Week in Perspective By Kevin Headland. Keep Calm and Carry On. Kevin Headland. What they did. August 28, 2015

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1 August 28, 2015 Kevin Headland Director, Capital Markets & Strategy Manulife Asset Management Week in Perspective By Kevin Headland Keep Calm and Carry On Keep Calm and Carry On was a motivational poster produced by the British government in 1939 in preparation for the Second World War. The poster was intended to raise the morale of the British public, threatened with widely predicted mass air attacks on major cities. Although 2.45 million copies were printed, and although the Blitz happened, the poster was hardly ever publicly displayed and was little known until a copy was rediscovered in It has since been re-issued by a number of private companies, and has been used as the decorative theme for a range of products. The motto is a good one to use to motivate the current investor as their psyche may have been damaged by recent market turmoil. Yet, despite the many markets hitting the ten percent correction level, both the Dow Jones and S&P 500 have recovered about half their drop. Let s take a deeper dive into what transpired during the last few weeks. What they did China s central bank, The People s Bank of China (PBoC) unexpectedly weakened the RMB on 11 August 2015, lowering its official fixing rate almost 2% to to the US dollar its lowest point in almost three years from the previous day 1. The central bank stated this was a one-off adjustment to better reflect market rates. The PBoC also announced an important change to how the onshore USD/CNY fixing rate would be determined. 2. Up until now, the central bank had set the mid-point of the exchange rate at 9:15am each trading day (Beijing time) with the onshore RMB spot rate allowed to trade within a +/-2% band around the mid-point. Effective 11 August 2015, the mid-point will be based on market maker submissions based on the previous day's USD/CNY spot market closing price, thereby taking into account supply and demand dynamics and the movement of other major currencies. PBoC also moved to cut benchmark 1-year lending rate by 25bps to 4.60% and 1-year deposit rate by 25bps to 1.75%, effective from August 26, In addition, they announced a 50bp RRR cut for all depository financial institutions, an additional 50bp RRR cut for qualified financial institutions with a focus on rural and SME loans and additional 300bp RRR cuts for financial

2 leasing companies and auto financing companies, effective from 6 September Why they did it It seems that the PBOC was acting in response to both weak economic data and concerns that the RMB will not be included in the IMF s Special Drawing Rights (SDR) basket of currencies. On the former, it is likely the first overt indication that China may not be able to achieve their targeted 7% economic growth rate due to weaker global demand for their exports and slower transition to a consumption lead economy. Recent data released on more tangible economic indicators such as electricity usage, rail freight and auto sales point to a much slower rate of growth. Source: Bloomberg, July 31, 2015 However, a 1.9% devaluation is likely to do very little to boost Chinese exports or stoke inflation. Therefore, it is possible we ll see further devaluations. China is still likely to be cautious about leaning on the devaluation button for fear of sparking capital outflows and creating difficulties in servicing foreign-denominated debt. There is also a timing issue, as Chinese President Xi Jinping is set to visit the United States in September, his first official visit. There are already many contentious items on the agenda, and another devaluation would further hurt an already strained relationship. Given the soft peg to the strong US Dollar, prior to the devaluation on August 11, over the last 12 months the RMB has rallied 21% against the Euro, 20.5% against the Yen and nearly 24% against the Australian Dollar. 3 The currency could very well have had a large impact on the weak export figures announced for the month of July. Exports to the European Union fell 12.3 percent in July while those to the United States dropped 1.3 percent. Demand from Japan, another big trading partner, slid 13 percent. The Chinese economy could no longer afford to have their currency driven higher at the expense of their economy.

3 Bloomberg, as of August 10, 2015 On the latter, it is still unclear if these changes are enough to satisfy the IMF s requirements to be included in the SDR basket. The Special Drawing Right (SDR) is an interest-bearing international reserve asset created by the IMF in 1969 to supplement other reserve assets of member countries. It is based on a basket of international currencies comprising the U.S. dollar, Japanese yen, euro and pound sterling. The value of the SDR is not directly determined by supply and demand in the market, but is set daily by the IMF on the basis of market exchange rates between the currencies included in the SDR basket 4. You can think of the SDR as a notional currency that the IMF uses to settle accounts. While the SDR has some tangible benefits, in the grand scheme of things, inclusion is more about pride and status. Given the current members, you can see why China wants to belong to this prestigious club. It remains to be seen how much a hand the PBOC really allows the markets to have in setting exchange rates. The Chinese yuan is increasingly used in cross-border transactions and heavily traded in Asia, but it is only thinly traded in North America and is not commonly used in international debt securities. Although the IMF has delayed a decision until next year, the inclusion of the RMB in the SDR basket is not a foregone conclusion for September Impact China's devaluation jolted global markets, with the currencies of South Korea, Australia and Singapore falling at least 1 percent amid bets other countries will seek weaker exchange rates to keep exports competitive. Shares of Chinese airlines sank on concern dollar debt costs will rise, while commodities retreated amid speculation yuan weakness will erode the buying power of Chinese consumers. U.S. Treasuries gained on growing demand for dollar assets. These changes are going to benefit some while hurting others. Notable winners should be Chinese exports and countries importing from China, such as the U.S. However, the U.S. will now be importing deflation which could lead the Fed to delay rate lift-off until Lower economic growth would also keep oil prices near current depressed levels, which would benefit

4 oil importing countries at the expense of oil exporting countries. Korea, Japan and the European Union, the major sources of Chinese imports, would be negatively impacted as the lower Yuan makes imports more expensive. Lastly, all other commodities will likely remain under pressure due to lower demand. This will have a strong impact on commodity producing economies, such as Australia, Brazil and to a lesser extent, Canada China Top 10 Export Markets, USD Million 2014 China Top 10 Import Sources, USD Million Rank Country/Region Amount % of Total Rank Country/Region Amount % of Total 1 US 396, Korea 190, Hong Kong 363, Kapan 163, Japan 149, US 159, Korea 100, Taiwan 152, Germany 72, Germany 105, Netherlands 64, Australia 98, Vietnam 63, Malaysia 55, UK 57, Brazil 51, India 54, Saudi Arabia 48, Russia 53, South Africa 44, Top 10 Total 1,375, Top 10 Total 1,069, European Union 370, European Union 244, Total 2,343,220 Source: China General Administration of Customs 100 Total 1,973, What now? Despite market volatility exacerbated by recent announcements coming out of China, developed market fundamentals remain strong. Global economic growth, while likely slower, still remains positive. And China while no longer growing at double digits is still contributing meaningfully to the global economy as its current growth rate is off a much bigger base. It is important to remember that the Chinese stock market volatility that has been discussed in the headline news has been mainly isolated to the onshore A-Share market, which trades on the Shanghai and Shenzhen stock exchanges, it not does reflect the H-Share market, which constitutes close to a hundred Chinese companies listed on the Hang Seng exchange. This A-Share market is essentially closed off to international investors, except for approved Qualified Foreign Institutional Investors (QFII), which receive an allotment amount or quota. The current quota amount granted is USD76 billion, which may seem like a lot, except when you compare it to the combined size of the two markets of USD9.6 trillion. To reiterate our comments from last week, our expectations regarding equity returns have not changed. Equity returns are likely to be below average over the next year or so. Slower, but steady GDP growth will contribute to modest earnings growth. Stock market valuations that are above their 5-year average have also kept our return expectations somewhat more subdued. This however, does not lead to bear market expectations. As such, while we are in correction territory for Canadian, European and Asian equity markets, and at or near for the US (whether your yardstick is the Dow Jones Industrial Average or the S&P 500 Index) the current volatility may be an opportunity to take advantage of market weakness for an improved return profile. 1 Bloomberg, 12 August Bloomberg, 10 August

5 Key Statistics (week-over-week) Ending August 28, 2015 Weekly Change YTD MSCI World Index (USD) 0.4% -3.0% S&P 500 Index (USD) 0.9% -3.4% S&P/TSX Composite Index 2.9% -5.2% MSCI Europe Index (EUR) 0.5% 5.2% MSCI Emerging Market Index (USD) 1.0% -4.2% Hang Seng (HKD) -3.6% -8.4% Topix Index (JPY) -1.5% 10.1% Current Week Previous Week CAD/USD $ $ EUR/USD $ $ USD/JPY Year US Treasury Yield 2.18% 2.04% 10-Year GoC Yield 1.44% 1.27% Gold USD/oz. $1, $1, Oil USD/bbl. $45.22 $40.45 Source: Bloomberg

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