM2.5 and PM10 levels dropped 8.5% and 8.2% YoY respectively. That said, air quality deteriorated in Sept due to weather conditions. Our stock picks for the sector are United Science & Technology ( CH), Qingshuiyuan Technology ( CH), Focused Photonics ( CH), Sanju Environmental Protection & New Materials ( CH) and Tus-Sound Environmental Resources ( CH). Macro: Strong economic data strengthen case for a Dec hike Tapering remains the main risk before year-end At the last FOMC meeting, the Fed kept its policy rate unchanged as officials wanted to see further evidence that the US economy is recovering. Personal consumption was a concern as retail sales dropped unexpectedly in Aug. However, figures released last Friday showed that the decline was just temporary. Retail sales climbed 0.6% in Sept, following a revised 0.2% drop in Aug. We believe the strong retail sales will give Fed officials confidence that US domestic demand remained strong. On the other hand, crude oil prices rose to Page 3

4 US$50/barrel last week, the highest level in a year. Due to the low base last winter, we expect US inflation to pick up significantly in Dec, supported by high energy price growth. Overall, both economic data and inflation expectations strengthen the probability of a Dec hike. Financial market performance also reflects concerns about tapering. In the forex market, the US dollar index rose to 98, the highest level in seven months. In stock markets, the S&P 500 dropped for the second consecutive week, recording a two-month low. In the bond markets, the US 10-year treasury yield jumped to 1.80% last week, the highest level in four months. Looking ahead, we still expect tapering to be the main concern between now and the year-end. Yellen speech points towards accommodative policy in the medium term Fed Chair Janet Yellen attended an academic conference in Boston last week, and explained the Fed s mediumterm policy thinking. To reverse the damage from the financial crisis, Ms Yellen said that running a high-pressure economy could provide continued support to the real economy, even if it means a higher risk of inflation. She pointed out that the Fed would feel comfortable to let inflation rise above target for a while, saying that it is useful to consider the benefits of a "high-pressure economy". This could also be the reason why the Fed has not gone ahead with any policy measures in However, we do not think the speech signals that the Fed is not ready for a Dec hike. During the speech Ms Yellen also stated that an accommodative monetary stance, if maintained too long, could have costs that exceed the benefits. We see this as her way of explaining that the Fed will maintain its slow rate rises in the medium term. We therefore expect the Fed to only hike rates once or twice in 2017, meaning tapering should not be a key concern next year. China GDP data to be the next market focus China released mixed data last week. The latest inflation data show that the economic rebound continues. CPI inflation rose unexpectedly to 1.9% in Sept, much higher than expectation of 1.6%. More important was that non-food inflation also rose to 1.6%, the highest level in two years. In addition, PPI rose 0.1% in Sept, the first increase since 2012, finally ending the 54-month deflationary spiral. The continued rebound in PPI showed that industrial profit in China continues to improve. However, trade data showed there are still some uncertainties regarding external demand. Exports tumbled 10% in Sept, the largest decline in seven months. Overall, the economic data revealed that the Chinese economy has stabilized in the short term, but is not likely to post a strong rebound. We see a continued L-shaped outlook for the economy. China will report its initial GDP reading for 3Q16 this week. We expect economic growth to remain at 6.7%, the same as in 1Q-2Q16. The Chinese government will also release FAI, industrial production and retail sales data, which are expected to remain stable in Sept. (Alex Fan, CFA, Head of Research, SFC CE No. ADJ672, alexfan@gfgroup.com.hk ) (Frankie Wan, Research Analyst, SFC CE No. AVK969, frankiewan@gfgroup.com.hk ) Page 4

5 Rating Definitions Benchmark: Hong Kong Hang Seng Index Time horizon: 12 months Company ratings Buy Stock expected to outperform benchmark by more than 15% Accumulate Stock expected to outperform benchmark by more than 5% but not more than 15% Hold Expected stock relative performance ranges between -5% and 5% Underperform Stock expected to underperform benchmark by more than 5% Sector ratings Positive Sector expected to outperform benchmark by more than 10% Neutral Expected sector relative performance ranges between -10% and 10% Cautious Sector expected to underperform benchmark by more than 10% Analyst Certification The research analyst(s) primarily responsible for the content of this research report, in whole or in part, certifies that with respect to the company or relevant securities that the analyst(s) covered in this report: (1) all of the views expressed accurately reflect his or her personal views on the company or relevant securities mentioned herein; and (2) no part of his or her remuneration was, is, or will be, directly or indirectly, in connection with his or her specific recommendations or views expressed in this research report. 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