CHINA: SO BAD IT IS GOOD FOR EQUITIES

CHINA: SO BAD IT IS GOOD FOR EQUITIES Weak economic fundamentals and deflationary trends increase likelihood of accommodative monetary policy and further stimulus December 11, 214 Northern Trust Global Investments South La Salle Street Chicago, Illinois 663 northerntrust.com Edward Trafford Basic Materials and Industrials Analyst et44@ntrs.com Growth: The New Priority We believe China s government has altered its focus toward short-term growth, versus long-term economic stability, in order to reduce the chance of social unrest. We view the government s increasingly accommodative stance as coming from concern over the impact that the continued decline in property values, soft employment and weak trade will have on the consumer. At China s annual Economic Work Conference, held in early-december, the government made economic growth stabilization its key priority. We expect President Xi Jinping will release a 21 gross domestic product (GDP) target of approximately 7.% during the National People s Congress in March; down from the 7.% targeted for 214. Shanghai Composite Outperformance The Citi Surprise Index (Exhibit 1) remains our preferred indicator for market positioning; adding exposure to the market as the index troughs. We also acknowledge that much of the recent market strength has resulted from asset flows from mainland investors via the Shanghai-HK stock connect program; the shift in assets from alternate investment vehicles such as real-estate and wealth management products; and the increased use of leverage. The surprise rate-cut on November 21 also acted as a key catalyst giving investors increased confidence that the government will indeed adopt a more-accommodative stance. We do not view the move in the market as reflecting improved long-term prospects for the country but rather the product of lower rates and the government s policy shift toward economic growth thereby allowing for higher valuation multiples. Easing Expectations for monetary easing and fiscal stimulus increase as China s economic data weakens. This has historically, and continues, to aid the local stock market. In this vein, we would highlight November s interest-rate cut and the mid-september three-month, billion Renminbi (RMB) loan issued to the major banks. We continue to anticipate a reserve requirement ratio cut, particularly given benign inflation (Exhibit 2); the negative producer price index (PPI) figures; the government s need to generate economic growth; and reduced liquidity as banks repay the RMB billion loan.

EXHIBIT 1 EXHIBIT 2 Invest When the Citi Surprise Index Troughs Low Inflation Allows for Required Reserve Ratio Cut 2,9 2,8 2,6 2, 2,3 2,2 2, 1,9 () (1) Shanghai Composite Citi China Surprise Index (1) 8/24/212 8/24/213 8/24/214 Source: Bloomberg, Citigroup Global Markets Required Reserve Ratio (%) 22 RRR (LHS) 21 2 19 18 17 CPI (RHS) 16 1 Source: Bloomberg, PBoC, NBS of China 7 6 4 3 2 1 CPI % Change Y/Y OUR KEY CONCERNS Bad Loans S&P reported on December 1 that 3% 4% of corporate loans in China use real-estate and/or land as collateral. The resulting decline in these assets has resulted in bad loans reaching a six-year high. We would note that in weaker regional markets, certain homebuilders are providing price guarantees on new construction, whereby the homebuilder will repurchase the property at the original purchase price should the owner be unable to resell at/above the original purchase price. Given that the homebuilders are backed by the major banks, we have some concern over the potential ramification of this guarantee in light of continued weakness in the residential markets. However, bank reform is underway. Financial institutions will self-insure, paying a premium to a third party, with the funds being used as deposit insurance. This reduces, but does not eliminate, the risk associated with the government being forced to bail out banks. In addition, the government tightened rules surrounding non-standard financial products and local government funding vehicles with the latter facing tighter collateral rules surrounding short-term loans. In conjunction with this, bonds rated sub-aaa can no longer be used as collateral to secure loans for repurchase agreements. While the equity market hardly applauded this step the Shanghai Composite corrected by.4% on December 9 we think this is a necessary step to ensure the longer-term viability of the economic system. Dis-Inflation / Deflation Both the November PPI, down 2.7% year-over-year, and the consumer price index, up a meager 1.4%, suggest that deflation is likely to be an increasing concern for the government. As Exhibit 3 shows, the PPI has been trending downward for approximately three years. In light of the government s concern over bad loans, the negative PPI is a key focus, with the string of weak reports making it increasingly difficult for companies to repay or service their debt burden. We view the weak PPI as an indicator of excess manufacturing capacity, with the International Monetary Fund estimating capacity utilization to be about %, down from roughly 9% in 22. However, as the five-year break-even in Exhibit 4 2

illustrates, inflation expectations have also trended downward in developed economies, including the United States. EXHIBIT 3 EXHIBIT 4 Weak PPI Indicative of Excess Capacity Global Expectations for Inflation in Decline PPI % Change Y/Y 3 2 2 1 1 () (1) China PPI Yield (%) 2.6 2.4 2.2 2. 1.8 1.6 1.4 1.2 1. US yr Breakeven Source: Bloomberg, NBS of China Source: Bloomberg The Consumer Even the wealthy have reined in their spending. We would note that Macau gaming revenue is down 18%+ year over year. It is difficult to tease out how much of this relates to the government s focus on taming corruption and how much relates to the consumer retrenching. However, we do not view the gaming revenue as an aberrant datapoint given that spending on luxury goods is also down sharply (~12% yoy) and auto sales growth is decelerating. In addition, we view the anemic CPI data as reflecting weak underlying consumer demand. As Exhibit and 6 show, November s consumer confidence continues to trend down lining up with the decline in home prices. EXHIBIT EXHIBIT 6 The Chinese Consumer is Sick As is the Housing Market 13 2 China Consumer Sentiment 13 China Residential Real Estate 2 12 Existing House Prices Beijing 12 1 11 1 Shanghai 11 1 Guangzhou () (1) () Source: Bloomberg, Deutsche Boerse AG 12/1/29 4/1/21 8/1/21 12/1/21 4/1/211 8/1/211 12/1/211 4/1/212 8/1/212 12/1/212 4/1/213 8/1/213 12/1/213 4/1/214 8/1/214 3

Employment We believe the government is in a challenging position in which it is striving to ensure full employment to reduce the risk of social unrest. However, as Exhibit 7 shows, the manufacturing employment picture is actually weakening. We would flag the correlation between the Employment Purchasing Manager Index (PMI) and GDP, and would note that non-manufacturing (service) employment, Exhibit 8, is deteriorating and has actually been in contractionary territory (sub-) since July. While the slowdown in manufacturing employment is somewhat intuitive as the government attempts to shift the economy toward a service/consumer-based model, the services employment data suggest that the government s plan is not working. EXHIBIT 7 EXHIBIT 8 Manufacturing Employment Contracting Service Employment also Contracting 13 12 11 1 9 8 7 6 China GDP (LHS) Employment PMI (RHS) 1/1/1999 1/1/2 1/1/21 1/1/22 1/1/23 1/1/24 1/1/2 1/1/26 1/1/27 1/1/28 1/1/29 1/1/21 1/1/211 1/1/212 1/1/213 1/1/214 4 2 48 46 44 42 Employment PMI 3 2 1 49 Non-manufacturing Employment 48 8/31/213 2/28/214 8/31/214 Source: China Federation of Logistics & Purchasing, China NBS Source: China Federation of Logistics & Purchasing Government Spending: Not the Long-Term Solution China s National Development and Reform Commission appears to be focused on transportation infrastructure as a way to spur economic growth. As Exhibit 9 highlights, government spend already makes up ~48% of GDP, a level we do not view as sustainable. In October and November alone, the government announced approximately $16 billion worth of projects, including six airports, more than 2 railways and one port. However, railway freight traffic (Exhibit 1), a good barometer of the broader economy, looks anemic. Volume growth has been in negative territory since February, with October volumes down 6.% year over year. This hardly creates a compelling case for increased Fixed Asset Investment (FAI) spend, particularly as it relates to transportation infrastructure. 4

EXHIBIT 9 EXHIBIT 1 Government Spend at Unsustainable Level Increase FAI Spend When Freight Vols Negative? % of GDP 48 46 44 42 4 38 36 34 32 3 China Investment to GDP 12/1/198 8/1/1983 4/1/1986 12/1/1988 8/1/1991 4/1/1994 12/1/1996 8/1/1999 4/1/22 12/1/24 8/1/27 4/1/21 12/1/212 Millions of Carloads 37 3 32 3 27 2 22 2 1 (1) China Rail Freight Volumes Source: International Monetary Fund China Construction China s construction market collapsed early in 214, with new residential floor space started down 27.4% year over year. As Exhibit 11 highlights, new construction remains in negative territory. Construction machinery, a barometer for broader construction activity, continues to weaken. China s November industry excavator sales volumes were down 38.3% year over year, accelerating from the year-to-date figure of down ~18% year over year. In addition, we would flag the widening spread in steel pricing between that of the United States and China (Exhibit 12), largely indicative of weakening Chinese demand. We believe there has been a massive pull-forward in construction activity, noting that China s consumption of cement per capita in 213 was eight times that of India, 7.3 times that of the United States and 3.1 times that of the entire world. EXHIBIT 11 EXHIBIT 12 New Construction in Negative Territory Weak Chinese Steel Price Reflect Demand 3 2 1 (1) (2) (3) (4) Floor Space of Buildings Newly Started $/Short Ton (US) / $/Tonne (China) 9 8 7 6 4 3 US Steel Price China Steel Price 7/1/211 11/1/211 3/1/212 7/1/212 11/1/212 3/1/213 7/1/213 11/1/213 3/1/214 7/1/214 Source: Steel Business Briefing, Metal Bulletin

Slowdown in Trade China s competitive advantage historically its low-cost workforce is a distant memory. As Exhibit 13 shows, wage inflation has been trending in the low double digits since 26. As can be seen in Exhibit 14, export growth from China has been in a downward trend with November marking a seven-month low. Given the slowdown in the global economy, ex-north America and Mexico, we do not find this slowdown surprising. China s PMI data reflect a slowing manufacturing backdrop, with the official PMI hitting an eight-month low of.3, down basis points month over month and missing the consensus estimate of.. The slowdown was driven by both the new-orders and production sub-indices, while the HSBC figure fell 4 bps month over month to. with softness more centered in production. It remains unclear how much of November s weak manufacturing prints were temporary, related to environmental concerns while Beijing hosted the APEC summit, rather than structural in nature. However, we have a hard time arguing that a return to an export-driven economy is likely and, as such, believe that this continued slowdown in the manufacturing sector will remain a meaningful impediment to economic growth. Exports in November were up 4.7% year over year, a large miss to consensus estimates for an 8% lift. The PMI new export orders index has also been softening for the last two months. New export orders, reported within the PMI, contracted further in November to 48.4 versus October s 49.9. EXHIBIT 13 EXHIBIT 14 Wage Inflation Making China Less Competitive Trade Data Disappoints 1 2 China Trade Data China Wage Inflation 8 2 Imports 6 1 1 4 2 (2) Exports (4) 12/1/29 4/1/21 8/1/21 12/1/21 4/1/211 8/1/211 12/1/211 4/1/212 8/1/212 12/1/212 4/1/213 8/1/213 12/1/213 4/1/214 8/1/214 FOR MORE INFORMATION To learn more, please visit northerntrust.com or contact your Northern Trust relationship manager. 6

Important Information There are risks involved in investing including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met. Risk controls and models do not promise any level of performance or guarantee against loss of principal. This material is directed to eligible counterparties and professional clients only and should not be relied upon by retail investors. The information in this report has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. Opinions expressed are current as of the date appearing in this material only and are subject to change without notice. This report is provided for informational purposes only and does not constitute investment advice or a recommendation of any security or product described herein. Indexes and trademarks are the property of their respective owners. All rights reserved. Information intended for use with institutional investors only. Not to be distributed to or relied upon by retail investors. Past performance is not necessarily a guide to the future. Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Index performance is based upon information provided by the index providers. Indexes and trademarks are the property of their respective owners, all rights reserved. There are risks involved with investing, including possible loss of principal. For Asia Pacific markets, this material is directed to institutional investors, expert investors and professional investors only and should not be relied upon by retail investors. Asset management at Northern Trust comprises Northern Trust Investments, Inc., Northern Trust Global Investments Ltd., Northern Trust Global Investments Japan, K.K., The Northern Trust Company of Connecticut and its subsidiaries, including NT Global Advisors, Inc., and investment personnel of The Northern Trust Company. Northern Trust Global Investments Japan, K.K. is regulated by the Japan Financial Services Agency. The Northern Trust Company has a branch in China mainly regulated by the China Banking Regulatory Commission, People s Bank of China and State Administration of Foreign Exchange. The Northern Trust Company of Hong Kong Limited is regulated by the Hong Kong Securities and Futures Commission. In Singapore, Northern Trust Global Investments Limited (NTGIL), and Northern Trust Investments, Inc. are exempt from the requirement to hold a Financial Adviser s License under the Financial Advisers Act and a Capital Markets Services License under the Securities and Futures Act with respect to the provision of certain financial advisory services, and fund management activities. In Australia, NTGIL is exempt from the requirement to hold an Australian Financial Services License under the Corporations Act 21 in respect to the provision of financial services. Issued by NTGIL. NTGIL is authorised and regulated by the Financial Services Authority under UK laws, which may differ from Australian laws. This material is for information purposes only. The views expressed are those of the author(s) as of the date noted and not necessarily of the Corporation and are subject to change based on market or other conditions without notice. The information should not be construed as investment advice or a recommendation to buy or sell any security or investment product. It does not take into account an investor s particular objectives, risk tolerance, tax status, investment horizon, or other potential limitations. All material has been obtained from sources believed to be reliable, but the accuracy cannot be guaranteed. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. IRS CIRCULAR 23 NOTICE: To the extent that this message or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see http://www.northerntrust.com/circular23. No bank guarantee May lose value NOT FDIC INSURED 7