Income Partners Thoughts on the recent RMB weakness 27 th February, 2014

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1 Executive Summary Despite recent weakness and negative headline driven market speculation, we reiterate our stance that economic fundamentals in China remain supportive for the continued gradual appreciation of the RMB. We expect 1-2% annual appreciation of the RMB against the USD in The current weakness of the RMB reflects policy-induced short-term volatility, thus a good buying opportunity for long-term investors. We continue to actively manage our RMB Funds credit, currency and rates exposures and will aim to continue to provide the best risk-adjusted returns with an emphasis on downside protection. We strongly believe that the portfolio s high and stable credit carry will continue to amply mitigate any further RMB currency volatility and enable the Funds to achieve stable returns in Performance review The CNH (offshore RMB spot) has depreciated almost one percent (-0.92%) against the USD and the CNY (onshore RMB spot) has depreciated (-1.30%) since the beginning of the year. However, both of Income Partners RMB Bond Funds ( the Funds ) have achieved positive returns (in RMB terms) during this period. We have effectively mitigated the currency drawdown owing to our active management of both RMB currency and China rates exposures, as well as having achieved stable portfolio credit carry due to defensive positioning. Consequently, both Funds are well positioned to outperform for the rest of the year. As of the 26 February close, on a year-to-date basis: Current policy-induced short-term volatility in RMB provides good buying opportunity the CNH (offshore RMB spot) has weakened -0.92% against the USD and the CNY (onshore RMB spot) has weakened -1.16% against the USD Income Partners RMB Investment Grade Fund has returned -0.63% in USD, and +0.29% in RMB Income Partners RMB High Yield Bond Fund has returned +0.16% in USD, and +1.08% in RMB For the High Yield strategy, active management of RMB currency and China rates exposures contributed +0.70% (in RMB) to that Fund s outperformance. The portfolio s credit carry accounts for the rest. On the credit side, we are positioned defensively and maintain very short duration for both Funds: 1.3 years for the RMB Investment Grade Fund and 3.0 years for the RMB High Yield Bond Fund. Short duration and prudent credit selection have anchored the portfolios stable carry and enabled both Funds to achieve positive returns (in RMB). Page 1

2 Our thoughts on the current RMB weakness Despite recent weakness and negative headline driven market speculation, we reiterate our stance that economic fundamentals in China remain supportive for the continued gradual appreciation of the RMB. We expect 1-2% annual appreciation of the RMB against the USD in We believe this round of RMB weakness was mainly driven by: profit-taking outflows given the more than 3.0% appreciation of the RMB against the USD over the past 12 months market fears of a potential broadening of the CNY trading band from 1% to 2% by the PBoC, as well as a potential upward adjustment of the CNY fixing weaker February HSBC/Markit China Manufacturing PMI Meanwhile, on the technical side, hedging activities from importers as well as structured currency forward positions may have accelerated the RMB s depreciation especially when higher USDCNY or USDCNH strike levels were reached or breached. Bottom-line: we believe the current RMB weakness primarily reflects policy-induced short-term volatility and thus a good buying opportunity for long-term investors. Even though China s economy has slowed from prior peak levels, as shown by recent PMI data, we feel this is a government orchestrated slowdown designed to push through structural reforms for more sustainable growth going forward. As such, we believe this round of RMB weakening is driven mainly by flows/technicals rather than fundamentals. Fundamentally, as showed in the graphs below, China continues to run a large current account surplus and is accumulating foreign exchange reserves, both of which are supportive of the RMB currency from a medium-term view. China s 2013 reserve build is close to its highs amid a substantial financial account surplus (USD bn) Page 2

3 China s trade surplus not as cyclical as you might expect (USD bn) In addition, we see the following positive drivers supporting the RMB: the high carry in RMB against the USD firm control and benign level of domestic inflation policy support stimulating domestic consumption, and China s ability to maintain comparatively much higher economic growth than that of the US. Further, this round of RMB weakening is very different from what happened in 2011 when systemic risk rose due to the European debt crisis. Even during that period, the maximal drawdown on CNH was -2.5% because the RMB is a controlled currency (see charts below). Page 3

4 Currently, without any comparative systemic risks to 2011, the drawdown of the CNH has already reached -1.6%, which indicates that further depreciation should be limited. Finally, we also believe this round of depreciation is beyond what the PBOC intended or expected to extend. The below chart highlights, since mid-january the PBOC has adjusted the CNY fixing upward by only 0.4%, which remains within the historical CNY fixing range and is far less than the -1.3% actual depreciation of the CNY year-todate. Broadening of the CNY trading band is highly possible in the near-term as the PBOC has notified the market of this possibility for over one year. What the PBOC appears to really care about, and emphasizes, is a two-way CNY volatility trading band, to wash out speculative money. Our view is that the RMB is not headed for a crash, and when the market stabilizes it will continue to appreciate once again. Page 4

5 Conclusion: Despite recent weakness and negative headline driven market speculation, we reiterate our stance that economic fundamentals in China remain supportive for the continued gradual appreciation of the RMB. We expect 1-2% annual appreciation of the RMB against the USD in We believe this round of RMB depreciation is beyond what the PBOC intended or expected to extend, and it is also very different from what happened in 2011 when systemic risk rose due to the European debt crisis. We believe the current RMB weakness primarily reflects policy-induced short-term volatility and thus a good buying opportunity for long-term investors. We continue to actively manage our Funds credit, currency and rates exposures and will aim to continue to provide the best risk-adjusted returns with an emphasis on downside protection. We strongly believe that the credit portfolio s high and stable carry will continue to amply mitigate any further RMB currency volatility and enable the Funds to achieve stable returns in Page 5