global rights, wrongs & returns -...

Please refer to page 49 for important disclosures and analyst certification, or on our website

www.macquarie.com/research/disclosures.

GLOBAL

Inside

Key Recommendations & Portfolios 2

Twilight between Ignorance & Confusion 3

FX – ‘Canary in a coalmine’ 9

What do flat yield curves tell us? 14

Five key Macro Agonies 17

The world of no earnings & high

multiples 32

Investment Strategy: Quality Growth

and Thematics 37

Appendices 45

MQ – Asia ex Quality Sustainable Growth Portfolio

Source: Bloomberg; Macquarie Research, July 2016. Refer Figure 107

Analyst(s) Viktor Shvets +852 3922 3883 [email protected] Chetan Seth, CFA +852 3922 4769 [email protected]

15 July 2016 Macquarie Capital Limited

Rights, Wrongs & Returns 2H16 – Investment Twilight zone 1H16 has thus far lived up to our expectations (Year of Living Dangerously and

sequel) that this might be a watershed year that would redefine investment styles

and reinforce our view that neither conventional mean-reversion, macro nor

momentum investment strategies are likely to work. We believe that investors

are residing in a ‘twilight’ zone between dying free market signals and the

coming era of state-driven credit, capital investment and consumption.

In our view, investors’ predicament is driven by interaction of two powerful forces

that preclude return to conventional business and capital market cycles.

First, there is a high global leverage. We describe it as a superstructure resting

on top of the underlying economy, constantly interacting with it. Global economy

has a debt burden of ~3x GDP and up to five times as much on a gross basis.

This superstructure therefore has high and unpredictable in-built volatilities,

interacting with the real economy and asset classes. Given our view that no

major economy can any longer de-leverage, volatility is unwelcome as it

undermines confidence without which further leveraging is not possible. Hence

CBs heightened sensitivity to any significant bout of volatility that might ‘infect’

cross-asset classes. As a live ‘volcano’, Debt Mountain rumbles, pouring

streams of lava that CBs work to isolate and contain. However, the need for

leveraging works against CBs by raising both frequency and strength of tremors.

Second, we do not view the current lack of productivity, as a temporary

phenomenon. Instead it is an inevitable outcome of LT secular shifts (Third

Industrial Revolution), compounded by overleveraging and the unintended

consequences of monetary policies to match stagnant demand with excess

capacity. We maintain that lack of productivity will be a consistent theme for

years to come. This will likely force CBs to maintain current monetary policies,

as the only way to avoid demand contraction and ensure that asset values are

rising to facilitate further leveraging. It is a classic ‘Catch 22’, as without

productivity, leveraging is the only way to grow but it increases volatility, flattens

yield curves, and undermines credit and in turn erodes growth rates.

We maintain that the only socially acceptable answer is what we call

‘nationalization of capital’, which in our definition implies state control over

capital allocation and spending. It is premised on the replacement of a private

sector that refuses to multiply money. Hence it will be perceived as the public

sector’s responsibility to support aggregate demand. However, as in Gresham’s

Law (‘bad money drives out good money’), an aggressive public sector lowers

the visibility of the private sector, and unless it is perceived to be temporary, the

impact is not just on visibility of demand but also on the economy’s single most

important price (cost of money). It is another ‘Catch 22’ that ultimately leads to

further capital misallocation, lower ROEs and either deflation/stagflation or

hyperinflation. Alas, there is no alternative and public stimulation of consumption,

infrastructure, R&D and bail out of the financial superstructure (all via direct CB

financing) will have a strong impact. It also creates its own investment signals.

How does one invest? We maintain that conventional mean reversion

strategies cannot work in the world of no conventional business/capital market

cycles and, given cross-currents, macro calls are also no longer possible. We

continue to highlight investment strategies based on ‘Quality Sustainable

Growth’ and pure ‘Thematics’. Our Asia ex ‘Quality’ portfolio is up ~4% YTD and

28% since inception (’13) whilst our Global ‘Quality’ portfolio is up by ~1% since

re-balancing in April and Global ‘Thematics’ is up by ~2% since launch (Jun’16).

95

100

105

110

115

120

125

130

135

Mar

-13

May

-13

Jul-

13

Sep

-13

No

v-1

3

Jan

-14

Mar

-14

May

-14

Jul-

14

Sep

-14

No

v-1

4

Jan

-15

Mar

-15

May

-15

Jul-

15

Sep

-15

No

v-1

5

Jan

-16

Mar

-16

May

-16

Jul-

16

ASXJ "Quality and Stability" portfolio (rel to MSCI ASXJ, $ TR basis)

Macquarie Research Rights, Wrongs & Returns

15 July 2016 2

Key Recommendations & Portfolios

Fig 1 MQ ASXJ ‘Quality’ Portfolio (July 16) Fig 2 MQ Global ‘Quality’ Portfolio (July 16)

Source: Macquarie Research, July 2016 Source: Macquarie Research, July 2016

Fig 3 MQ ASXJ ‘Thematics’ Portfolio (April 16) Fig 4 MQ Global ‘Thematics’ Portfolio (April 16)

Source: Macquarie Research, July 2016 Source: Macquarie Research, July 2016

Fig 5 MQ Asia ex JP – Country Allocation (%)

Source : Macquarie Research, July 2016

Code Company Name Reco. Analyst Name Country

700 HK Tencent O/P Wendy Huang HONG KONG

2330 TT TSMC O/P Patrick Liao TAIWAN

ST SP SingTel O/P Prem Jearajasingam SINGAPORE

ITC IN ITC O/P Amit Mishra INDIA

INFO IN Infosys Limited N/R Not Rated INDIA

000333 CH Midea Group (A-Share) O/P Terence Chang CHINA

035420 KS NAVER RESTRICTED RESTRICTED SOUTH KOREA

090430 KS Amorepacific O/P Kwang Cho SOUTH KOREA

MSIL IN Maruti Suzuki India O/P Amit Mishra INDIA

288 HK WH Group Ltd. (HK) N/R Not Rated HONG KONG

1044 HK Hengan O/P Linda Huang HONG KONG

GCPL IN Godrej Consumer Products O/P Amit Mishra INDIA

EIM IN Eicher Motors Ltd. O/P Amit Mishra INDIA

669 HK Techtronic Industries N/R Not Rated HONG KONG

2313 HK Shenzhou International O/P Terence Chang HONG KONG

600066 CH Zhengzhou Yutong Bus (A) O/P Zhixuan Lin CHINA

1193 HK China Resources Gas O/P Candice Chen HONG KONG

1999 HK Man Wah O/P Timothy Lam HONG KONG

5347 TT Vanguard Neutral Patrick Liao TAIWAN

HTHT US China Lodging Group O/P Timothy Lam CHINA

Code Company Name Reco. Analyst Name Country

GOOGL US Alphabet O/P Ben Schachter UNITED STATES

MSFT US Microsoft Neutral Sarah Hindlian UNITED STATES

JNJ US Johnson & Johnson N/R Not Rated UNITED STATES

FB US Facebook O/P Ben Schachter UNITED STATES

700 HK Tencent O/P Wendy Huang HONG KONG

ORCL US Oracle O/P Sarah Hindlian UNITED STATES

DIS US The Walt Disney Company Neutral Tim Nollen UNITED STATES

V US Visa Inc. Class A N/R Not Rated UNITED STATES

2330 TT TSMC O/P Patrick Liao TAIWAN

AMGN US Amgen Inc. N/R Not Rated UNITED STATES

NOVOB DC Novo Nordisk A/S Class B N/R Not Rated DENMARK

OR FP L'Oréal Neutral Toby McCullagh FRANCE

MA US MasterCard Class A N/R Not Rated UNITED STATES

BAYN GR Bayer AG N/R Not Rated GERMANY

MC FP LVMH O/P Daniele Gianera FRANCE

NKE US NIKE O/P Laurent Vasilescu UNITED STATES

ST SP SingTel O/P Prem Jearajasingam SINGAPORE

ADP US Automatic Data Processing N/R Not Rated UNITED STATES

AIR FP Airbus Group SE N/R Not Rated NETHERLANDS

FDX US FedEx O/P Kelly Dougherty UNITED STATES

INFO IN Infosys Limited N/R Not Rated INDIA

CON GR Continental AG N/R Not Rated GERMANY

4503 JP Astellas Pharma Inc. N/R Not Rated JAPAN

ADS GR adidas O/P Andreas Inderst GERMANY

4452 JP Kao Corp. N/R Not Rated JAPAN

WPP LN WPP O/P Tim Nollen UNITED KINGDOM

NVDA US NVIDIA O/P Deepon Nag UNITED STATES

6981 JP Murata Mfg O/P George Chang JAPAN

EA US Electronic Arts O/P Ben Schachter UNITED STATES

ILMN US Illumina, Inc. N/R Not Rated UNITED STATES

MSIL IN Maruti Suzuki India O/P Amit Mishra INDIA

HO FP Thales SA N/R Not Rated FRANCE

COLOB DC Coloplast A/S Class B N/R Not Rated DENMARK

CAP FP Cap Gemini SA N/R Not Rated FRANCE

7741 JP HOYA O/P Damian Thong JAPAN

8035 JP Tokyo Electron O/P Damian Thong JAPAN

IPG US Interpublic Group O/P Tim Nollen UNITED STATES

EIM IN Eicher Motors Ltd. O/P Amit Mishra INDIA

669 HK Techtronic Industries Co., Ltd. N/R Not Rated HONG KONG

2313 HK Shenzhou International O/P Terence Chang HONG KONG

Ticker Name Country Ticker Name Country

Security, Prisons and Bullets Robots, Industrial, Automation and Technology

2357 HK AviChina China 300124 CH Shenzhen Inovance China

002415 CH Hikvision China HOLI US HollySys Automation Tech. China

2634 TT Aerospace Industrial Development Taiwan 002241 CH GoerTek China

047810 KS Korea Aerospace Industries Korea 2049 TT Hiwin Technologies Taiwan

079550 KS LIG NEX1 Korea 2308 TT Delta Electronics Taiwan

STE SP ST Engineering Singapore 1590 TT AirTAC Taiwan

Educational & Training services Shifts in manufacturing migration/competitiveness

EDU US New Oriental Education & Tech. China 2333 HK Great Wall Motor Company China

XRS US TAL Education Group China 600066 CH Zhengzhou Yutong Bus (A-Share) China

NORD US Nord Anglia Education China 600031 CH Sany Heavy Industry China

Environmental Constraint 425 HK Minth Group China

2208 HK Xinjiang Goldwind China 2382 HK Sunny Optical China

2688 HK ENN Energy China 1766 HK CRRC Corp Ltd China

3800 HK GCL-Poly Energy China 2313 HK Shenzhou International China

257 HK China Everbright International China 1476 TT Eclat Textile Taiwan

1193 HK China Resources Gas China 600741 CH Huayu Automative China

958 HK Huaneng Renewables China 3606 HK Fuyao Glass China

SIIC SP SIIC Environment Singapore Demographics

EDC PM Energy Development Philippines 2628 HK China Life Insurance China

MWC PM Manila Water Philippines 300015 CH Aier Eye Hospital Group Co. Ltd. China

Entertainment Services GE SP Great Eastern Holdings Ltd Singapore

1970 HK IMAX China China RFMD SP Raffles Medical Group Singapore

002739 CH Wanda Cinema China BDMS TB Bangkok Dusit Medical Services Thailand

700 HK Tencent China BH TB Bumrungrad Hospital Thailand

NTES US Netease.com China IHH MK IHH Healthcare Bhd Malaysia

GENM MK Genting Malaysia Malaysia KPJ MK KPJ Healthcare Malaysia

079160 KS CJ CGV Korea FORH IN Fortis Healthcare India


Theme 1: "Replacing Humans": Robots, Industrial Automation & AI Theme 4: "Bullets and Prisons": Defense, Security, Prisons/Correction Centres

ABBN VX ABB Ltd. Switzerland 047810 KS Korea Aerospace Industries, Ltd. South Korea

300024 CH SIASUN Robot & Automation A China 002415 CH Hangzhou Hikvision Digital A China

6506 JP Yaskawa Electric Corp. Japan LMT US Lockheed Martin Corporation United States

ISRG US Intuitive Surgical, Inc. United States RTN US Raytheon Company United States

SIE GR Siemens AG Germany NOC US Northrop Grumman Corporation United States

HON US Honeywell International United States HO FP Thales SA France

6503 JP Mitsubishi Electric Corp. Japan ESLT IT Elbit Systems Ltd Israel

6645 JP OMRON Corporation Japan CXW US Corrections Corporation of America United States

300124 CH Shenzhen Inovance Tech. A China GEO US GEO Group Inc United States

1590 TT AirTAC Taiwan Theme 5: "Education & Skilling"

NVDA US NVIDIA Corporation United States PSON LN Pearson PLC United Kingdom

MLNX US Mellanox Technologies, Ltd. Israel JW/A US John Wiley & Sons, Inc. Class A United States

Theme 2: "Augmenting Humans": Genome/Biotechnology/DNA sequencing EDU US New Oriental Education & Tech. Sp ADR China

AMGN US Amgen Inc. United States XRS US TAL Education Unspons. ADR Class A China

BIIB US Biogen Inc. United States NORD US Nord Anglia Education, Inc. Hong Kong

ABBV US AbbVie, Inc. United States WKL NA Wolters Kluwer NV Netherlands

ILMN US Illumina, Inc. United States Theme 6: "Demographics": Funeral Parlours and Psychiatric Centres

Theme 3: "Opium of the people": Games, Casinos/Virtual Reality 1448 HK Fu Shou Yuan International Group Ltd. China

700 HK Tencent Holdings Ltd. China SCI US Service Corporation International United States

ATVI US Activision Blizzard, Inc. United States UHS US Universal Health Services, Inc. Class B United States

EA US Electronic Arts Inc. United States ACHC US Acadia Healthcare Company, Inc. United States

NTES US NetEase, Inc. Sponsored ADR China Theme 7: "Disruptors & Facilitators"

7974 JP Nintendo Co., Ltd. Japan AMZN US Amazon.com, Inc. United States

LVS US Las Vegas Sands Corp. United States TSLA US Tesla Motors, Inc. United States

1928 HK Sands China Ltd. Macau FB US Facebook, Inc. Class A United States

002241 CH GoerTek Inc. Class A China CRM US salesforce.com, inc. United States

NFLX US Netflix, Inc. United States

GOOGL US Alphabet Inc. Class A United States

-2 -1 0 1 2 3

India

Philippines

Taiwan

China

Korea

Malaysia

Singapore

Thailand

Hong Kong

Indonesia


15 July 2016 3

Twilight between Ignorance & Confusion “In the middle of the journey of our life I found myself within a dark woods where the

straight-way was lost” Dante Alighieri;

“There is a fifth dimension beyond which is known to man...is the middle ground

between the pit of man’s fears and the summit of his knowledge”, Twilight Zone

The last several weeks were exceptionally interesting. Following Brexit, virtual implosion of

the Italian and Portuguese banking sectors and poor May payrolls, investors witnessed a

jump in June payrolls as well as full panic mode by the central banks and public authorities,

including: (a) expected BoE easing; (b) potential Japanese “helicopter money”; (c) growing

calls for public/taxpayer re-capitalization of the Eurozone banking sector; (d) expectations of

further easing in a plethora of countries including Korea and Singapore; India and Australia;

and (e) acceptance that the Fed cannot tighten.

The result was that correlation between asset classes jumped, with both risk-on and risk-

off assets delivering strong returns:

1. Equities recaptured pre-Brexit highs, driven by the perception that central banks and public

instrumentalities would panic sufficiently not to worry about asset bubbles, and hence so

long as corporates can squeeze-out even tiny EPS growth rates, the stage is set for a

further equity rally;

2. Global Bonds delivered some of the strongest gains ever, as yields collapsed across the

entire term structure for both DM and most EMs. Given that over US$12 trillion of sovereign

bonds are now trading at negative yields, the chase for yields has been exerting massive

gravitational pull. At the same time, term premium has collapsed (in the case of the US into

deeply negative territory) as investors accepted that risks of CBs tightening is virtually non-

existent whilst at the same time investors do not currently see any signs of inflationary

surprises (refer discussion below);

3. Gold has also delivered strong returns, driven by investor understanding that the current

policies would ultimately result in either deflation or stagflation or hyperinflation (all good

outcomes for gold).

Can one make any sense of these erratic changes? Our answer is no.

“You are travelling into another dimension...Your next stop is the twilight zone” – quote from The Twilight Zone

As in the ‘Twilight Zone’ TV series or in Dante’s description of the after-life above, we believe

that investors find themselves in a no man’s land, residing in the twilight zone between

relatively free market capitalist economies (with its own set of investment signals, such as

spreads, mean reversion, risk-return trade-off) and the environment which is completely

dominated by the state (with its own distinct set of signals)

Although most free market signals have been weakening for a decade, we maintain that over

the next one or two years, free market signals would finally perish (never to be resurrected

again or at least not in our life time). As we have discussed over the last 12 months, we

believe that the global economy is shifting in the direction of “nationalization of capital and

credit”. In other words, the pendulum is rapidly shifting in favour of the state, as it did after

1933-34 FRD’s New Deal and that particular period of state dominance lasted until 1979/80.

As the state becomes more dominant, it will increasingly evolve into a key source of

multiplication of money and aggregate demand. In other words, as the private sector refuses

to multiply money, the public sector would start undertaking this function.

As discussed in our prior notes, we believe that it would take the form of breaking nexus

between borrowing and spending by getting Central Banks to directly fund state investment (via

cash deposits or issuance of never to be redeemed and non-transferrable bonds) in four key

areas:

1. Stimulation of consumption (through minimum income guarantees and spending vouchers);

2. Financing of fixed asset investment and infrastructure spending;

3. Financing R&D and skilling investment; and finally

4. Rescuing and nationalizing the entire ‘bankrupt’ financial super structure, ranging from

banks to insurance and life companies to pension funds.

Last month

witnessed a jump in

cross-asset price

correlations

As in the Twilight

Zone, investors

inhabit an

intermediate stage

between degrading

market signals and

the future of direct

state control of

capital & credit


15 July 2016 4

This would be a completely different world (far more distorted than 1930s or 1960s-70s) and

investment signals would change radically. The key questions guiding investment decisions

would not be relationship between spreads and credit risk or between volatilities and values

but rather “what does the state want to achieve and where is the state likely to direct

investment and spending flows?” Whilst there are already clear signs of these occurring

(witness the ongoing power of Central Bankers), the pendulum is likely to swing even further

in this direction. Ultimately, we believe that the entire financial superstructure would need to

be nationalized (i.e. bankers and financial players would increasingly emerge as de-facto

public servants or largely co-opted by the public sector) to ensure the availability of insurance,

life and pension products whilst controlling volatilities that can have a devastating impact on

real economies. In other words, finance would likely be perceived as far too dangerous and

important to be left to “individuals behind the screens”.

As discussed in the past (here and here) some of this government (state) hyperactivity is

inevitable, as the global economy is progressing through the final stages of what we call

“Third Industrial Revolution”, with probably a more apt description being Declining Returns

on Humans that we incorporate into our Global Thematics portfolio. As the value and the

need for human input changes and generally declines, there would be a need to address

related issues of welfare policies, state involvement in demand multiplication etc. Hence,

as productivity rates and incomes stagnate and as labour that is currently effectively

‘warehoused’ in low productivity occupations is displaced, there would be growing demand for

changes in welfare and other income support policies to support aggregate demand.

However, in other areas, such as infrastructure investment, governments are likely to

continue to embrace this method of money multiplication not because there are significant

productivity gains to be derived from (say) faster trains, but because this represents the

largest ‘bang for the buck’. One area where we believe it would make a great deal of sense to

become far more involved is R&D spending and skilling. We maintain that in most countries,

the government over the past three decades has withdrawn too much from sponsoring R&D

and ensuring skilling, but unfortunately, this type of spending tends to have long-term pay

back periods.

Thus we believe that the ultimate destination for most investors will be an increasingly more

aggressive state involvement in multiplication of aggregate demand and ensuring that

financial sector volatilities do not flow through into various cross-asset prices and do not have

a significant negative real economy impact.

However, are we there yet?

We have discussed nationalization of credit for more than a year and the latest news of

Japan’s fiscal stimulus seem to be linked in the investors’ mind with the elusive concept of

“helicopter money” and the tectonic shift towards the state. In our view, investors have not

yet reached this inflection point. It seems more likely that over the next 12-18 months,

governments will continue tinkering on the edges with “start and go” type projects (similar to

Japan’s one-off supplemental budgets). As discussed below, we also do not believe that the

Eurozone is ready to fully embrace loose fiscal policy and the outright rescue of financial and

banking sectors. China is likely to continue fine-tuning its growth, debt and liquidity whilst the

US is likely to remain torn between desire to normalize and inability to do so.

What do we need to finally enter the above described Communist or Fascist (depending on

political preferences) paradise of state controlled and directed investment and spending?

Previously we have outlined four key door-steps conditions for such a dramatic public sector

shift, with very high volatilities being the key (with other preconditions being full acceptance

by investors and principals that conventional monetary and QE policies have come to an end;

acceptance that there is no escape velocity and the need for an intellectual case to be made

for an alternative policy). It is unquestionable that commentators from both the academic and

the popular end of the spectrum (from Woodford and Turner to Larry Summers and Martin

Wolf and Krugman) have already embraced this vision of a far more powerful mix of fiscal and

monetary policies. However we are still not convinced that either investors or principals fully

accept impotence of monetary policies or their inability to generate productivity.

However, as described above, our most important reservation is that principals (and

investors) need a significant “jolt” of extreme volatilities (far more than that experienced in

Dec’15-Jan’16) to force coalescence around far more aggressive policies.

We maintain that the

pendulum is

aggressively

moving towards

state activism in...

...support of income

& consumption;

fixed asset

investment and

ultimately rescuing

the entire financial

super structure

Japan might be the

first country to

integrate, fiscal,

income support and

monetary policies

However, before

that happens, we

need to experience

much stronger

bouts of volatility


15 July 2016 5

Whilst we don’t think that we are there yet, tremors (a la Brexit) would continue and at some

stage over the next 12 months or so, the shift is likely to occur. At that stage, a new set of

investment signals is likely to emerge. We maintain that Japan is bound to be the first country

to wholeheartedly embrace this powerful mix of fiscal, income support and monetary policies,

however, everyone eventually will likely follow the same path. It is just a matter of time (here).

Today’s close linkages between state, economy and the markets in China and to a

large extent Japan is likely to be the future for the global economy and investment.

However before arriving in a state sponsored ‘paradise’, confusion will continue to reign

In the meantime, confusion will continue to reign, as investors desperately try to find some

consistency in market signals that no longer make much sense.

Whilst understandable (finding patterns is hard wired into human and animal psyche as a key

survival strategy), it is not very useful in the world that is rapidly losing its market signals and

hence for every good bet, one usually finds two bad ones. This explains both overcrowding

and volatility spikes as investors en masse suddenly decide to reposition themselves, on the

basis of relatively small delta (news flow, economic variables or simply positioning).

For example, is recent massive flattening of yield curves signal that there would be no growth

(as it would impair the credit cycle)? The answer normally would be yes, but what if we no

longer need conventional banking and credit cycles, as governments decide and drive

investment and spending directly, largely by-passing banking and credit markets? The same

largely applies to negative interest rates. Is it a recipe for accelerated investment and

consumption or is it a mechanism that would destroy credit cycles, severely damage

insurance, life and pension industries whilst turning working capital on its head and

encourage considerable investment of energy in devising artificial means of avoidance

(such as prepayment of taxes or establishment of cash warehouses)? (refer to: What caught

my eye? v.54 - Negative rates and the war on savers 2 March 2016)

One market that we continue to believe remains relatively free is the currency market and

exchange rates would be the ‘canary in the coalmine’ (until of course this market would be

also eventually impaired through various forms of capital control, and China is already ahead

of the curve!). Therefore, the key challenge in the shorter-term is how will Central Banks

avoid severe macro cross-currents and contain currency volatilities? For example, an

aggressive push by Japan and Eurozone and any hint of Fed tightening (perhaps after

another strong payroll report) could be sufficient to accelerate US$ appreciation, whilst

potentially massively devaluing Yen and Euro. This in turn could easily display Rmb, with

7+ becoming the new 6, causing a potentially massive global deflationary wave.

Investment strategies – focus on fundamentals; or be contrarian

How does one invest in this climate? The simple answer is that one cannot invest

conventionally or at least until the new rules of the game and new investment signals

become clearer. At the same time, most other conventional strategies predicated on mean-

reversion (sector rotation; value vs growth; GARP etc) are unlikely to work. In the world that

no longer has identifiable business and capital market cycles and with most market signals

degrading, neither micro nor macro calls can be made, with any degree of certainty or

confidence.

We maintain that whilst there are severe reservations whether either macro economics or

standard finance theory reflects current reality, there is no doubt that microeconomics and

accountancy are a real science and would never go out of fashion (i.e. fundamentals never

die, although there are times when they do not work well in the investment market place).

In periods of severe dislocation (like now, as well as 1930s; 1960s-70s or Japan since 1990),

mean reversion and other conventional strategies stumble, as there is no longer any reliable

mean to revert to. Also during these dislocations, both business and capital cycles tend to be

distorted, implying severely limited ability to make sectoral calls.

We believe that the current dislocation is far more disruptive than previous episodes, simply

because, investors are encountering an unusual combination of:

1. Structural shifts (technology and declining return on humans);

In the meantime,

confusion would

reign with...

...lack of

conventional

business and capital

market cycles,

implying non-mean

reversion and

inability to make

macro calls


15 July 2016 6

2. Over-leveraging and over-capacity, across almost every sector of service and

merchandizing economies, as well as public, finance and private sectors; and

3. Aggressive public policies designed to avoid and minimize business and capital

market cycle volatilities and dislocations.

Our long held view was that in such non-mean reversionary times with a high degree of

uncertainty, the type of investment that tends to work is the one that highlights traditional

quality and sustainable growth characteristics. At the end of the day, the only reason to have

corporates is to reduce transaction costs and deliver ROE above the cost of capital. The non-

mean reversionary times have traditionally tended to favour this type of investment (whether

American ‘Nifty Fifties’ of late 1960s-late 1970s or Japan over the last 25 years).

This has been the essence of our ‘Quality & Stability’ or ‘Quality Sustainable growth’

portfolios that we have run since early 2013.

One problem that investors usually raise with us is that investing in quality has been a

consensus idea for at least five years and hence these types of strategies are expensive and

overcrowded. We disagree. Investors seem to have various definitions of what is meant by

Quality, which in most cases strikes us as not quality at all. For example some investors

highlight lack of volatility and defensiveness. Others highlight valuations, GARP or the need

to be in every sector (selecting what these investors believe to be the best choices within

sectors) or cash flow. We do not view any of these criteria (in isolation) as being Quality.

Our definition of quality focuses purely on ROEs (not defensiveness, stability, lack of

volatility or value) and ROEs that are supported primarily by margins (not revenues) and we

try to avoid excessive and rising leverage. The only sector we dislike and ignore are financials

(as discussed above, we believe that this sector is severely impaired) but we have no

problem with any other sector, if they qualify. Do we pay attention to valuations? Not really. In

a non-mean reversionary world, valuations lose their elasticity (thus there is no difference

between say 10x and 15x), as there is no longer a reliable mean against which existing

multiples can be measured. However, we do look at valuations at extremes, and in the last

three years, whenever we overruled fundamentals because of multiples, it has almost always

ended up to be a wrong call. If our view is correct that conventional business and capital

market cycles are unlikely to return for years (and possibly decades), then there is no need

to be concerned about potential end of non-mean reversionary strategies.

As can be seen from sections below (refer discussion on stocks and methodology), this

Portfolio has survived the strongest ‘trash rally’ since 2009 (low quality outperformed high

quality in most markets by over 10% between Feb and May 2016) and it is currently returning

~400bps relative to MSCI Asia ex Japan YTD and is up 28%-29% since our launch in early

2013. Our Global version of the same portfolio was launched in late January 2016, and is

broadly Neutral YTD (and is up 100bps-200bps since our latest rebalancing in Apr’16).

The key question for us whether this portfolio would also survive eventual (and inevitable, in

our view) transition to complete dominance by public sector. Whilst there are no Western

parallels of the extent to which we think public sector would come to dominate the macro

economy and finance, we suspect that our definition of Quality might survive even state

control. The reason for this is that we are not aiming to be defensive or cheap. We are simply

looking for sustainable ROEs and hence our portfolio tends to be populated by a plethora of

IT, software, biotech/pharma, industrial and consumer discretionary stocks that have their

own volatility and growth (staples almost never make it due to declining margins and

leverage).

Another type of investment that we think investors are likely to increasingly embrace is pure

Thematics. We have been discussing Thematics for at least three years but it is only in the

last six months that investors have started to pay attention, for three reasons:

1. There is a growing realization slow productivity growth rates is not just a temporary

anomaly but rather it is the inevitable and long-term outcome of significant structural

shifts that are likely to continue dominating the economic landscape for years and

decades to come. Hence, there is a growing interest from investors to try to identify

the right Themes and participate in these long-term structural shifts.

We continue to

recommend mostly

uncorrelated

strategies of...

...’quality,

sustainable growth’

and ‘thematics’

whilst...


15 July 2016 7

2. Given the above described volatility of macroeconomic and state-induced outcomes,

investors are exceptionally keen to adopt strategies that are independent of vagaries

of central bank cycles. Thematics, being long-term structural in nature, are some of

the least dependent on macro policy settings;

3. Thematics is also one of the most uncorrelated strategies relative to other equity

strategies.

However, as in the case of Quality, we believe that it is important to identify the ‘right’

Thematics. As discussed in our prior reviews, most of the past Thematics (such as

demographics, consumption etc) have largely outlived their usefulness. The new macro and

investment landscape is one of the constraints not opportunities.

Our preference is to invest in the Theme of ‘Declining Returns on Humans’, which include

either complete ‘replacement of humans’ (i.e. robotics, automation and AI); ‘augmentation of

humans’ (biotech, primarily genome); ‘opium of the people’ (i.e. games, consoles, artificial

reality, entertainment, gambling); ‘education and skilling’; ‘bullets and prisons’ (social and

geopolitical dislocation); ‘morbid demographics’ (funeral parlours, hospitals and psychiatric

institutions) and ‘disrupters and facilitators’.

We have been running a version of this portfolio in Asia ex Japan for almost two years

(although due to sector and stock limitations, we have also introduced a number of other

themes, such as environment and manufacturing shifts). Despite the fact that the Thematic

portfolios have no quality or any other screen and that it is inevitably tilted towards China (as

there are very few themes in ASEAN), it has performed broadly in line with the market, since

inception in Sep 2014. In June 2016, we have launched a much more focused Global

Thematics Portfolio. Thus far it is up ~2% against its benchmark (MSCI World).

One of the issues that is usually raised by clients is that both ‘Quality’ and ‘Thematics’

portfolios are viewed as long-term in nature and investors are constantly worried about

missing out on some short-term changes in direction. Our view is that long-term is now short-

term, as the current climate favour investors and penalizes traders. Hence, less is more.

However, one portfolio or strategy that could become important as we progress towards

increasing state control is the one that targets government spending and priorities. We have

experimented in the past with what we call ‘Anti Quality’ strategy (i.e. low margins, high

leverage and negative free cash flows). Indeed, by early May 2016, that screen was up by

more than 10% YTD (although it has given up some of the gains recently). It is currently

mostly populated by materials and infrastructure stocks. However, in due course this screen

could be converted into ‘Follow the Government Portfolio’, when it becomes clearer where

state priorities are likely to reside (for example split between infrastructure, income support

and other state priorities). We are reluctant to support these types of portfolios (whilst

recognizing that over time it could become a more important strategy) as it leaves investors at

the mercy of sudden and rapid shifts in state priorities.

Apart from Quality and Thematics, are there any other strategies that investors could deploy?

One of the strategies that might work is to take extreme contrarian positions. For example

should investors buy volatility, if (say) VIX approaches 12? The answer is more than likely in

the affirmative. Given that the private sector has no visibility, neither do investors and hence

there is a considerable degree of ‘overcrowding’. These contrarian positions are designed to

benefit not so much from mean reversion but rather from ‘stampedes’.

Country Allocations – we continue to like India, Philippines and to a lesser extent Taiwan & China

We continue to maintain our largest positive positions in India and the Philippines, for

several interrelated reasons:

1. As discussed below, we believe that Japan and Eurozone are likely to adopt more

aggressive monetary (and fiscal) stance. At the same time, we believe that China

would attempt to gradually bring down the Rmb without causing excessive global or

regional dislocation. This should push up the US$ (but not at a strongly accelerating

rate, as the Fed is likely to try to avoid widening the degree of monetary divergence).

In that scenario, commodity prices are likely to remain relatively range-bound and

create a Goldilocks environment for both countries (particularly India).

Preparing for

“Follow the

Government” and

“deglobalization”

strategies


15 July 2016 8

2. In the world of no productivity growth rates, India and the Philippines are some of the

very few countries globally that are still delivering productivity gains. To some extent

this is due to the fact that both countries are some of the least developed in the

region (generally we estimate that countries with some remaining productivity gains

represent not much more than 10% of global demand). At the same time, economic

outcomes are usually an ‘afterglow’ of past structural and tactical reforms, which

unless maintained tend to peter-out within two to three years. Although we have

significant reservations regarding sustainability of structural reform agenda in either

country, it is likely that over the next two years, both would deliver strong (5%-6%,

if one ignores overstating of India’s deflators) GDP growth rates, with relatively

contained inflation.

3. Whilst both markets remain expensive and EPS estimates seem excessive (particularly

in the case of India), the degree of investor enthusiasm and expectations have declined

significantly and neither market is now significantly over bought, unlike 18 to 24 months

ago when both markets were severely over bought.

We also maintain an O/W position in China, even though we have come to conclusion over

the last 12 months that despite much cleaner ‘line of sight’ in terms of both defining and

implementing structural reforms, there is very low probability of domestic non-capital

market structural reform. As discussed below, this implies that there is no escape for China

and assuming no global recovery, it would become a question of not just the degree of slow

down but also chances of social dislocation and financial crisis.

Nevertheless, as we have highlighted in the past, large and externally competitive economies

with high saving rates do not go down easily, and in most circumstances avoid an outright

external and credit crisis but instead experience sharp and permanent slow down. We

maintain that whilst there are a number of areas where China is far worse off than Japan of

1990s (refer What caught my eye? v.60 - Parallel lives: Japan vs. China 23 June 2016), it

does have a much higher degree of monetary and currency flexibility, whilst most of China’s

corporate debt already effectively resides on state’s books.

In the world where we expect US$ to drift up and Yen down and Rmb depreciate in a

relatively orderly manner, China liquidity position is likely to be contained. At the same time,

we continue to believe that China’s interest rates would ultimately drop to zero, as capital cost

must be matched with excess capacity. In terms of market internals, neither China’s earnings

estimates nor multiples strike us as excessive (at least as far as 2016 is concerned).

On the other side, we remain reluctant to embrace Indonesia. In the three most likely currency

outcomes over the next six to twelve months, Indonesia looses in two (either temperate or

accelerated US$ appreciation and Yen depreciation). Only weakness of US$ and strength of

Yen, pushing commodity prices higher would lead to a much better outcome for Indonesian

equities. At the same time, neither EPS estimates nor valuations look attractive.

We also remain Underweight Thailand and domestic Hong Kong and Singapore and

remain broadly neutrally positioned in Malaysia and Korea.

As described in section below, at the end of the day, the key driver of our country selection is

direction and strength of currency movements. If indeed US$ appreciates gradually (rather

than sharply) and Yen as well as Rmb depreciate gradually, EM equities should perform

broadly in line with DMs. If one assumes a sharp appreciation of US$, leading to a strong

deflationary wave and contraction of global demand, then clearly EMs (particularly terms of

trade EMs) would significantly underperform DMs. We remain in the camp of either Neutral or

relative Underperformance by EM equities. Only weakness in US$ and strengthening Yen

would propel EM strongly forward, in our view.

In terms of DMs, we continue to like Japan, as we maintain that it would be the first major

country to embrace integration of fiscal, income support and monetary policies (directly

funded by BoJ, without incurring incremental debt). This should lead to significant downside

to Yen exchange rate and although other countries would follow, Japan should have the first

mover advantage. The benefit of stimulus and lower currency should in turn flow into

Japanese equities. On the other hand, we remain concerned that US equities are vulnerable

to a potentially significant pull back.

Our country and

region allocation

largely depends on

currency

assumption, and in

particular direction

and strength of US$,

Yen and Rmb

We remain

overweight India

and the Philippines

and to some extent

China

We continue to like

Japan but are

concerned that US

equities could pull

back


15 July 2016 9

FX – ‘Canary in a coalmine’ As we highlighted in our preview of 2016 (here), US$ is the single most important price in the

world and its direction (both strength and duration) largely determines performance of

most asset classes.

Indeed, it cannot be any other way as the global economy continues to reside on the US$

standard, with US$ responsible for ~80% of trade and around 75% of global finance. Hence,

the price of US$ is one of the key determinants of ebbs and flows of global liquidity as well as

direction and strength of commodity prices and inflationary outcomes. It is also the key driver

of global demand and value of global trade. Rapidly rising US$ essentially deflates global

demand, erodes global trade and liquidity. Whilst the global economy can tolerate a gradual

appreciation, an economic and investment shock is inevitable when there is a rapid US$

acceleration.

There are three key variables that determine both direction and strength of changes in US$

exchange rates, namely:

1. Supply of US$ - remains weak.

Since our previous review in April 2016, there has been no significant change in

the pace of supply of US$. Essentially, supply remains exceptionally low, whether

we examine broad or narrow definition. It appears that supply of US$ into global

economy continues to be constrained by inability of the US economy to accelerate

at a pace that is sufficiently robust to significantly lift its current account deficit

whilst at the same time, QE3 ended in October 2014 and hence there is limited

expansion of the US monetary base. We maintain that current supply of US$ is

remaining broadly flat (hugging zero). In other words, there is simply not enough

US$ to support global growth and inflation.

Fig 6 Global US$ (Broad Definition) (% YoY) Fig 7 Global US$ (Narrow Definition) (% YoY)

Source: Bloomberg; Macquarie Research, July 2016 Source: Bloomberg; Macquarie Research, July 2016

2. Demand for US$ - remains strong.

We tend to judge the likely demand for US$ by examining basis swaps that banks

(and indirectly corporates) are prepared to pay to guarantee supply of US$.

We also tend to look at real bond spreads, as an indication of potential for

accelerated flow of funds into the US market.

As can be seen below, banks/corporates are currently paying ~45-50bps to swap

Euro into US$, whilst in the case of ¥, the swap rates are closer to 80-90bps.

In both cases, this is close to the maximum level of 50bps-75bps which is the

Fed’s pricing for swap lines with other Central Banks (and hence the price of

theoretically unlimited amount of US$ on request).

At the same time, the real bond yield spreads (10Y) between US Treasuries on the

one side and German Bunds and JGB’s remains at one of the highest levels ever

(around 120bps in the case of Bunds and ~90bps in the case of JGB), despite

recent significant erosion in the US 10Y bond yields. Given that over US$10 trillion

of government bonds are now trading at negative rates, US Treasury yields are

being massively pulled down (further discussion below) but still yield a much

higher relative return.

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Ja

n-0

4

Au

g-0

4

Ma

r-0

5

Oc

t-0

5

Ma

y-0

6

De

c-0

6

Ju

l-0

7

Fe

b-0

8

Se

p-0

8

Ap

r-0

9

No

v-0

9

Ju

n-1

0

Ja

n-1

1

Au

g-1

1

Ma

r-1

2

Oc

t-1

2

Ma

y-1

3

De

c-1

3

Ju

l-1

4

Fe

b-1

5

Se

p-1

5

Ap

r-1

6

US Monetary Base + Global FX Reserves

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Ja

n-1

0

Ma

y-1

0

Se

p-1

0

Ja

n-1

1

Ma

y-1

1

Se

p-1

1

Ja

n-1

2

Ma

y-1

2

Se

p-1

2

Ja

n-1

3

Ma

y-1

3

Se

p-1

3

Ja

n-1

4

Ma

y-1

4

Se

p-1

4

Ja

n-1

5

Ma

y-1

5

Se

p-1

5

Ja

n-1

6

Ma

y-1

6

World US$ (US M0+US Treasuries owned by Foreigners)

FX remains the

‘canary in a

coalmine’ and driver

of the world’s most

important price,

i.e. US$

Supply of US$

remains low and

is unlikely to

increase and...

...demand remains

strong


15 July 2016 10

Fig 8 Euro Basis swaps (bps) Fig 9 Yen Basis swaps (bps)


Fig 10 Real Bond Spreads (10Y) (%) (using 12 MMA CPI)

Fig 11 US Treasuries vs. German Bunds (real using TIPS)


3. The degree of policy divergence is critical.

We maintain therefore that there is a ‘firm’ quote for the US$, which makes it

hard to depreciate the currency (i.e. limited supply and strong demand ensures

ongoing support).

However, the degree of appreciation and its steepness depends critically on the

perception of divergence of monetary policies. As we discussed on numerous

occasions in the past, we do not believe that the Fed can tighten and we were

surprised when the Fed has actually made a decision to tighten in Dec 2015.

The principal reason for our stance was our long-standing view that combination of

structural and leverage headwinds is sufficiently strong to preclude any meaningful

acceleration of growth rates and whilst there could be short periods of stagflation,

generally inflationary pressures would remain subdued. To put it another way, we

maintain that structural and leverage/overcapacity constraints would result in a

continuing fall in velocity, as private sector refuses to multiply money. As can be

seen below, the US velocity of money has dropped in 1Q2016 to the historically

lowest ever level of 1.44x (vs. long-term average of closer to 1.6x-1.7x and the

high of more than 2x in the lead-up to dot.com in late 1990s). The same applies to

most other jurisdictions (with the exception of some of the least developed

economies, such as India or the Philippines).

In a world where the private sector lost confidence and refuses to multiply money,

the only way for grow aggregate demand is to either inject hard cash (i.e. QE

equivalents) or make public sector multiply aggregate demand (i.e. aggressive

fiscal policies, preferably funded directly by Central Banks or what is now

commonly referred to as ‘helicopter money’).

-80

-70

-60

-50

-40

-30

-20

-10

0

10

Ma

y-0

2

Fe

b-0

3

No

v-0

3

Au

g-0

4

Ma

y-0

5

Fe

b-0

6

No

v-0

6

Au

g-0

7

Ma

y-0

8

Fe

b-0

9

No

v-0

9

Au

g-1

0

Ma

y-1

1

Fe

b-1

2

No

v-1

2

Au

g-1

3

Ma

y-1

4

Fe

b-1

5

No

v-1

5

EUBS5 EUBS10

-100

-80

-60

-40

-20

0

20

40

Ma

y-0

2

Fe

b-0

3

No

v-0

3

Au

g-0

4

Ma

y-0

5

Fe

b-0

6

No

v-0

6

Au

g-0

7

Ma

y-0

8

Fe

b-0

9

No

v-0

9

Au

g-1

0

Ma

y-1

1

Fe

b-1

2

No

v-1

2

Au

g-1

3

Ma

y-1

4

Fe

b-1

5

No

v-1

5

JYBS10 JYBS5

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

De

c-9

2S

ep-9

3Ju

n-9

4M

ar-

95

De

c-9

5S

ep-9

6Ju

n-9

7M

ar-

98

De

c-9

8S

ep-9

9Ju

n-0

0M

ar-

01

De

c-0

1S

ep-0

2Ju

n-0

3M

ar-

04

De

c-0

4S

ep-0

5Ju

n-0

6M

ar-

07

De

c-0

7S

ep-0

8Ju

n-0

9M

ar-

10

De

c-1

0S

ep-1

1Ju

n-1

2M

ar-

13

De

c-1

3S

ep-1

4Ju

n-1

5M

ar-

16

Real Bond Yield Spread vs Bunds Real Bond Yield Spead vs JGB

-1.0

-0.5

0.0

0.5

1.0

1.5

Ju

n-0

9

Oct-

09

Fe

b-1

0

Ju

n-1

0

Oct-

10

Fe

b-1

1

Ju

n-1

1

Oct-

11

Fe

b-1

2

Ju

n-1

2

Oct-

12

Fe

b-1

3

Ju

n-1

3

Oct-

13

Fe

b-1

4

Ju

n-1

4

Oct-

14

Fe

b-1

5

Ju

n-1

5

Oct-

15

Fe

b-1

6

Ju

n-1

6

Real Spreads vs Bunds (using TIPS Break-even)

It is a good

environment for US$

but the pace and

degree of change

depends on...


15 July 2016 11

Fig 12 US – Velocity of Money (GDP/M2) (x) Fig 13 Japan – Velocity of Money (GDP/M2) (x)


Fig 14 Eurozone – Velocity of Money (GDP/M2) (x) Fig 15 China – Velocity of Money (GDP/M2) (x)


Fig 16 Brazil, Russia & India – Velocity of Money (GDP/M2) (x)

Fig 17 Malaysia, Thailand & Korea – Velocity of Money (GDP/M2) (x)


In this environment of limited capacity to accelerate growth by means of

conventional business and capital market cycles, it becomes a ‘race to the bottom’

as a growing number of countries stimulate and embark on increasingly more

aggressive monetary experiments. However as described (here), the more non-

Fed Central Banks (whether it is BoJ, ECB, PBoC or BoE) do, the worse it gets,

as it tends to accentuate monetary policy divergence between the Fed and the

rest. This, in turn, tends to accelerate US$ appreciation, causing contraction in

US$ denominated demand (GDP), erosion of liquidity and trade.

Indeed, the situation becomes even more problematic if the Fed instead of

remaining a neutral party decides that its domestic mandate requires that interest

rates must be raised. Any tightening by the Fed further increases monetary

divergence, causing even faster US$ appreciation.

1.30

1.40

1.50

1.60

1.70

1.80

1.90

2.00

2.10

2.20

De

c-5

9

Ma

y-6

2

Oc

t-6

4

Ma

r-6

7

Au

g-6

9

Ja

n-7

2

Ju

n-7

4

No

v-7

6

Ap

r-7

9

Se

p-8

1

Fe

b-8

4

Ju

l-8

6

De

c-8

8

Ma

y-9

1

Oc

t-9

3

Ma

r-9

6

Au

g-9

8

Ja

n-0

1

Ju

n-0

3

No

v-0

5

Ap

r-0

8

Se

p-1

0

Fe

b-1

3

Ju

l-1

5

Velocity Average (1990-2013)

Average (1960-1990)

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

Ma

r-5

7

Se

p-5

9

Ma

r-6

2

Se

p-6

4

Ma

r-6

7

Se

p-6

9

Ma

r-7

2

Se

p-7

4

Ma

r-7

7

Se

p-7

9

Ma

r-8

2

Se

p-8

4

Ma

r-8

7

Se

p-8

9

Ma

r-9

2

Se

p-9

4

Ma

r-9

7

Se

p-9

9

Ma

r-0

2

Se

p-0

4

Ma

r-0

7

Se

p-0

9

Ma

r-1

2

Se

p-1

4

Velocity Average (1957-1987) Average (1988-2014)

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

1.60

1.70

1.80

Ma

r-9

5

Ju

n-9

6

Se

p-9

7

De

c-9

8

Ma

r-0

0

Ju

n-0

1

Se

p-0

2

De

c-0

3

Ma

r-0

5

Ju

n-0

6

Se

p-0

7

De

c-0

8

Ma

r-1

0

Ju

n-1

1

Se

p-1

2

De

c-1

3

Ma

r-1

5

Velocity Average (1995-2013)

0.40

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

China Velocity

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

De

c-9

6

Oct-

97

Au

g-9

8

Ju

n-9

9

Ap

r-00

Fe

b-0

1

De

c-0

1

Oct-

02

Au

g-0

3

Ju

n-0

4

Ap

r-05

Fe

b-0

6

De

c-0

6

Oct-

07

Au

g-0

8

Ju

n-0

9

Ap

r-10

Fe

b-1

1

De

c-1

1

Oct-

12

Au

g-1

3

Ju

n-1

4

Ap

r-15

Brazil Russia India, rhs

0.60

0.80

1.00

1.20

De

c-9

6

Oct-

97

Au

g-9

8

Ju

n-9

9

Apr-

00

Fe

b-0

1

De

c-0

1

Oct-

02

Au

g-0

3

Ju

n-0

4

Apr-

05

Fe

b-0

6

De

c-0

6

Oct-

07

Au

g-0

8

Ju

n-0

9

Apr-

10

Fe

b-1

1

De

c-1

1

Oct-

12

Au

g-1

3

Ju

n-1

4

Apr-

15

Malaysia Thailand Korea

...divergence of

monetary policies


15 July 2016 12

Given our view that Japan, Eurozone and China (as well as increasingly the UK

and a plethora of smaller economies, such as Korea, Singapore, India etc) have

no choice but to increase the degree of monetary accommodation, the Fed

cannot tighten. Otherwise, there is likely to be significant dislocation that would

ultimately flow back into the US domestic economy.

A number of investors asked us as to how and why Chair Yellen would be hawkish

in Nov’15; dovish in Feb/Mar’16; hawkish in May’16 and confused in Jun’16, the

answer is that the Fed, as with most other Central Banks, is gradually learning how

to ‘ride’ the debt wave. As discussed in our prior reviews, most key global

economies can no longer deleverage, and hence as accepted recently by IMF, both

CBs and investors need to learn how to ‘live with excessive debt burden’. Hence,

the role of CBs’ communication is absolutely paramount and even the smallest delta

(either news flow or economic) could result in unpredictable and uncontrolled

volatilities. In the world of excessive and ongoing leveraging, volatilities are not just

unwelcome but outright dangerous, as they undermine confidence (the foundation

stone of leveraging process). In this world, consistency and survival do not

coincide. One needs to choose either one or the other.

As can be seen below, the combination of below-expectation May payrolls (partly

offset by stronger June) and Brexit prompted a massive collapse in tightening

probabilities all the way into 2017 (current expectations are not much more than

35% even by May 2017). In fact, probability expectations do not envisage any

significant tightening until 2018. Indeed, we would argue that even that late date

might be too optimistic. As discussed below, we believe that merger of fiscal and

monetary policies are the most obvious longer-term answer for Japan and

Eurozone (and it is already an answer for China). Easing of monetary and fiscal

stance by non-Fed actors could cause an even greater than otherwise spike in

US$ and hence severely limiting Fed’s room for tightening.

Fig 18 Federal Reserve Tightening Probabilities (as at Jul 12 2016)

Source: Bloomberg; Macquarie Research, June 2016

As discussed below, we believe that the Fed is determined to try to normalize

monetary policy settings. There are several reasons for this however the primary

motivation is that the Fed finally recognizes that low rates do not stimulate either

consumption or investment. The Fed would like to raise and steepen rates to

stimulate credit growth and ‘animal spirits’. The Fed also would like to have

‘dry powder’ to offset any sudden economic setbacks.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

7/1

2/2

01

6

7/5

/2016

6/2

8/2

01

6

6/2

1/2

01

6

6/1

4/2

01

6

6/7

/201

6

5/3

1/2

016

5/2

4/2

01

6

5/1

7/2

01

6

5/1

0/2

01

6

5/3

/201

6

4/2

6/2

016

4/1

9/2

01

6

4/1

2/2

01

6

4/5

/201

6

3/2

9/2

01

6

3/2

2/2

016

3/1

5/2

016

3/8

/201

6

3/1

/201

6

2/2

3/2

01

6

2/1

6/2

016

2/9

/2016

2/2

/201

6

1/2

6/2

01

6

1/1

9/2

01

6

1/1

2/2

016

Jul'16 Sep'16 Nov'16 Dec'16

The greater

divergence, the

faster US$ is likely

to appreciate...

...hence we do not

believe that the Fed

can tighten


15 July 2016 13

However, any hint of tightening would inevitably widen the degree of monetary

divergence, forcing faster-than-desirable appreciation of the US$. It seems like a

‘checkmate’ but it does not rule out mistakes.

We maintain that one of the key challenges would be if the US is already in a

mild stagflation (i.e. low and generally volatile GDP growth rates and rising

inflationary pressures). In other words, whilst it is unlikely that the US would

encounter an equivalent of late 1960s stagflation (global deflationary pressures are

just too strong for that), it is quite possible that whilst nominal GDP growth rates

are unlikely to accelerate beyond 3%-3.5%, most of it could end up as inflation

(primarily service markets). This could force the Fed to act irrespective of either

domestic or global consequences.

Thus, on balance, we maintain that the macro cross-currents remain far too strong to make

any systematic judgement as to the likely medium-term direction (beyond short-term

considerations, such as the latest US payrolls and immediate repricing of odds). Our view

remains that so long as the global economy is stuck in low equilibrium, supply of US$ remains

low and Japan, Eurozone and China need to consider much more robust monetary and fiscal

response, the timing and quantum of FX shifts are largely unpredictable and could be

potentially violent.

Our base case remains that over the next 12 months, US$ is likely to be higher whilst

¥ and Rmb lower and Euro direction would critically depend on the extent of Eurozone’s

response to strong gravitational pressures that threaten to destroy political, monetary and

economic union. As discussed in our prior notes, we do not believe that maintenance of the

commonly believed Feb’16 Plaza Accord (with Central Banks reputedly agreeing to maintain

currency stability, depreciate US$ and stabilize Rmb) is sustainable. The interests of the key

counterparts are just diametrically opposed (i.e. BoJ wants lower ¥; ECB wants lower €; Fed

does not want significant acceleration of US$ whilst PBoC wants stability to allow China to

gradually and slowly depreciate Rmb).

The forthcoming Japanese stimulus and the degree of change in BoJ’s monetary stance could

be the first move in unravelling whatever stability agreement was reached in February 2016.

Macro calls are

difficult as cross-

currents are too

strong but...

...we are still in

camp of higher US$,

lower Yen and

lower Rmb


15 July 2016 14

What do flat yield curves tell us? One of the challenges that we traditionally encounter with the US economists is their

predisposition to look at the Fed and the US economy in almost complete isolation. Whilst

domestic considerations are important, investors and governments are residing in globalized

and integrated economy and markets.

Given that Central Banks are increasingly confronting an empty chest of monetary instruments,

negative interest rates are becoming the last gasp of monetary activism. Whilst we do not

believe that negative rates would achieve their desired objectives (even currency depreciation

is far from guaranteed), nevertheless, it is clear that BoJ and ECB are likely to continue easing

into negative territory whilst BoE is likely to further ease. The same largely applies to PBoC and

a plethora of other central Banks.

As interest rates approach zero (or go negative), the conventional economics change

drastically. In the past we have described it as effectively going from traditional physics and

quantum mechanics (i.e. laws of small objects are different to laws of large objects, such as

planets). As described in our recent reviews (refer, What caught my eye? v.54 - Negative

rates and the war on savers 2 March 2016), zero or negative rates change the nature of

working capital management, value of cash and precious metals and encourage a

‘Prohibition-style’ avoidance. It also massively flattens yield curves; threatens to interrupt

credit cycles and further disconnects savers from investors whilst damaging insurance, life

and pension industries. It encourages desperate search for yield, creating significant

anomalies in the bond, equity and real estate markets.

As can be seen below, developed market bond yields have collapsed over the last three

years and this applies whether one looks at shorter or longer-term duration and it also applies

whether we include or exclude the US.

Fig 19 Developed Markets Sovereign Bond Yields – Total and Excluding US (%)

Fig 20 Developed Markets Sovereign Bond Yields – Short and Longer-term End (%)


Fig 21 Developed Markets Sovereign Bond Yield Curve (%)

Fig 22 US Yield Curve (%)


0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

Ju

n-1

3

Au

g-1

3

Oct-

13

De

c-1

3

Fe

b-1

4

Apr-

14

Ju

n-1

4

Au

g-1

4

Oct-

14

De

c-1

4

Fe

b-1

5

Apr-

15

Ju

n-1

5

Au

g-1

5

Oct-

15

De

c-1

5

Fe

b-1

6

Apr-

16

Ju

n-1

6

BGSV BGSX

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

0.0

0.5

1.0

1.5

2.0

2.5

Ju

n-1

3

Au

g-1

3

Oct-

13

De

c-1

3

Fe

b-1

4

Apr-

14

Ju

n-1

4

Au

g-1

4

Oct-

14

De

c-1

4

Fe

b-1

5

Apr-

15

Ju

n-1

5

Au

g-1

5

Oct-

15

De

c-1

5

Fe

b-1

6

Apr-

16

Ju

n-1

6

BGSV5-10 BGSV 1-5 years, rhs

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

Ju

n-1

3

Au

g-1

3

Oct-

13

De

c-1

3

Fe

b-1

4

Apr-

14

Ju

n-1

4

Au

g-1

4

Oct-

14

De

c-1

4

Fe

b-1

5

Apr-

15

Ju

n-1

5

Au

g-1

5

Oct-

15

De

c-1

5

Fe

b-1

6

Apr-

16

Ju

n-1

6

5-10 less 1-5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

0.6

1.1

1.6

2.1

2.6

3.1

Ju

l-11

Oct-

11

Ja

n-1

2

Apr-

12

Ju

l-12

Oct-

12

Ja

n-1

3

Apr-

13

Ju

l-13

Oct-

13

Ja

n-1

4

Apr-

14

Ju

l-14

Oct-

14

Ja

n-1

5

Apr-

15

Ju

l-15

Oct-

15

Ja

n-1

6

Apr-

16

Ju

l-16

Yield Curve (10Y-2Y) Yield Curve (30Y-2y), rhs

Massive flattening

of yield curves

places question

mark over....


15 July 2016 15

Given that almost US$12 trillion of sovereign bonds are now trading in a negative territory and

that blended average across developed market universe (ex US) is not much more than 10-

15bps, there is a growing gravitational pressure on the US treasury market, with yield curve

collapsing across the entire range. For example (10Y-2Y) is now trading at ~80bps vs.

historic average of ~160bps whilst (30Y-2Y) is at ~150bps vs historic average of ~250bps.

Across DM universe, the yield curve is down to only around 20-30bps. The same process is

now compressing EM average sovereign bond yields (US$), with an average yield across EM

universe sovereign base is now down to ~4.3% vs. 5.4% in Jan’16. Even the longest

durations (i.e. 10 years plus) are now yielding 5% vs. 6.5%-7.0% earlier in the year.

The collapse of term premium as calculated by the New York Fed has been unprecedented. It

has turned negative several months ago and is currently estimated (as term premium cannot

be observed but instead needs to be derived) at negative 70bps. Indeed one needs to go

back to the Kennedy administration in 1962 to witness a premium as low as current levels.

Fig 23 US Term Premium (%)

Source: NY Fed; Macquarie Research, June 2016

Essentially term premium reflects the risk of holding long-dated (say ten-year bonds) vs.

rolling short-term (say one or two year) bonds. Over the last ten years, term premium

emerged from the confines of fixed income and academic circles to become one of the key

investment topics. Given that term premiums should be normally positive, why are we seeing

such a massive compression of term premiums demanded by investors?

Whilst there are many explanations offered by Central Banks and academics, none are fully

satisfactory. It is argued that demand for perceived safety is driving all global yields down,

including term premiums and as Central Banks increasingly ‘vacuum’ more and more bonds

(around 20% of global bonds are already on CBs’ balance sheets), the scramble for

remaining bonds drives the premium down. It has also been suggested that low premiums

reflect, effectively, a lack of risk perceived by the investors, as Central Banks focus on

reducing volatilities and there is strong market consensus that inflation is unlikely to be a

problem (unlike say uncertainties that were pervasive in 1970s).

Whilst all of these explanations are reasonable, we believe that the key to declining term premiums

is investors’ acceptance of secular stagnation (which we define as the outcome of structural and

over leverage forces, compounded by active monetary policies). In other words, so long as structural

forces pin down productivity gains and so long as Central Banks fight to maintain aggregate demand

by taxing savers and subsidizing borrowers, term premium would remain low. However, as countries

gradually accept the need to ‘nationalize credit’ and finally embark on far more robust version of QE

(via CBs direct funding of fiscal, infrastructure and income support policies), there would be time,

when shock of the degree of expansion of monetary policy could easily prompt a massive term

rerating, creating a significant headache for CBs.

-1

0

1

2

3

4

5

Ju

n-6

1

Ju

n-6

4

Ju

n-6

7

Ju

n-7

0

Ju

n-7

3

Ju

n-7

6

Ju

n-7

9

Ju

n-8

2

Ju

n-8

5

Ju

n-8

8

Ju

n-9

1

Ju

n-9

4

Ju

n-9

7

Ju

n-0

0

Ju

n-0

3

Ju

n-0

6

Ju

n-0

9

Ju

n-1

2

Ju

n-1

5

ACMTP10 Average (1961-2015)

...medium- and

longer-term growth

and inflation


15 July 2016 16

In the meantime, Greenspan’s conundrum of 2005-06 (when the Fed was raising rates only

to see long end yields coming down) could be easily replayed again, as the yield curve

continues to flatten, despite the Fed’s best attempts to convince investors that the short end

is going to go up. This could be true even in an environment of higher inflation rates.

As yield curves flatten, credit cycles gradually run out of steam and pension and life industries

suffer. In other words, the essence of contemporary debt-driven economy becomes untenable.

This re-enforces our view that as private sector increasingly refuses to multiply money, it

would be argued that it is the responsibility of the public sector to support demand. In our

previous notes we have identified four key doorstep conditions that need to be satisfied

before the private sector is prepared to embark on such a radical plan, with much higher-

than-currently-prevailing volatility being the single most important condition.

In a world where the public sector is multiplying money and generates credit, does steepness

of the yield curve matter? Also in a world where 35% of JGBs and over 20% of the US

Treasuries and close to 15% of Bunds are already owned by respective Central Banks and in

the case of both JGB and Bunds, the ratio is rising rapidly and policy rates are either close to

zero or testing deeply negative levels, what does steepness or flatness of the yield curve tell

investors, regarding the longer-term outlook?

We don’t believe that there are any definitive answers, other than to argue that Central Banks

do not engage in such a massive manipulation of the markets, unless the consequences of a

debilitating deflationary bust were not just unbearable but also real, with a meaningful

probability of occurrence.

However in a

heavily distorted

market, it is hard to

be definitive


15 July 2016 17

Five key Macro Agonies We believe that investors are facing five key macro dangers over the next six to 12 months:

1. ‘The agony of Japan’. Is it ready to jump?

As discussed in our prior notes, the more Abenomics fails the higher ¥ goes and

the higher ¥ goes, the more Abenomics fails and to infinity. Unless the current

course is changed, ¥ might test the 90-95 level and by that stage ROEs of

Japanese companies would return back towards 5%-6%; profits would be negative

and there would be neither cash flow nor investment and indeed no inflation.

We maintain that neither slightly altering the amount of purchases nor going further

into negative interest rate territory would do much (if anything) to alter the current

self-destructive trajectory. What is needed is a radical re-think. Whilst we do not

agree with most of Paul Krugman’s views, his suggestion last year that fiscal and

monetary policies must be combined into a single ‘jolt’ might be Japan’s last

chance. The only difference between us and ‘flow based’ economists is that we

appreciate that at a certain level of debt, a country (or a business) goes bankrupt,

irrespective of the cost of money. The reason for that is that at some stage, the

private sector completely loses confidence (something that is not part of

conventional economic theory). We therefore believe that a far more rational policy

is to merge income support, fiscal and monetary tools via mechanism of BoJ

directly funding public spending and multiplication of aggregate demand.

We maintain that it is highly likely that Japan would be the first major economy to

experiment and deploy what we have in the past described as ‘nationalization of

credit’, with the state effectively taking control over credit and aggregate demand

multiplication. In the case of Japan, the most rational areas of stimulation include

minimum income guarantees, spending vouchers and rescue/nationalization of

national pension and banking sectors. Whilst most governments love the ‘quick

returns’ of infrastructure investments and indeed the Japanese government is

likely to do some of that, we do not believe that in the case of Japan it is needed.

As soon as Japan ‘jumps’, investors would immediately recognize that this new

policy has no limitation (as it breaks the link between spending and borrowing);

hence it is likely to result in sharp ¥ depreciation, resuscitating Abenomics,

propelling Japanese corporate ROEs into double digits and stoking some inflation.

The impact on currency would clearly depend on the ‘boldness’ and timing, but it

wouldn’t be unreasonable to believe that if the proposal is sufficiently robust ¥

would drop to below 120 level. Whilst the impact would be eventually replicated

by other countries, there is always a bonus for the first country that embraces what

essentially can be described as a far more potent version of QE.

Otherwise, Abenomics would completely unwind and there would be no growth; no

inflation and the country would be worse off than it was in 2012.

Fig 24 Japan – CPI (%) - ...declining trend whether one includes or excludes food & energy

Fig 25 Japan – PPI (%) - ...the same for PPI

Source: CEIC; Macquarie Research, July 2016 Source: CEIC; Macquarie Research, July 2016

-3

-2

-1

0

1

2

3

4

Ja

n-0

0

Se

p-0

0

Ma

y-0

1

Ja

n-0

2

Se

p-0

2

Ma

y-0

3

Ja

n-0

4

Se

p-0

4

Ma

y-0

5

Ja

n-0

6

Se

p-0

6

Ma

y-0

7

Ja

n-0

8

Se

p-0

8

Ma

y-0

9

Ja

n-1

0

Se

p-1

0

Ma

y-1

1

Ja

n-1

2

Se

p-1

2

Ma

y-1

3

Ja

n-1

4

Se

p-1

4

Ma

y-1

5

Ja

n-1

6

CPI CPI ex Tax CPI - ex Food & Energy & Tax

-10

-8

-6

-4

-2

0

2

4

6

8

10

Ja

n-0

0

Se

p-0

0

Ma

y-0

1

Ja

n-0

2

Se

p-0

2

Ma

y-0

3

Ja

n-0

4

Se

p-0

4

Ma

y-0

5

Ja

n-0

6

Se

p-0

6

Ma

y-0

7

Ja

n-0

8

Se

p-0

8

Ma

y-0

9

Ja

n-1

0

Se

p-1

0

Ma

y-1

1

Ja

n-1

2

Se

p-1

2

Ma

y-1

3

Ja

n-1

4

Se

p-1

4

Ma

y-1

5

Ja

n-1

6

PPI PPI ex Tax

Five key macro

agonies...

Would Japan

embrace integration

of fiscal, income

support and

monetary policies?

When and How?


15 July 2016 18

Fig 26 Japan – Nominal GDP (%) - ...receding Fig 27 Japan – Real GDP Growth & Deflator


Fig 28 Japan – Wages – Nominal & Real (%) Fig 29 Japan – Machinery Orders (%)


Fig 30 Japan – Non-Financial Corporates – continuing to deleverage – Net Debt/EBITDA (x)

Fig 31 Japan – Consumer Expectation of Inflation – coming off


Fig 32 Japan – Sectoral Balances (% GDP) – private sector is saving....

Fig 33 Japan – Sectoral Balances (% GDP) - ....continuing its long standing trend


-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

Mar-

81

Se

p-8

2

Mar-

84

Se

p-8

5

Mar-

87

Se

p-8

8

Ma

r-9

0

Se

p-9

1

Ma

r-9

3

Se

p-9

4

Mar-

96

Se

p-9

7

Mar-

99

Se

p-0

0

Mar-

02

Se

p-0

3

Mar-

05

Se

p-0

6

Mar-

08

Se

p-0

9

Ma

r-1

1

Se

p-1

2

Mar-

14

Se

p-1

5

Nominal GDP (% YoY)

(3.0)

(2.0)

(1.0)

-

1.0

2.0

3.0

4.0

5.0

6.0

-15.0

-10.0

-5.0

0.0

5.0

10.0

Ma

r-8

1

De

c-8

2

Se

p-8

4

Ju

n-8

6

Ma

r-8

8

De

c-8

9

Se

p-9

1

Ju

n-9

3

Ma

r-9

5

De

c-9

6

Se

p-9

8

Ju

n-0

0

Ma

r-0

2

De

c-0

3

Se

p-0

5

Ju

n-0

7

Ma

r-0

9

De

c-1

0

Se

p-1

2

Ju

n-1

4

Ma

r-1

6

Real GDP Growth (%) GDP Deflator (%), rhs

-5

-4

-3

-2

-1

0

1

2

3

Ma

r-10

Ju

l-1

0

No

v-1

0

Ma

r-11

Ju

l-1

1

No

v-1

1

Ma

r-12

Ju

l-1

2

No

v-1

2

Ma

r-13

Ju

l-1

3

No

v-1

3

Ma

r-14

Ju

l-1

4

No

v-1

4

Ma

r-15

Ju

l-1

5

No

v-1

5

Ma

r-16

Real Average Wage Earnings

Nominal Average Wage Earnings

-40

-30

-20

-10

0

10

20

30

40

Ju

n-9

9

Ma

r-0

0

De

c-0

0

Se

p-0

1

Ju

n-0

2

Ma

r-0

3

De

c-0

3

Se

p-0

4

Ju

n-0

5

Ma

r-0

6

De

c-0

6

Se

p-0

7

Ju

n-0

8

Ma

r-0

9

De

c-0

9

Se

p-1

0

Ju

n-1

1

Ma

r-1

2

De

c-1

2

Se

p-1

3

Ju

n-1

4

Ma

r-1

5

De

c-1

5

Machinery Orders 3MMA

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Ma

r-7

1

Mar-

73

Mar-

75

Mar-

77

Mar-

79

Mar-

81

Ma

r-8

3

Ma

r-8

5

Mar-

87

Mar-

89

Mar-

91

Mar-

93

Mar-

95

Ma

r-9

7

Ma

r-9

9

Mar-

01

Mar-

03

Mar-

05

Mar-

07

Mar-

09

Ma

r-1

1

Ma

r-1

3

Mar-

15

Net Debt/EBITDA (x) Average (1970-2013)

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

Apr-

04

No

v-0

4

Ju

n-0

5

Ja

n-0

6

Au

g-0

6

Mar-

07

Oct-

07

May-0

8

Dec-0

8

Jul-

09

Feb-1

0

Se

p-1

0

Apr-

11

Nov-1

1

Jun

-12

Jan

-13

Au

g-1

3

Mar-

14

Oct-

14

May-1

5

Dec-1

5

HH expecting prices to go up less than 2%

HH expecting prices to go up more than 2%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

Dec-9

8

Se

p-9

9

Jun-0

0

Mar-

01

Dec-0

1

Se

p-0

2

Jun-0

3

Ma

r-0

4

De

c-0

4

Se

p-0

5

Jun-0

6

Mar-

07

Dec-0

7

Se

p-0

8

Ju

n-0

9

Mar-

10

Dec-1

0

Se

p-1

1

Jun-1

2

Ma

r-1

3

De

c-1

3

Se

p-1

4

Jun-1

5

ROW Private Sector Public Sector

Saving

Spending

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

19

80

19

82

19

84

19

86

19

88

19

90

19

92

19

94

19

96

19

98

20

00

20

02

20

04

20

06

20

08

20

10

20

12

20

14

Private Sector Government ROW

Saving

Spending


15 July 2016 19

2. ‘The agony of the Eurozone’ – would it disintegrate?

We have always maintained that political capital invested in the concept of Europe

has been so enormous and the degree of its emotional appeal is so strong that

neither the EU nor the Eurozone would ever be allowed to disintegrate. Indeed, if

the EU was allowed some space (perhaps one or two more generations), it is quite

conceivable that the project of creating and solidifying a distinct European identity

might have succeeded. Alas, it was not to be and the growing economic tensions

(not just within EU but globally) are gradually fracturing the Union on the lines of

traditional ethnic and national lines.

At the same time, the incompleteness of the Union (i.e. it is neither a pure trading

block nor a unified country) and bureaucratic incompetence, when combined with

institutional settings that are massively different across the EU (i.e. some countries

like Spain, Greece or Italy have institutional settings far closer to emerging

markets than to Germany or Netherlands), creates lack of trust, without which it is

almost impossible to find solutions. Indeed, ECB has been arguably the only entity

with some degree of coherence.

Hence, a break-up or at least significant structural change is becoming

increasingly likely. How can the Union (both monetary and political) survive?

We maintain our view that either the EU needs to devolve back towards essentially

a trading block (essentially demand of Brexit followers) and the common currency

experiment would need to be terminated or the EU (and the Eurozone in particular)

would need to embark on much closer integration of monetary and fiscal policies,

with implicit (or explicit) transfers between states and common responsibility for

the banking sector. In our view there is no other alternative. We therefore, expect

that the Eurozone could be the second most prominent candidate for

‘nationalization of credit’ after Japan.

Indeed under normal circumstances we would have placed the Eurozone as the

next logical target for this policy. However, the Eurozone is as far from ‘normal’ as

one would ever likely to get. Hence, the question is whether the Eurozone would

continue to procrastinate until some other major emergencies were to force

resolution. If there is one sentence in a highly ‘stilted’ Eurozone bureaucratic

vocabulary that exemplifies for us how the Eurozone operates is ‘a period of deep

reflection is required and individual states are embarking on this process’. There

were several occasions over the last decade when these periods of ‘reflection’

continued until one stroke to midnight. There is no reason to believe that this time

it would be different, despite the obvious shock of Brexit.

The key vulnerability that has never been addressed is the Eurozone’s banking

sector and failure to achieve two key objectives: (a) disconnect banks from a

sovereign ‘doom machine’; and (b) re-capitalize the banking sector and recognize

and clear non-performing loans.

Given that the Eurozone is far more reliant on the banking transmission

mechanism (than say, the US or UK, as its debt and equity markets are under-

developed), making sure that banks are capable of transmitting funds into a real

economy is critical. Unlike, the US, where forced-fed equity injections were not

allowed to be repaid until the Fed (through series of credible tests) was convinced

that banking institutions were able to do so, ECBs sponsored LTRO programme in

2012, allowed the banks to repay most of the funds within 12 months and none of

its tests had any credibility.

As can be seen below, whereas the US quickly resolved most of the outstanding

NPL issues in 2009-13, the Eurozone continued to pile up doubtful debts. ECB

estimates that on its own narrow definition of non-performing loans, around 5.6%

of Eurozone loans are classified in that category. EBA is more conservative and its

estimates are closer to 6% of gross loans. This compares with the US NPL’s which

are generally (depending on definitions) closer to 1.5%-2.0%, down from

recessionary levels of ~4% in 2008-09.

Would the Eurozone

disintegrate?

Banking sector

remains the key

area of

vulnerability...


15 July 2016 20

Whilst the cases of Greece or Cyprus are well known, the situation currently is

particularly dire in Italy and Portugal, where NPL levels continue to rise, with ratios

approaching 16%-19%, with no evident resolution (unlike Spain). The reason for

so much public attention paid to Italy is that its NPLs are now approaching €400bn

(including €200bn of bad loans and another €200bn in various stages of

impairment). In other words, in excess of 40% of the Eurozone’s entire burden of

NPLs is currently located in Italy.

Fig 34 Global NPL Levels (% Gross Loans) Fig 35 Eurozone estimated NPL Levels (€ bn)

Source: ECB; EBA; World Bank; Macquarie Research, July 2016 Source: ECB; EBA; Macquarie Research, July 2016

Such a high share of non-performing loans clearly weighs on the banks’ ability to

lend to real economy through three interrelated channels: (a) lower earnings

power; (b) higher capital requirements; and (c) higher funding costs (although this

could be mitigated by ECB).

Another issue facing the Eurozone is that not only its banks have an excessive

level of NPLs but also ECB’s bond buying spree is providing banks with an

opportunity to front-run its Central Bank, and hence, proceeds are re-invested

back into either lending to governments or acquisition of sovereign debt (mostly

national). If we combine lending to various governments as well as bond holding,

we estimate that Eurozone Banks are currently have almost €3 trillion invested in

such instruments (up from about €2 trillion in early 2007). Once again, Italian

Banks have the single largest commitment (~€734bn as at May 2016),

representing ~20% of total assets of the Italian Banking system (vs. 9% for

Eurozone as a whole and 14% for Spain and 12% for Portugal and 6% for France).

Thus, the combination of high stored NPLs and a significant commitment in supporting

its sovereigns (explaining sensitivity of ECB to sovereign ratings and trading, as it

could easily set-up a ‘doomsday machine’ of rising sovereign yields, feeding through

into banking balance sheets and vice versa), implies limited ability to lend to the real

economy. The pace of recovery in lending remains far below the ECB’s monetary

stimulus (although at least across the Eurozone as a whole there are some first

tentative signs of small improvement). However, it does not apply to countries with the

highest levels of NPL and largest sovereign exposure (such as Italy).

Fig 36 Sovereign Exposure (% of assets)

Fig 37 Eurozone – Lending to Household and Non-Financial Corporate Sector (Dec’12=100)

Source: ECB; Macquarie Research, July 2016 Source: ECB; Macquarie Research, July 2016

ECB EBA

2008 2011 2013 2015 2015

Greece 3.1 10.7 24.6 37.9 43.5

Italy 5.1 9.7 13.2 16.3 16.9

Portugal 1.8 6.2 8.8 15.2 18.5

Spain 2.5 5.3 7.9 5.3 6.8

France 3.2 4.7 4.7 3.6 4.2

Germany 1.8 1.6 1.8 2.0 3.2

Eurozone 2.5 4.5 5.9 5.6 6.0

US 3.0 3.8 2.5 1.5

Global 3.0 3.9 4.1 4.3

EBA

2008 2011 2013 2015 % 2015

Italy 127 241 316 397 41% 410

France 125 209 205 160 17% 188

Germany 85 76 80 91 9% 144

Spain 59 119 145 90 9% 115

Greece 8 33 61 85 9% 97

Portugal 6 20 25 39 4% 47

Eurozone 459 834 1,010 964 100% 1,035

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

2008

-10

2009

-02

2009

-06

2009

-10

2010

-02

2010

-06

2010

-10

2011

-02

2011

-06

2011

-10

2012

-02

2012

-06

2012

-10

2013

-02

2013

-06

2013

-10

2014

-02

2014

-06

2014

-10

2015

-02

2015

-06

2015

-10

2016

-02

Italy Spain Portugal Eurozone

65.0

70.0

75.0

80.0

85.0

90.0

95.0

100.0

105.0

110.0

2012

-12

2013

-02

2013

-04

2013

-06

2013

-08

2013

-10

2013

-12

2014

-02

2014

-04

2014

-06

2014

-08

2014

-10

2014

-12

2015

-02

2015

-04

2015

-06

2015

-08

2015

-10

2015

-12

2016

-02

2016

-04

Italy Spain Portugal

France Germany

...particularly in

Italy, Portugal

and Greece

The potentially

highly disruptive

“embrace” between

banks and

sovereigns has not

been broken


15 July 2016 21

As highlighted in our previous reviews, the ability to accelerate lending and

transmit ECB’s largesse into real economic outcomes is further constrained by

tepid demand for money. In essence, it is a version of Japan’s liquidity trap.

As ECB surveys highlight, there has been recently some recovery in demand for

money (primarily by household consumer credit sector), it remains quite weak.

Fig 38 ECB – Net Enterprise demand for Borrowing

Fig 39 ECB – Net Enterprise Easing of Borrowing Conditions


Fig 40 ECB – Net HH Mortgage Demand Fig 41 ECB – Net HH Consumer Credit Demand


Tepid demand and supply of credit translate into highly uneven low-equilibrium

and high volatility of economic outcomes. It particularly applies to inflation. Whilst

the base effect should bring inflation rates up, most indicators continue to signal

strong deflationary pressures (as economists argue whether there is a real

difference between minus 0.2% or plus 0.2% inflation). This applies to CPI, PPI

as well as core (ex energy and food) CPI and PPI. Also, the EC survey of

consumers continues to highlight that ~45% of consumers expect prices to be

either flat or down in the next 12 months.

Fig 42 Eurozone – CPI (% YoY) Fig 43 Eurozone – Core CPI (% YoY)


-50.0

-40.0

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

Ja

n-0

5

Ju

l-05

Ja

n-0

6

Ju

l-06

Ja

n-0

7

Ju

l-07

Ja

n-0

8

Ju

l-08

Ja

n-0

9

Ju

l-09

Ja

n-1

0

Ju

l-10

Ja

n-1

1

Ju

l-11

Ja

n-1

2

Ju

l-12

Ja

n-1

3

Ju

l-13

Ja

n-1

4

Ju

l-14

Ja

n-1

5

Ju

l-15

Ja

n-1

6

Net Enterprise Demand Increase

-70.0

-60.0

-50.0

-40.0

-30.0

-20.0

-10.0

0.0

10.0

20.0

Ja

n-0

5

Ju

l-05

Ja

n-0

6

Ju

l-06

Ja

n-0

7

Ju

l-07

Ja

n-0

8

Ju

l-08

Ja

n-0

9

Ju

l-09

Ja

n-1

0

Ju

l-10

Ja

n-1

1

Ju

l-11

Ja

n-1

2

Ju

l-12

Ja

n-1

3

Ju

l-13

Ja

n-1

4

Ju

l-14

Ja

n-1

5

Ju

l-15

Ja

n-1

6

Net Enterprise Easing

-80.0

-60.0

-40.0

-20.0

0.0

20.0

40.0

60.0

Ja

n-0

5

Ju

l-05

Ja

n-0

6

Ju

l-06

Ja

n-0

7

Ju

l-07

Ja

n-0

8

Ju

l-08

Ja

n-0

9

Ju

l-09

Ja

n-1

0

Ju

l-10

Ja

n-1

1

Ju

l-11

Ja

n-1

2

Ju

l-12

Ja

n-1

3

Ju

l-13

Ja

n-1

4

Ju

l-14

Ja

n-1

5

Ju

l-15

Ja

n-1

6

Net HH Mortgage Demand Increase

-60.0

-50.0

-40.0

-30.0

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

Ja

n-0

5

Ju

l-05

Ja

n-0

6

Ju

l-06

Ja

n-0

7

Ju

l-07

Ja

n-0

8

Ju

l-08

Ja

n-0

9

Ju

l-09

Ja

n-1

0

Ju

l-10

Ja

n-1

1

Ju

l-11

Ja

n-1

2

Ju

l-12

Ja

n-1

3

Ju

l-13

Ja

n-1

4

Ju

l-14

Ja

n-1

5

Ju

l-15

Ja

n-1

6

Net CC Demand Increase

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Ja

n-0

8

Ju

n-0

8

No

v-0

8

Ap

r-09

Se

p-0

9

Fe

b-1

0

Ju

l-10

De

c-1

0

Ma

y-1

1

Oct-

11

Ma

r-12

Au

g-1

2

Ja

n-1

3

Ju

n-1

3

No

v-1

3

Ap

r-14

Se

p-1

4

Fe

b-1

5

Ju

l-15

De

c-1

5

Ma

y-1

6

CPI (%)

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Ja

n-0

8

Ju

n-0

8

No

v-0

8

Ap

r-0

9

Se

p-0

9

Fe

b-1

0

Ju

l-1

0

De

c-1

0

Ma

y-1

1

Oc

t-1

1

Ma

r-1

2

Au

g-1

2

Ja

n-1

3

Ju

n-1

3

No

v-1

3

Ap

r-1

4

Se

p-1

4

Fe

b-1

5

Ju

l-1

5

De

c-1

5

Ma

y-1

6


15 July 2016 22

Fig 44 Eurozone – PPI (% YoY) Fig 45 Eurozone – Core PPI (% YoY)


Fig 46 Eurozone – Inflation break-even rates (%) Fig 47 Eurozone – Inflation break-even Rate (5Y/5Y)


Fig 48 Eurozone – Consumers expecting Flat/Lower Prices in the next 12 months (%)

Fig 49 Eurozone – Consumer Inflation Expectation (Index)

Source: EC; Macquarie Research, July 2016 Source: EC; Macquarie Research, July 2016

Whilst backward looking, the same message of a lack of any significant change in

private sector behaviour is apparent when we examine sectoral balances, either

across the Eurozone or for individual economies. As can be seen below, private

sector savings remain exceptionally high (~5%-6% of GDP) across the entire

region. The same applies to the key vulnerable economies (such as Italy, France

and Spain). As current account surpluses rise, the block sends a strong signal that

it is unable to utilize its private sector savings and needs to export it to other

destinations.

-6

-4

-2

0

2

4

6

8

Fe

b-1

1

Ma

y-1

1

Au

g-1

1

No

v-1

1

Fe

b-1

2

Ma

y-1

2

Au

g-1

2

No

v-1

2

Fe

b-1

3

Ma

y-1

3

Au

g-1

3

No

v-1

3

Fe

b-1

4

Ma

y-1

4

Au

g-1

4

No

v-1

4

Fe

b-1

5

Ma

y-1

5

Au

g-1

5

No

v-1

5

Fe

b-1

6

Ma

y-1

6

Eurozone PPI

-2

-1

0

1

2

3

4

5

Fe

b-1

1

Ma

y-1

1

Au

g-1

1

No

v-1

1

Fe

b-1

2

Ma

y-1

2

Au

g-1

2

No

v-1

2

Fe

b-1

3

Ma

y-1

3

Au

g-1

3

No

v-1

3

Fe

b-1

4

Ma

y-1

4

Au

g-1

4

No

v-1

4

Fe

b-1

5

Ma

y-1

5

Au

g-1

5

No

v-1

5

Fe

b-1

6

Ma

y-1

6

Eurozone PPI ex Construction & Energy

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Ma

r-10

Ju

l-1

0

No

v-1

0

Ma

r-11

Ju

l-1

1

No

v-1

1

Ma

r-12

Ju

l-1

2

No

v-1

2

Ma

r-13

Ju

l-1

3

No

v-1

3

Ma

r-14

Ju

l-1

4

No

v-1

4

Ma

r-15

Ju

l-1

5

No

v-1

5

Ma

r-16

Ju

l-1

6

EUSWIT5 EUSWIT3

0.5

0.7

0.9

1.1

1.3

1.5

1.7

1.9

2.1

2.3

2.5

Ja

n-1

2

Ap

r-1

2

Ju

l-1

2

Oc

t-1

2

Ja

n-1

3

Ap

r-1

3

Ju

l-1

3

Oc

t-1

3

Ja

n-1

4

Ap

r-1

4

Ju

l-1

4

Oc

t-1

4

Ja

n-1

5

Ap

r-1

5

Ju

l-1

5

Oc

t-1

5

Ja

n-1

6

Ap

r-1

6

Ju

l-1

6

FWISEU55

1.25%

18.0

22.0

26.0

30.0

34.0

38.0

42.0

46.0

Mar-

11

Jun

-11

Se

p-1

1

Dec-1

1

Ma

r-1

2

Jun

-12

Se

p-1

2

De

c-1

2

Mar-

13

Ju

n-1

3

Se

p-1

3

De

c-1

3

Mar-

14

Ju

n-1

4

Se

p-1

4

De

c-1

4

Mar-

15

Ju

n-1

5

Se

p-1

5

Dec-1

5

Ma

r-1

6

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16


15 July 2016 23

Fig 50 Eurozone – Sectoral Balances (% GDP) Fig 51 Spain – Sectoral Balances (% GDP)


Fig 52 Italy – Sectoral Balances (% GDP) Fig 53 Portugal – Sectoral Balances (% GDP)


Although we maintain that the Eurozone’s case is nowhere near as advanced as that

of Japan, we continue to view it as being essentially on the same course towards a

long-term liquidity trap, with unresolved banking and pension sectors, compounded

by declining private sector confidence.

We also maintain that negative interest rates (here) are essentially a form of Russian

roulette, with significant (and underappreciated it seems) risks of stalling credit

growth destruction of life and pension industries, without achieving the type of

stimulatory impact that ECB is aiming for. Whilst negative rates are likely to remain

the key instrument for Scandinavia, Switzerland and Japan, we view it as desperation

or more precisely inability to find any other instrument to stimulate economies that

are already over-leveraged and over-capacitated.

We maintain that the only feasible answer is nationalization of credit. However,

whilst in Japan it is not strictly illegal (it just against convention and regulation) and

the new policies can be introduced in the confines of one nation, the same cannot be

said for the Eurozone. Therefore there is, in our view, a serious risk that neither

banking nor demand issues would be resolved in a timely fashion, leading to a

potentially disruptive slow-down later in the year and possibly a rolling banking crisis.

In order to appreciate how important banks are to the Eurozone, one needs to

remember that banking assets represent 3x Eurozone’s GDP vs. under 1x for the US

(different accounting for derivatives in the US, would increase this ratio to ~1.5x

GDP). The decline in banking assets to GDP since 2010/11 is unfortunately primarily

a reflection of banking retrenchment rather than faster GDP growth rates.

Fig 54 Eurozone – Banking Sector Assets (% GDP)

Source: ECB; Bloomberg; Macquarie Research, June 2016

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

20

15

Q4

20

15

Q2

20

14

Q4

20

14

Q2

20

13

Q4

20

13

Q2

20

12

Q4

20

12

Q2

20

11

Q4

20

11

Q2

20

10

Q4

20

10

Q2

20

09

Q4

20

09

Q2

20

08

Q4

20

08

Q2

20

07

Q4

20

07

Q2

20

06

Q4

20

06

Q2

20

05

Q4

20

05

Q2

20

04

Q4

20

04

Q2

20

03

Q4

20

03

Q2

20

02

Q4


Saving

Spending

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

Dec-0

0

Se

p-0

1

Jun

-02

Mar-

03

Dec-0

3

Se

p-0

4

Jun

-05

Mar-

06

De

c-0

6

Se

p-0

7

Jun

-08

Ma

r-09

Dec-0

9

Se

p-1

0

Jun

-11

Ma

r-12

Dec-1

2

Se

p-1

3

Ju

n-1

4

Mar-

15

Dec-1

5


Saving

Spending

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

Dec-0

0

Dec-0

1

Dec-0

2

Dec-0

3

De

c-0

4

Dec-0

5

Dec-0

6

Dec-0

7

Dec-0

8

De

c-0

9

Dec-1

0

Dec-1

1

Dec-1

2

Dec-1

3

Dec-1

4

Dec-1

5


-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

Dec-0

0

Oct-

01

Au

g-0

2

Jun

-03

Apr-

04

Feb-0

5

Dec-0

5

Oct-

06

Au

g-0

7

Jun

-08

Apr-

09

Feb-1

0

Dec-1

0

Oct-

11

Au

g-1

2

Jun

-13

Apr-

14

Feb-1

5


Eurozone Germany France Italy Spain Neth Other

2000 2.4 2.9 2.5 1.4 1.8 2.6 2.5

2005 2.8 3.0 3.1 1.7 2.4 3.1 3.4

2010 3.4 3.1 4.1 2.5 3.4 3.7 3.9

2015 3.0 2.5 3.7 2.4 2.6 3.8 3.2

Eurozone remains

one of the prime

candidates for

‘nationalization of

credit’, however...

...it is not clear

that there is a

political will


15 July 2016 24

3. ‘The agony of China’ – currency vs. debt vs. structural reform

As we have discussed extensively in the past (here, here, here and here), China

is facing a highly complex set of challenges that over the next 12 months could

either result in more sustainable growth or cause global deflationary wave.

The challenge facing China is that it is paying an increasingly heavy price for past

over investment. Depending on estimates that one prefers to use, China’s TFP

growth rates are either close to zero (according to official growth numbers) or

indeed have already turned steeply negative if one utilizes alternative measures

(such as Wu-Maddison estimates). In the absence of productivity growth rates, the

economy can only grow via leveraging, unless of course the leadership accept a

sharply lower growth rates (potentially close to zero).

However, as discussed (here), the challenge facing China (which was not the case

with Japan in 1990s) is that unlike Japan, China has very high levels of income

and wealth inequality, and hence, sharp slowdown could result in much more

robust social dislocation and given lack of strong institutions of state capable of

delivering impersonal services, it could also lead to an accelerated capital flight

(something that was not the case in Japan).

Fig 55 China – TFP Growth Rates (%) – productivity growth might have already gone negative...

Fig 56 China – GDP Growth Rates (%) – nominal GDP is down significantly

Source: TED; Macquarie Research, July 2016 Source: CEIC; Macquarie Research, July 2016

Fig 57 China – Saving & Investment Rate (% GDP) – saving rates remain high, which need to be invested

Fig 58 China – ICOR Rates (x) ...leading to rising incremental-output ratios and...

Source: World Bank; Macquarie Research, July 2016 Source: World Bank; Macquarie Research, July 2016

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

Official Wu-Maddison

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

22.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

12.0%

13.0%

Mar-

10

Jul-1

0

No

v-1

0

Mar-

11

Jul-1

1

Nov-1

1

Ma

r-1

2

Jul-1

2

Nov-1

2

Mar-

13

Ju

l-1

3

Nov-1

3

Mar-

14

Jul-1

4

No

v-1

4

Mar-

15

Jul-1

5

Nov-1

5

Ma

r-1

6

Real GDP Nominal GDP, rhs

20%

25%

30%

35%

40%

45%

50%

55%

19

80

19

82

19

84

19

86

19

88

19

90

19

92

19

94

19

96

19

98

20

00

20

02

20

04

20

06

20

08

20

10

20

12

20

14

Saving Rate Gross Capital Formation

-

1.00

2.00

3.00

4.00

5.00

6.00

7.00

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

China - ICOR Average 1991-2007

China’s agony of

currency, debt,

investment &

structural reform


15 July 2016 25

Fig 59 China – National debt to GDP (%) - ...rising debt levels and its declining efficiency with...

Fig 60 China – Financing Requirement to generate GDP (x) ...$3-4 of debt required for every $ of GDP

Source: World Bank; Macquarie Research, July 2016 Source: CEIC; Macquarie Research, July 2016

Whilst the economy is slowly re-balancing, the pace is glacial and in the absence

of more robust policy changes, it would take decades to complete. There is limited

difference between real retail sales (as a consumption proxy) and real fixed asset

investment; at the same time, whilst services contribution is increasing, the areas

of the greatest growth are the least productive segments (finance and real estate).

Fig 61 China – Household & government Consumption (% GDP) – very slow re-balancing

Fig 62 China – Services are growing but mostly in financial and real estate sub-sectors


As we highlighted recently (refer What caught my eye? v.56 - Capital – Time for

a vegetarian diet? 11 May 2016), China needs to reconsider how and where it

invests its savings. Instead of compounding current over-capacity challenges,

China needs to invest much more in ‘softer areas’ (such as social, education, R&D,

skilling, welfare, medical care, intellectual property rights etc). However, this would

require a major mental shift from regarding government departments as project

managers to becoming stewards of public funds and from mega projects to

multitude of small and less glamorous investments that has capacity to improve

longer-term labour productivity. It seems unlikely that this mental shift would occur

until circumstances change. In other words, it might need to get much worse.

We maintain that ‘canary in the coalmine’ would be corporate profitability and

corporate ROEs (as indeed it was the case in Japan of 1980s-early 1990s).

As highlighted in our previous notes, there are already strong signs of eroding ROEs.

What can be done to alter the current self-destructive course?

We continue to believe that the key lies in the ability of China to undertake deep

domestic (non-capital markets) structural reforms. Whilst China is exceptionally

competitive internationally, it is not very productive domestically. We estimate that

China’s agricultural productivity is less than 10% of the US levels; the productivity of

its utilities sector is not much more than 20% of the US and construction is around

40%. Domestic reforms should aim to lift agricultural productivity, increase mobility of

labour and confront domestic SOE monopolies. Whilst there are a number of

tentative moves at the local level, there has been no evidence over the last three

years, that China is prepared and willing to confront vested interests in the areas of

greatest monopolistic profit (but also areas of the greatest labour hoarding).

0%

50%

100%

150%

200%

250%

300%

350%

2000 2007 2008 2009 2010 2011 2012 2013 2014 2015

Public Sector Non-Financial Corporates Household Financial

-

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

Financing needed for Rmb of GDP Growth

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

25.0%

35.0%

45.0%

55.0%

65.0%

75.0%

1952

1956

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

2004

2008

2012

HH Consumption Government Consumption, rhs

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0M

ar-

08

Au

g-0

8

Jan

-09

Jun

-09

Nov-0

9

Apr-

10

Se

p-1

0

Feb-1

1

Jul-

11

Dec-1

1

May-1

2

Oct-

12

Mar-

13

Au

g-1

3

Jan

-14

Ju

n-1

4

No

v-1

4

Apr-

15

Se

p-1

5

Fe

b-1

6

Wholesale & reatail Accomodation & Catering

Financial Intermediation Other Services

Real Estate

The pace of re-

balancing is

“glacial” whilst...

...domestic

structural reforms

are not progressing


15 July 2016 26

In the absence of any meaningful domestic reforms, the only other alternative

available to China (in order to raise productivity) is to become even more efficient

and competitive externally. However, the challenge is that China is already

approaching a ‘technology frontier’ and hence it becomes harder to continue

climbing the value chain at the same pace as it used to in the previous decade. Also,

unlike Japan in the 1990s, China is unlikely to benefit from accelerating global trade

and growth. Hence it is facing a far more difficult task of attempting to raise share of

a static market. However, this can be only achieved by lower unit labour costs,

either through lower wages or lower currency. Given the choices, we continue to

believe that China is far more likely to depreciate currency, although the pace of

depreciation would critically depend on the domestic liquidity environment and on

the policy options and decisions of other Central Banks (principally the Fed, BoJ and

ECB).

As can be seen below, despite some mild recent depreciation, the Rmb remains in

overvalued territory. If indeed, the BoJ embarks on a much more aggressive course

(i.e. the BoJ funded government and consumption spending) and the Eurozone

decides on a more aggressive course and the Fed tightens, it is almost guaranteed

that the Rmb would fall significantly below 7 (against the US$). As described below,

this would unleash a potentially significant global deflationary wave.

Fig 63 Real Effective Exchange Rates (REER)

Source: BIS; Bloomberg; Macquarie Research, June 2016

China would prefer that all other Central Banks remain stationary and allow China

freedom to slowly and gently depreciate Rmb without causing any significant

domestic or global dislocation whilst providing the country with pressure outlet to

ensure some degree of support. Unfortunately, we do not believe that this is likely

to occur, as both Japan and Eurozone need to embark on a much more

aggressive course whilst the Fed might commit an error of premature tightening.

4. ‘The agony of the Fed’ – will they or won’t they? Can they?

We continue to believe that although the Fed would like to return back to some

form of normality of monetary and economic policies it would be unable to do so.

Hence, although the sell-side continues to insist on expected several tightening

cycles, the buy-side is not buying it. The Fed needs to maintain the narrative of

normalization (otherwise investors would be questioning the ability of corporates to

deliver EPS growth rates), but it is doubtful that it would be able to tighten. Indeed,

even if it does tighten, it is likely that Greenspan’s conundrum would strike again,

with the yield curve continuing to flatten.

60

70

80

90

100

110

120

130

140

150

Jan

-95

Feb

-96

Mar

-97

Ap

r-9

8

May

-99

Jun

-00

Jul-

01

Au

g-0

2

Sep

-03

Oct

-04

No

v-0

5

De

c-0

6

Jan

-08

Feb

-09

Mar

-10

Ap

r-1

1

May

-12

Jun

-13

Jul-

14

Au

g-1

5China Japan Korea Eurozone US

Rmb OvervaluedRmb undervalued

This leaves

currency to do most

of the lifting


15 July 2016 27

In our view, there are three challenges facing the Fed:

The dynamics of the US labour market – deformed

As discussed in our previous notes (here) whether one defines the US

labour market as ‘fissured’ or ‘gig’ economy or attaches some other

description, it is clear that labour market has deformed to an extent that it

is impossible to estimate labour market slack or indeed, the extent to

which labour costs are likely to accelerate, particularly as productivity

rates remain low (whether measured by output per hour or TFP).

As can be seen below, despite an extended recovery (it has been 85

months since the end of recession vs. an historical average since 1947 of

58 months), neither labour participation rates nor proportion of

employment in full time jobs nor wage growth outcomes seem to fit nicely

into the narrative of rapidly diminishing slack, leading to an accelerating

flow into wage outcomes. The same applies to conventional demographic

arguments, with participation rates amongst Baby Boomers and older

rising whilst prime cohorts are stagnating and/or declining.

Fig 64 US – Labour Force Participation (%) Fig 65 US – Labour Participation – Prime Cohort


Fig 66 US – Part-Time Employment/Total (%) Fig 67 US – Low vs High End Jobs (%)


Fig 68 US – Average Hourly Earnings (% YoY) Fig 69 US – Employment Cost Index (% YoY)


54.0

56.0

58.0

60.0

62.0

64.0

66.0

68.0

Jan-4

8

De

c-5

0

Nov-5

3

Oc

t-5

6

Se

p-5

9

Au

g-6

2

Jul-6

5

Jun-6

8

May

-71

Ap

r-7

4

Ma

r-7

7

Feb-8

0

Jan-8

3

Dec-8

5

No

v-8

8

Oc

t-9

1

Se

p-9

4

Au

g-9

7

Jul-0

0

Ju

n-0

3

May

-06

Ap

r-0

9

Mar-

12

Fe

b-1

5

Labour Force Participation rate

86.0

87.0

88.0

89.0

90.0

91.0

92.0

93.0

94.0

95.0

96.0

Ma

r-8

2

Se

p-8

3

Ma

r-8

5

Se

p-8

6

Ma

r-8

8

Se

p-8

9

Ma

r-9

1

Se

p-9

2

Ma

r-9

4

Se

p-9

5

Ma

r-9

7

Se

p-9

8

Ma

r-0

0

Se

p-0

1

Ma

r-0

3

Se

p-0

4

Ma

r-0

6

Se

p-0

7

Ma

r-0

9

Se

p-1

0

Ma

r-1

2

Se

p-1

3

Ma

r-1

5

25-34Y 35-44Y

Males

12.0%

13.0%

14.0%

15.0%

16.0%

17.0%

18.0%

19.0%

20.0%

Ja

n-6

8

Fe

b-7

0

Ma

r-7

2

Ap

r-7

4

May

-76

Ju

n-7

8

Ju

l-8

0

Au

g-8

2

Se

p-8

4

Oc

t-8

6

No

v-8

8

De

c-9

0

Ja

n-9

3

Fe

b-9

5

Ma

r-9

7

Ap

r-9

9

May

-01

Ju

n-0

3

Ju

l-0

5

Au

g-0

7

Se

p-0

9

Oc

t-1

1

No

v-1

3

De

c-1

5

Part-Time/Total Employment

Expansionary phases

43.0%

43.5%

44.0%

44.5%

45.0%

45.5%

36.0%

37.0%

38.0%

39.0%

40.0%

41.0%

42.0%

43.0%

Ja

n-9

0

Ma

y-9

1

Se

p-9

2

Ja

n-9

4

Ma

y-9

5

Se

p-9

6

Ja

n-9

8

Ma

y-9

9

Se

p-0

0

Ja

n-0

2

May

-03

Se

p-0

4

Ja

n-0

6

Ma

y-0

7

Se

p-0

8

Ja

n-1

0

Ma

y-1

1

Se

p-1

2

Ja

n-1

4

Ma

y-1

5

Lowest Paid Occupations (% of Private)

Highest Paid Occupations (% of Private), rhs

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

Jan-0

0

Oct-

00

Jul-

01

Apr-

02

Jan-0

3

Oct-

03

Ju

l-04

Apr-

05

Ja

n-0

6

Oct-

06

Jul-

07

Apr-

08

Jan-0

9

Oct-

09

Jul-

10

Apr-

11

Ja

n-1

2

Oct-

12

Ju

l-13

Apr-

14

Jan-1

5

Oct-

15

Private Sector

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

Mar-

02

De

c-0

2

Se

p-0

3

Jun-0

4

Ma

r-0

5

Dec-0

5

Se

p-0

6

Ju

n-0

7

Mar-

08

Dec-0

8

Se

p-0

9

Jun-1

0

Mar-

11

De

c-1

1

Se

p-1

2

Jun-1

3

Ma

r-1

4

Dec-1

4

Se

p-1

5

Private Cost Private Wages

Fed’s agony is

centred on

deformed labour

markets...


15 July 2016 28

Fig 70 US – Productivity per Hour (%) Fig 71 US – TFP Growth rates (%)

Source: CEIC; Macquarie Research, July 2016 Source: SF Fed; Macquarie Research, July 2016

It seems to us that a structural shift in labour market towards lower

productivity occupations and increasing fracturing of professions and

occupations (an integral part of our ‘declining returns on humans’

thesis) implies that labour inputs are neither as valuable nor as required

as in previous decades. At the same time, given a higher than average

degree of uncertainty (imbedded in a ‘gig’ or ‘fissured’ economy), it is far

from clear to us that personal saving rates would decline. A lower return

on money (as a consequence of overcapacity and monetary activism)

implies the need for much higher rather than lower savings.

Inflationary climate remains benign – on almost any measure

Whether one examines CPI, core CPI, PPI or core PPI or the broadest

measures of inflation (deflators) or indeed inflation break-even rates

(TIPS), there is no evidence of any significant build-up of inflationary

pressures. Indeed, the same applies even if we examine 5Y/5Y (i.e.

inflation expectation in five years’ time).

Fig 72 US – GDP deflator (%) Fig 73 US – PCE (%)


Fig 74 US – CPI (% YoY) Fig 75 US – Core CPI (% YoY)


0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

1901

-10

1911

-20

1921

-30

1931

-40

1941

-49

1950

-54

1955

-59

1960

-64

1965

-69

1970

-74

1975

-79

1980

-84

1985

-89

1990

-94

1995

-99

2000

-04

2005

-09

2010

-15

Productivity Average (1970-2015) Average (1901-70)

Illusion?

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1950

-1955

1956

-1960

1961

-1965

1966

-1970

1971

-1975

1976

-1980

1981

-1985

1986

-1990

1991

-1995

1996

-2000

2001

-2005

2006

-2010

2011

-2015

TFP Growth Rates (%) Average 1950-1980

Average (1980-2015)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Mar-

00

Dec-0

0

Sep-0

1

Jun-0

2

Mar-

03

Dec-0

3

Sep-0

4

Jun-0

5

Mar-

06

Dec-0

6

Sep-0

7

Jun-0

8

Mar-

09

Dec-0

9

Sep-1

0

Jun-1

1

Mar-

12

Dec-1

2

Sep-1

3

Jun-1

4

Mar-

15

Dec-1

5

GDP Deflator Average (1950-2014)

Average (1990-2014)

1.2%

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Ma

r-00

Dec

-00

Se

p-0

1

Ju

n-0

2

Mar-

03

Dec

-03

Se

p-0

4

Jun

-05

Ma

r-06

Dec

-06

Se

p-0

7

Jun

-08

Mar-

09

De

c-0

9

Se

p-1

0

Jun

-11

Mar-

12

Dec

-12

Se

p-1

3

Jun

-14

Mar-

15

De

c-1

5

PCE (YoY %) Average (1950-2014)

Average (1990-2014)

1.0%

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Ja

n-0

0

Oct-

00

Jul-0

1

Apr-

02

Jan-0

3

Oct-

03

Jul-0

4

Apr-

05

Jan-0

6

Oct-

06

Ju

l-0

7

Apr-

08

Jan-0

9

Oct-

09

Jul-1

0

Apr-

11

Jan-1

2

Oct-

12

Ju

l-1

3

Apr-

14

Jan-1

5

Oct-

15

CPI (YoY %) Average (1960-2015)

Average (1990-2015)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Ja

n-0

0

Oc

t-0

0

Jul-0

1

Ap

r-0

2

Jan-0

3

Oc

t-0

3

Ju

l-0

4

Ap

r-0

5

Jan-0

6

Oc

t-0

6

Jul-0

7

Ap

r-0

8

Ja

n-0

9

Oc

t-0

9

Jul-1

0

Ap

r-1

1

Jan-1

2

Oc

t-1

2

Jul-1

3

Ap

r-1

4

Jan-1

5

Oc

t-1

5

Core CPI (YoY %) Average (1960-2015)

Average (1990-2015)

...lack of inflationary

pressures and...


15 July 2016 29

Fig 76 US – PPI & Core PPI (%) Fig 77 US – Inflation Break-Even Rates (5Y & 3Y)


Nominal GDP has de-rated with limited capability for re-acceleration

The US economy has undergone over the last decade a significant de-

acceleration, with nominal GDP growth rates slowing from the run rate of

~5%-6% per annum towards 3%-3.5%.

Whilst it is by far the best performance amongst major economies (due to

a lower pre-existing debt burden as well as a much more aggressive

combination of fiscal and monetary response post GFC), it nevertheless is

not sufficiently robust to widen US current account deficit and inject

sufficient demand and US$ into global economy. There does not appear

anything right now that would suggest probability of sustained

acceleration of growth rates, with excessive debt burden and limited (if

any) productivity gains, leaving the US economy range bound.

We would also argue that it is highly unlikely that non-residential fixed

asset investment is likely to increase due to: (a) significant structural shifts

that are altering the importance of both infrastructure and human inputs;

and (b) an aggressive public sector stance which reduces private sector

visibility, both in terms of demand and supply but perhaps more

importantly price of money. We maintain that it is far more rational to

engage in financial engineering (such as dividends and share buy-backs)

and/or support margins through the creation of monopolies and

oligopolies (i.e. M&A) rather than committing resources to uncertain fixed

asset projects.

Fig 78 US – Nominal GDP (% YoY) Fig 79 US – Real Final Sales (4QMMA %)


0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Apr-

11

Ju

l-11

Oct-

11

Ja

n-1

2

Apr-

12

Ju

l-12

Oct-

12

Jan-1

3

Apr-

13

Jul-

13

Oct-

13

Jan-1

4

Apr-

14

Jul-

14

Oct-

14

Jan-1

5

Apr-

15

Jul-

15

Oct-

15

Jan-1

6

Apr-

16

PPI Final Demand PPI Final Demand ex Food & Energy, rhs

0.5

0.7

0.9

1.1

1.3

1.5

1.7

1.9

2.1

2.3

2.5

Ja

n-1

3

Mar-

13

Ma

y-1

3

Jul-

13

Se

p-1

3

Nov

-13

Jan-1

4

Mar-

14

May-1

4

Jul-

14

Se

p-1

4

Nov

-14

Jan-1

5

Mar-

15

May-1

5

Jul-

15

Se

p-1

5

No

v-1

5

Jan-1

6

Mar-

16

May-1

6

Ju

l-16

USGGBE05 USGGBE03

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

Mar-

85

Jul-8

6

Nov-8

7

Mar-

89

Jul-9

0

Nov-9

1

Mar-

93

Jul-9

4

Nov-9

5

Mar-

97

Jul-9

8

No

v-9

9

Mar-

01

Jul-0

2

No

v-0

3

Mar-

05

Jul-0

6

No

v-0

7

Mar-

09

Jul-1

0

No

v-1

1

Mar-

13

Jul-1

4

No

v-1

5

Nominal GDP (% YoY) Average (1980-2014)

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

Mar-

60

Au

g-6

2

Jan-6

5

Jun-6

7

Nov-6

9

Ap

r-7

2

Se

p-7

4

Feb-7

7

Jul-7

9

Dec-8

1

May

-84

Oc

t-8

6

Mar-

89

Au

g-9

1

Jan-9

4

Jun-9

6

Nov-9

8

Ap

r-0

1

Se

p-0

3

Feb-0

6

Jul-0

8

De

c-1

0

Ma

y-1

3

Oc

t-1

5

Real Final sales 4QMMA Average (1960-2013)

...low productivity

and constrained

nominal GDP and

inability to stimulate

investment or...


15 July 2016 30

Fig 80 US – Real Household Income (Median) Fig 81 US – Gini Income Inequality Index


Fig 82 US – Residential vs. Non-residential Investment(Real % YoY)

Fig 83 US – Gross capital Formation (% GDP)

Source: CEIC; Macquarie Research, July 2016 Source: BEA; Macquarie Research, July 2016

Fig 84 US – NF Corporates Dividends & Share buy backs (US$ bn)

Fig 85 US – Current Account (US$ bn)

Source: Fed; Macquarie Research, July 2016 Source: CEIC; Macquarie Research, July 2016

On balance, it is not clear to us that there is a strong case to be made for tightening

in the domestic context, other than arguing that keeping rates artificially low for an

extended period invites anomalies that could jeopardize domestic financial and

asset markets. However, that argument has been the case for at least a decade

(if indeed arguably since 1990s). Neither politics nor society seems to be prepared

to accept sharply slower growth rates commensurate with low productivity.

If the Fed tightens, it is likely that apart from the negative impact via equities and

earnings expectations (and it needs to be remembered that equity and equity-

linked securities are the second largest HH asset class and there is a strong

correlation between net assets to disposal income on the one hand and personal

savings on the other), rising US$ could also prompt more robust depreciation of

Rmb and hence increase the pace of the US wholesale price deflation.

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

35,000

40,000

45,000

50,000

55,000

60,000

69 72 75 78 81 84 87 90 93 96 99 02 05 08 11 14

Median Household Income (Real) 3Y MMA

0.340

0.360

0.380

0.400

0.420

0.440

0.460

0.480

0.500

19

67

19

69

19

71

19

73

19

75

19

77

19

79

19

81

19

83

19

85

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

20

03

20

05

20

07

20

09

20

11

20

13

-30

-25

-20

-15

-10

-5

0

5

10

15

20

Mar-

00

Dec-0

0

Se

p-0

1

Jun-0

2

Mar-

03

Dec-0

3

Se

p-0

4

Jun-0

5

Mar-

06

Dec-0

6

Se

p-0

7

Jun-0

8

Mar-

09

De

c-0

9

Se

p-1

0

Jun-1

1

Mar-

12

De

c-1

2

Se

p-1

3

Jun-1

4

Mar-

15

De

c-1

5

Non-Residential Residential

15.0%

17.5%

20.0%

22.5%

25.0%

27.5%

19

50

19

53

19

56

19

59

19

62

19

65

19

68

19

71

19

74

19

77

19

80

19

83

19

86

19

89

19

92

19

95

19

98

20

01

20

04

20

07

20

10

20

13

20

16

National Gross Capital Formation/GDP

Average (1950-1990)

Average (1990-2013)

0

200

400

600

800

1,000

1,200

19

52

Q1

19

54

Q2

19

56

Q3

19

58

Q4

19

61

Q1

19

63

Q2

19

65

Q3

19

67

Q4

19

70

Q1

19

72

Q2

19

74

Q3

19

76

Q4

19

79

Q1

19

81

Q2

19

83

Q3

19

85

Q4

19

88

Q1

19

90

Q2

19

92

Q3

19

94

Q4

19

97

Q1

19

99

Q2

20

01

Q3

20

03

Q4

20

06

Q1

20

08

Q2

20

10

Q3

20

12

Q4

20

15

Q1

Net dividends & Share Buy backs

-6.0

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

-900.0

-800.0

-700.0

-600.0

-500.0

-400.0

-300.0

-200.0

-100.0

0.0

100.0

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

CA (US$ bn) % GDP, rhs

...sufficient demand

and US$ into global

economy


15 July 2016 31

Fig 86 US – HH Net Assets/Disposable Income vs. Personal Saving Rates

Fig 87 US – China Import Prices (%)

Source: Fed; Macquarie Research, July 2016 Source: CEIC; Macquarie Research, July 2016

5. ‘De-globalization & Populism agony’ – brand new world is dawning

As discussed in our prior notes (refer What caught my eye? v.44 - Barbarians at

the gate, 5 August 2015), we believe that investors are increasingly residing in a

world characterized by de-globalization (reversal of the key trend over the previous

three decades).

The key drivers of this reversal are a combination of:

Declining global productivity trends, due in part to the impact of ‘Third

Industrial Revolution’ and also by unintended consequences of the public

sector fight against strong deflationary pressures and avoidance of

closure of excess capacity. As cost of capital has been kept artificially low,

it discourages rationalization of excess capacity whilst encouraging

unproductive malinvestment.

Rising global, regional and local income and wealth inequalities.

The trend has been decades in the making and in our view was driven by

a similar toxic mix of declining productivity and aggressive public sector

(predominantly monetary) response. One could also argue (as Marxists

do) that rising inequalities is just part and parcel of capital system

evolution that ultimately gets reset either in revolution or destruction of

military conflicts (here). Marxists’ argument works through businesses

and owners of capital capturing institutions of state (such as regulators).

Declining returns on humans, and hence the ‘agony’ of countries that

happened to have surplus of human power. In other words, the mix of the

above factors implies that demographic dividends are turning into

demographic curses, and hence, social and geopolitical tensions; waves

of immigrants and the prospect of some of the largest movements of

people in search of non-existent jobs.

The most obvious political and societal answer is not just proactive fiscal and

monetary policies (to reduce the level of pain) but also deglobalization to protect

interests of local residents and citizens. Although most of the ‘global elites’ would

attempt to stop it, it is unlikely that they would succeed, as we expect the public

would continue to cry out for help and politics would respond (as indeed it is

already occurring now from the US elections to Brexit to France, Austria etc).

Ultimately this would lead to even less growth and trade but would also change

investment styles. As referred to the above, we believe this would be the time for

‘Follow the governments’ portfolios, including investment in least efficient

and most protected domestic companies and stocks.

Whilst we believe that this trend is both inevitable and irreversible, the question

from an investors’ perspective is one of timing. Has it already arrived? Our answer

not yet but it is just a matter of time, and the next six to twelve months should be

critical in charting this course.

0

5

10

15

400

450

500

550

600

650

700

19

53

Q3

19

56

Q3

19

59

Q3

19

62

Q3

19

65

Q3

19

68

Q3

19

71

Q3

19

74

Q3

19

77

Q3

19

80

Q3

19

83

Q3

19

86

Q3

19

89

Q3

19

92

Q3

19

95

Q3

19

98

Q3

20

01

Q3

20

04

Q3

20

07

Q3

20

10

Q3

20

13

Q3

Net Worth/Disposable IncomeNet Worth/Disposable Income (average)Personal Saving rate, rhs

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

-10%

-5%

0%

5%

10%

15%

Dec-0

4

Jul-05

Feb

-06

Sep

-06

Ap

r-07

No

v-0

7

Jun-0

8

Jan-0

9

Aug

-09

Mar-

10

Oct-

10

May-1

1

Dec-1

1

Jul-12

Feb

-13

Sep

-13

Ap

r-14

No

v-1

4

Jun-1

5

Jan-1

6

RMB/$ y/y chg (lhs) US Import prices f rom China y/y ($)

Fifth, agony for

investors is de-

globalization and

populism and how

to reflect it in

portfolios


15 July 2016 32

The world of no earnings & high multiples As discussed in our latest ‘Rights, Wrongs & Returns’ quarterly review in April 2016 (here),

investors are now residing in the world of no growth, no trade, the tail end of more

conventional monetary and buy-back policies and no EPS. As investors progress into the

world completely dominated by the state (refer Pendulum is swinging towards the state)

the dynamics would change (though ultimately not for the better, as it would be public rather

than private sector multiplying demand). In the meantime, we do not believe that there will

be any meaningful EPS growth rates anywhere globally.

No EPS growth in 2015-16; but analytical bias creeps into 2017

As can be seen below, investor expectations for 2015 SPX earnings (in late 2014) were for

EPS of ~US$130/share (up 12%). At the end of the day, 2015 earnings ended up almost flat

on 2014. At the same time in late 2014, investors and analysts were expecting 2016 EPS of

~US$145/share. This dropped to US$125/share in late 2015 and now investors expect

another year of no EPS growth (even ex commodities expectation is not much more than

3%-4%). The cycle however is starting all over again for 2017. In early 2015, expectation for

SPX EPS was ~150/share. It is by now down to US$133/share (i.e. broadly the same level

that investors initially expected for 2015 reporting season). Whether one includes or excludes

commodities, this would represent a double-digit (10%-12%) gain. One also needs to

remember that the above outlined EPS estimates are already after accounting for various

accounting adjustments and the benefit of share buy-backs. According to BEA, the aggregate

corporate level of profitability has been already declining for some time.

Fig 88 SPX – Earnings Estimates (US$/Share) – no growth in 2015 or 2016

Fig 89 SPX EPS & revenue Growth Rates (%)

Source: Thomson; Macquarie Research, July 2016 Source: Thomson; Macquarie Research, July 2016

Fig 90 SPX ex Resources – EPS & revenue growth Fig 91 US – Corporate Sector Profitability (% YoY)

Source: Thomson; Macquarie Research, July 2016 Source: BEA; Macquarie Research, July 2016

Not surprisingly, a similar trend of consistent over estimation of earnings, followed by late

revisions and then once again by downward drift only to have another round of analytical

bias, with acceleration into the following year, is evident on other key regions. Whilst we

believe it would be sad if it was not funny, it does reflect the fundamental nature of equities

when compared to other key asset classes. Whereas fixed income or currency analysts are

quite happy to move either forward or backward, equities generally do not work, unless there

is growth with contained inflation. Hence, the inevitable bias towards growth.

105

110

115

120

125

130

135

140

145

150

155

Feb

-14

Ap

r-1

4

Jun

-14

Au

g-1

4

Oct

-14

De

c-1

4

Feb

-15

Ap

r-1

5

Jun

-15

Au

g-1

5

Oct

-15

De

c-1

5

Feb

-16

Ap

r-1

6

Jun

-16

2015 2016 2017

-5.0

0.0

5.0

10.0

15.0

20.0

2011 2012 2013 2014 2015P 2016E 2017E

EPS Gr Y/y Rev Gr Y/y

Hope never dies

0.0

2.0

4.0

6.0

8.0

10.0

12.0

2013 2014 2015P 2016E 2017E

EPS Gr Y/y Rev Gr Y/y

Hope never dies

-4%

-2%

0%

2%

4%

6%

8%

2014 2015 2016

Pre-Tax

The world of no

earnings...

...anywhere,

including the US


15 July 2016 33

Fig 92 Eurozone – EPS (LC) – No growth in 2016 Fig 93 MSCI China – EPS (LC) – No growth in 2016


Fig 94 MSCI Asia Ex – EPS (US$) – No growth in 2016 Fig 95 Topix – EPS (LC) – still looking for G in Japan


If we focus on Asia ex Japan and its individual components, the picture that emerges is one of

no growth in either 2015 or 2016, whether one includes or excludes commodities and materials.

As highlighted in our recent Microstrategy review (refer MicroStrategy - Beyond Brexit,

back to Asian fundamentals; where to from here? 29 June 2016), we remain concerned

that expectations for 2016 in India and Indonesia remain on the high side, but we are

comfortable with current estimates in China, Taiwan and Korea. However, as we progress

into 2017, analytical bias once again re-asserts itself, and there is almost nowhere to hide

from excessive estimates. We view forecasts in India, Indonesia and Thailand as being

particularly suspect.

Fig 96 MSCI Asia ex Japan – Earnings Estimates (% Growth)

Source: IBES; Thomson; Macquarie Research, June 2016

However, equities clearly move as an interaction between earnings and valuation multiples.

10

11

12

13

14

15

16

17

18

19

Feb

-14

Ap

r-1

4

Jun

-14

Au

g-1

4

Oct

-14

De

c-1

4

Feb

-15

Ap

r-1

5

Jun

-15

Au

g-1

5

Oct

-15

De

c-1

5

Feb

-16

Ap

r-1

6

Jun

-16

2015 2016 2017

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

8.0

Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16

2015 2016 2017

35

40

45

50

55

60

65

70

Feb

-14

Ap

r-1

4

Jun

-14

Au

g-1

4

Oct

-14

De

c-1

4

Feb

-15

Ap

r-1

5

Jun

-15

Au

g-1

5

Oct

-15

De

c-1

5

Feb

-16

Ap

r-1

6

Jun

-16

2015 2016 2017

80

85

90

95

100

105

110

115

120

125

130

Jan

-15

Feb

-15

Mar

-15

Ap

r-1

5

May

-15

Jun

-15

Jul-

15

Au

g-1

5

Sep

-15

Oct

-15

No

v-1

5

De

c-1

5

Jan

-16

Feb

-16

Mar

-16

Ap

r-1

6

May

-16

Jun

-16

2015 2016 2017

Country 2015 2016E 2017E 2015 2016E 2017E

Asia ex Japan 0.2% 2.0% 11.5% 0.1% 1.2% 10.4%

China -3.2% 1.2% 14.8% 4.0% 3.2% 11.6%

India 3.7% 13.2% 18.2% 6.3% 15.3% 17.0%

Indonesia -8.2% 8.2% 13.4% -5.7% 8.4% 14.3%

Korea 16.4% 3.5% 8.7% 15.1% -2.4% 9.1%

Malaysia -1.3% -0.2% 8.4% -2.0% 0.8% 8.1%

Philippines 5.8% 7.4% 9.9% 5.9% 7.2% 9.9%

Singapore -3.8% -1.8% 4.9% -3.8% -1.9% 5.0%

Taiwan 0.0% -4.3% 10.0% -0.4% -5.1% 10.4%

Thailand -1.4% 7.5% 13.6% -5.3% 0.4% 15.3%

Headline MSCI/IBES Ex Energy and Materials


15 July 2016 34

Valuation Multiples; extended to a breaking point in the US; better elsewhere but no bargains

Whilst we firmly believe that in the current distorted world, most valuation methodologies have

largely lost their meaning, nevertheless, sometimes an irrational view becomes reality

simply because investors feel compelled to look for patterns, rather than accept that

there are pretty much no patterns left.

If we look at the US, equities seem to be fully valued on almost any conventional valuation

measure. As frequent readers of our publications know, our favourite measures are CAPE

(Shiller inflation adjusted long-term multiples), Tobin Q (consistent measure of asset value,

akin to Price to Book) and market capitalization to GDP. As can be seen from the tables

below, all three measures signal over valuation (potentially as large as 20%-50%).

In the case of CAPE, the market is currently trading at ~27x vs historic average (1950-2106)

of ~19x and even longer average (1881-2016) of ~16x. Indeed only in 1929-30 and 2000

(Dot.Com) were CAPE multiples higher than they are today. If we examine Tobin Q, the

latest estimate (1Q2016) is currently trading at almost 1x vs. historic average of 0.7x and

academic consensus that the appropriate Tobin Q valuation is somewhere between 0.6x-0.7x.

Tobin Q is now trading at the highest level, apart from 2000 Dot.Com. The same answer is

derived when we examine another broad measure that looks at market capitalization to GDP

(currently ~160% vs. historic average of ~90%), again one of the highest levels ever.

Indeed, the only measure that signals only a moderate overvaluation is the market’s preferred

single point forward PER, which at just under 17x forward earnings is only around 1 standard

deviation above the mean.

Fig 97 US – CAPE (x) – the highest level apart from 1929 and 2000

Fig 98 Tobin Q (x) – the highest level apart from 2000

Source: Shiller; Macquarie Research, July 2016 Source: Fed; Macquarie Research, July 2016

Fig 99 US – Market Capitalization to GDP – one of the highest levels ever (%)

Fig 100 US – Forward PER (x) – almost one standard deviation above 30 year mean

Source: Fed; CEIC; Macquarie Research, July 2016 Source: Thomson; Macquarie Research, July 2016

Whilst investors are used to rolling into the next bullish forecast, if SPX cannot deliver

(at least 5%-7%) EPS growth, the market looks incredibly vulnerable. This allows us to come

to the point that we have made earlier regarding inability of the Fed to tighten, as any

interest rate dislocation and greater US$ headwind, could easily (and quickly) result in

double-digit value decline.

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

18

81

.01

18

85

.11

89

0.0

7

18

95

.04

19

00

.01

19

04

.1

19

09

.07

19

14

.04

19

19

.01

19

23

.11

92

8.0

7

19

33

.04

19

38

.01

19

42

.11

94

7.0

7

19

52

.04

19

57

.01

19

61

.1

19

66

.07

19

71

.04

19

76

.01

19

80

.11

98

5.0

7

19

90

.04

19

95

.01

19

99

.12

00

4.0

72

00

9.0

4

20

14

.01

Cyclicaly Adjusted PER Average (1881-2016)

Average (1950-2016)

-

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

19

51

Q4

19

53

Q4

19

55

Q4

19

57

Q4

19

59

Q4

19

61

Q4

19

63

Q4

19

65

Q4

19

67

Q4

19

69

Q4

19

71

Q4

19

73

Q4

19

75

Q4

19

77

Q4

19

79

Q4

19

81

Q4

19

83

Q4

19

85

Q4

19

87

Q4

19

89

Q4

19

91

Q4

19

93

Q4

19

95

Q4

19

97

Q4

19

99

Q4

20

01

Q4

20

03

Q4

20

05

Q4

20

07

Q4

20

09

Q4

20

11

Q4

20

13

Q4

20

15

Q4

Tobin Q

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

19

51

Q4

19

53

Q4

19

55

Q4

19

57

Q4

19

59

Q4

19

61

Q4

19

63

Q4

19

65

Q4

19

67

Q4

19

69

Q4

19

71

Q4

19

73

Q4

19

75

Q4

19

77

Q4

19

79

Q4

19

81

Q4

19

83

Q4

19

85

Q4

19

87

Q4

19

89

Q4

19

91

Q4

19

93

Q4

19

95

Q4

19

97

Q4

19

99

Q4

20

01

Q4

20

03

Q4

20

05

Q4

20

07

Q4

20

09

Q4

20

11

Q4

20

13

Q4

20

15

Q4

Market Cap (including financials) / GDP

Market Cap to GDP (avg 1950-2016)

5.0

10.0

15.0

20.0

25.0

Jan

-85

Sep

-86

May

-88

Jan

-90

Sep

-91

May

-93

Jan

-95

Sep

-96

May

-98

Jan

-00

Sep

-01

May

-03

Jan

-05

Sep

-06

May

-08

Jan

-10

Sep

-11

May

-13

Jan

-15

US S&P500 - 12M fw PER

Mean + 1sd

Mean

Mean - 1sd

US valuation

multiples are at a

breaking point...


15 July 2016 35

Whilst it is not possible to have the same rigorous longer-term framework for non-US markets,

nevertheless, over the shorter-term horizon we can also construct CAPE for several

developed markets. In the case of Japan, we estimate that current CAPE is ~19x vs. the

historic average (1982-2016) of ~40x. However, even if we ignore valuation extremes of late

1980s, the average is ~25x, implying that generally at the current levels, CAPE looks not

unreasonable. Eurozone’s CAPE is currently only ~12x whilst UK CAPE is ~13x, again on the

lower side.

Point in time forward PERs also ‘paint’ a very similar picture. In the case of Japan, the market

is currently trading at ~14x forward earnings (below historic averages, even if we ignore

massive past peaks) whilst Eurozone equities are trading at ~13.5x forward earnings, broadly

in line with historic norms.

Fig 101 Japan – CAPE (x) Fig 102 Eurozone - CAPE (x)


Fig 103 MSCI Japan – Forward PER (x) Fig 104 Eurozone – Forward PER (x)


What about Asia ex Japan and most importantly China?

Asia ex Japan equities are now trading at ~12x forward earnings, which is broadly in line

with historic averages. If one excludes Financials, the average valuation multiple indicates a

broadly neutral valuation. China’s equities are currently trading at ~11x forward earnings.

Whilst it is clearly much higher than depressed multiples of closer to 8x-9x earnings earlier in

the year, so long as China does not yet encounter a credit crisis and so long as Rmb

devaluation proceeds at relatively controlled pace, valuations do not signal distress, which if

combined with relatively modest earnings expectations into 2016, makes us reasonably

comfortable maintaining a small overweight position.

5

15

25

35

45

55

65

75

85

95

De

c-8

2

Au

g-8

4

Ap

r-8

6

De

c-8

7

Au

g-8

9

Ap

r-9

1

De

c-9

2

Au

g-9

4

Ap

r-9

6

De

c-9

7

Au

g-9

9

Ap

r-0

1

De

c-0

2

Au

g-0

4

Ap

r-0

6

De

c-0

7

Au

g-0

9

Ap

r-1

1

De

c-1

2

Au

g-1

4

Ap

r-1

6

Japan - CAPE

5

10

15

20

25

30

35

De

c-8

2

De

c-8

4

De

c-8

6

De

c-8

8

De

c-9

0

De

c-9

2

De

c-9

4

De

c-9

6

De

c-9

8

De

c-0

0

De

c-0

2

De

c-0

4

De

c-0

6

De

c-0

8

De

c-1

0

De

c-1

2

De

c-1

4

Eurozone - CAPE

5.0

15.0

25.0

35.0

45.0

55.0

65.0

75.0

85.0

De

c-8

7

Jul-

89

Feb

-91

Sep

-92

Ap

r-9

4

No

v-9

5

Jun

-97

Jan

-99

Au

g-0

0

Mar

-02

Oct

-03

May

-05

De

c-0

6

Jul-

08

Feb

-10

Sep

-11

Ap

r-1

3

No

v-1

4

Jun

-16

MSCI Japan - 12M fw PER

Mean + 1sd

Mean

Mean - 1sd

5.0

10.0

15.0

20.0

25.0

30.0

Jan

-87

Au

g-8

8

Mar

-90

Oct

-91

May

-93

De

c-9

4

Jul-

96

Feb

-98

Sep

-99

Ap

r-0

1

No

v-0

2

Jun

-04

Jan

-06

Au

g-0

7

Mar

-09

Oct

-10

May

-12

De

c-1

3

Jul-

15

Eurozone - 12M fw PER

Mean + 1sd

Mean

Mean - 1sd

...somewhat more

reasonable in

Japan, Eurozone

and Asia ex


15 July 2016 36

Fig 105 MSCI Asia ex Japan – Forward PER (x) Fig 106 MSCI China – Forward PER (x)


In Asia ex Japan, we continue to be concerned that valuations in India (17x), Indonesia (15x)

and the Philippines (19x) could be highly vulnerable to a pullback, if investors’ trust in longer-

term earnings power of these markets is misplaced.

Whilst we are comfortable that both macro and structural environment will remain relatively

benign for India and the Philippines, we are concerned that investors underestimate risks in

Indonesia. Particularly, if there is a much more robust shift in currency exchange rates. As

described above, our base case scenario assumes a steady appreciation of US$ and steady

depreciation of Yen and Rmb. This should continue to place pressure on terms of trade

countries (such as Indonesia and Malaysia) without causing massive dislocation.

However, if policy errors are made (however inadvertently), and suddenly there is much more

robust cross-currency volatility, the impact on Indonesia could be significant.

What is our macro call on country/region selection?

As described above, we maintain that FX is one of the few markets in the world which has

large volumes and which is relatively free and suffers from much a lower degree of direct

state interference (say unlike Bond market) or sentiment (unlike say equities). Accordingly we

view FX as a ‘canary in a coalmine’. We also believe that FX markets fix the world’s most

important price (i.e. US$).

Our selection of countries and markets are therefore primarily driven by views of strength and

direction of US$ and response by other currencies. We have traditionally identified three

possible outcomes (here and here):

1. US$ depreciates and Yen appreciates. This is the ‘goldilocks’ outcome for EM

equities and in particular markets that are commodity driven and suffer from

shortage of capital (such as Brazil, South Africa, Indonesia etc). In this scenario

EM would significantly outperform DMs;

2. US appreciates but steadily and Yen appreciates but also steadily, implying slow-

burn Rmb depreciation. In that scenario EMs should perform in line with DMs but

terms of trade and commodity-driven EM markets are likely to underperform;

3. US$ appreciates rapidly, Yen collapses, forcing an accelerated Rmb depreciation.

In this outcome EM equities are likely to severely underperform DM equities and

terms of trade markets (like Indonesia) would suffer from a potentially massive

decline.

As discussed above, we are very much somewhere between scenario (2) and (3) and hence

over the next 6-12 months we expect EMs to either perform broadly in line or slightly

underperform DMs and within EMs we avoid terms of trade countries and instead focus on

markets with ample domestic liquidity and countries that are mostly consumers rather than

producers of commodities. We are also prepared to pay a premium for shorter-term economic

strength. This continues to tilt us towards India and the Philippines, and to a lesser extent

Taiwan and China.

As far as DMs are concerned, we continue to like Japan, particularly as we expect this to be

the first market to attempt a fully integrated fiscal, income support and monetary policies. As

the first mover, Japan could secure at least temporary advantage. We also similarly remain

concerned that US equities are vulnerable.

7.0

9.0

11.0

13.0

15.0

17.0

19.0

May

-01

Mar

-02

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-03

No

v-0

3

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May

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15

May

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MSCI Asia x JP -12M fw PER

Mean + 1sd

Mean (since'06)

Mean - 1sd

5.0

10.0

15.0

20.0

25.0

May

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Mar

-02

Jan

-03

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v-0

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China - 12M fw PER

Mean + 1sd

Mean (since'06)

Mean - 1sd

Our macro calls

revolve around

currencies


15 July 2016 37

Investment Strategy: Quality Growth and Thematics As discussed above, we maintain that investors are essentially residing in a 3non-mean

reversionary world, without any conventional business or capital market cycles.

Under these circumstances, ‘Less is More’ is traditionally the best advice and emphasis on

the ability of corporates to deliver higher than average ROEs, on the back of strong market

positioning and branding, whilst avoiding an undue reliance on revenue growth rates or

leverage, is the key to sustainable (quality) growth. Also, strong secular trends of ‘declining

returns on humans’ (imbedded in the Third Industrial Revolution) provides, in our view,

powerful long-term Thematic opportunities. As highlighted above, there is a possibility that

investors would also embrace alternative strategies, focused on trying to capture changes in

government spending and longer-term trend towards de-globalization.

Portfolios – Still about Quality-Growth and Thematic investing…

In this review, we have made only minor changes to our flagship long only ‘Quality & Stability’

portfolios for Asia ex Japan as well as Global Quality portfolios. Our ‘Sustainable Dividends’,

‘Thematics’ and ‘Anti-Quality’ portfolios from Apr’16 are unchanged. We usually conduct a full

thorough rebalancing at the end of the year.

Our core selection criteria continue to follow the same broad framework in terms of key

financial metrics that we prefer our stocks to exhibit (refer below). Whilst the underlying

stocks have been identified on the basis of widely available fundamentals (reported and

consensus forecasts), we avoid the temptation of following a formulaic black-box approach.

In that sense, we continue to make some exceptions where we find companies are just ‘on

the margin’ of meeting our strict conditions but the core idea is to identify a broad list of

companies that meet all or most of our key conditions.

Summarised below are model portfolios for Asia ex Japan as well as Global investors.

1. Quality/Sustainable Growth: Our ‘Quality/Stability’ model portfolios continue to

emphasise high quality companies that have high ROEs (mostly driven by margins

instead of leverage or revenue); relatively low leverage, positive free cash flow

generation trends. We ignore financials (deflationary/stagflationary environment

should not be supportive of financials). Our core conditions to identify such

companies remain broadly the same as used previously. Key screening criteria:

a. Stocks that delivered and are expected to deliver positive revenue and profit

growth rates most of the years during 2014-2017E.

b. Stocks that are expected to deliver positive recurring profit CAGR growth of

at least 5% over the next 2 years i.e. 2015-2017E. Whilst we look for growth,

this is one of the conditions where we are much more relaxed and we made

several exceptions.

c. Stocks that have a high level of ROE (at least an average of 12% over 2014-

2017E), which we believe should in most cases be able to cover costs of capital.

At the same time, we avoid companies that have or are expected to have

declining ROEs going forward.

d. Average EBITDA margins of 5% over 2014-2017E but at the same time there

is a general trend of rising EBITDA margins during this period, as a measure

of margin sustainability and an attempt to avoid stocks in which ROE

improvements are delivered purely from rising revenues or increasing leverage.

e. We avoid companies with a Net Debt/EBITDA ratio of more than 2x and

rising overall leverage. That said, we are willing to make exceptions as long as

companies do not exhibit a rising leverage trend.

f. We continue to emphasise Free cash flow (FCF) generation and therefore

avoid companies with negative FCF.

g. We exclude Financials completely from the screen, as financials don’t tend to

perform well in either a deflationary or stagflationary climate.

We continue to

recommend non-

mean reversionary

strategies...

...particularly

“Quality Sustainable”

growth and...


15 July 2016 38

h. In our Asia ex portfolios, we place a liquidity filter on market cap greater than

US$2bn (vs. US$5bn in our Global portfolio) to ensure sufficient liquidity basis.

i. There are no explicit valuation criteria although in some extreme cases we

have excluded companies where current PEs seemed extremely high or

extremely low.

j. Lastly, where the shortlisted stocks are also covered by Macquarie fundamental

analysts, we have excluded companies where our analysts have an

‘Underperform’ rating.

Key changes to Asia ex Japan Quality/Stability portfolio: Our current Asia ex JP

‘Quality/Stability’ portfolio continues to have 20 stocks. We have added Amorepacific (Korea)

by removing Nexteer. Macquarie Analysts rate 16 of these stocks as ‘Outperform’ and one

stock as Neutral on a 12-month view. Three stocks in our model portfolio are currently not

rated by Macquarie.

The overall Asia Quality Sustainable Growth portfolio trades at forward PE of ~20x (vs post

2010 average of ~18x and current forward PER, excluding Financials of ~16x-17x) with

simple average ROE of ~24%; 2- year earnings CAGR of ~17% and Negative Net

Debt/EBITDA (i.e net cash). Refer stock composition below.

In terms of performance, our flagship Asia ‘Quality/Stability’ portfolio continues to do well with

year to date outperformance (over MXASJ, US$, Total returns basis) of 4%. Our model

portfolio has delivered an outperformance of over 28% since inception (March-2013).

In our Global ‘Quality & Stability’ portfolio, we now have 40 stocks (vs 42 earlier). We

have added three stocks: Alphabet, NVIDIA and Illumina; whilst we have removed 5 stocks

(ITV Plc, Toyota Motor, AbbVie, Danone and Telenor).

The overall Global Quality list trades at similar (as Asia) forward PE of ~20x (vs post 2010

average of ~18.5x) with simple average ROE of ~26%; 2-year earnings CAGR of ~11% and

Negative Net Debt/EBITDA (i.e net cash). Refer stock composition below.

In terms of performance, whilst it is early days, our Global Quality portfolio is broadly flat YTD

and it is up by ~100bps since re-balancing in April 2016.

Fig 107 Macquarie –Asia ex ‘Quality’ portfolio performance relative to MSCI Asia ex (since inception March 2013 until July 2016)

Fig 108 Macquarie –Asia ex ‘Quality’ portfolio performance relative to MSCI Asia ex (since April-16 rebalancing until July 2016)

Source: Bloomberg, Macquarie Research, July 2016: Note – Equal weighted portfolio; Returns are dollar returns including dividends; Excludes transaction costs; Past performance is not a guarantee of future performance; Until close of 11-July 2016

Source: Bloomberg, Macquarie Research, July 2016: Note – Equal weighted portfolio; Returns are dollar returns including dividends; Excludes transaction costs; Past performance is not a guarantee of future performance; Until close of 11-July 2016

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Jul-

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ASXJ "Quality and Stability" portfolio (rel to MSCI ASXJ, $ TR basis)

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Excess returns "Quality/Stability" returns MXASJ $

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Fig 109 Macquarie –Asia ex JP ‘Quality’ stock list (July-2016 edition)

Source: FactSet, Macquarie Research, July 2016; Fundamental data based on FactSet consensus estimates including covered stocks; Priced as of close of 14-July 2016

Ticker Company Name GICS L3 Name Reco. Analyst Name CountryMarket Cap

(US$M)

Target price

(Listing crncy)

Upside /

Downside

(%)

ROE ('16E)

Net debt /

EBITDA

('16E)

EBITDA

mgns

('16E)

Earnings

CAGR '15-

17

3M, perf

(LC), %

PER-12m

fw

PER-Avg

12M fw

(since'10)

% change

in 12m fw

EPS vs 3M

ago

700 HK Tencent Internet Software & ServicesO/P Wendy Huang HONG KONG 218,305 204.00 12.6 31.1 (1.8) 30.5 29.6 13.1 31.4 27.6 5.1%

2330 TT TSMC Semiconductors & Semiconductor EquipmentO/P Patrick Liao TAIWAN 136,910 180.00 6.8 23.8 (1.2) 33.9 5.6 7.9 13.2 12.6 3.2%

ST SP SingTel Diversified Telecommunication ServicesO/P Prem Jearajasingam SINGAPORE 49,969 4.42 3.8 15.5 2.2 23.3 5.8 16.8 16.6 14.0 0.2%

ITC IN ITC Tobacco O/P Amit Mishra INDIA 44,852 385.00 56.4 31.2 (1.2) 26.9 12.8 15.3 25.6 24.9 2.7%

INFO IN Infosys Limited IT Services N/R N/R INDIA 40,174 N/R N/R 23.8 (2.7) 21.0 12.5 (0.5) 17.4 17.7 2.5%

000333 CH Midea Group (A-Share) Household Durables O/P Terence Chang CHINA 23,890 27.00 (1.3) 26.1 (2.0) 9.5 10.7 35.2 13.4 10.2 -10.7%

035420 KS NAVER Internet Software & ServicesRestrict. Restricted SOUTH KOREA 21,675 950,000.00 25.3 30.5 (2.5) 19.5 37.2 12.7 27.6 23.3 14.6%

090430 KS Amorepacific Personal Products O/P Kwang Cho SOUTH KOREA 21,489 521,000.00 22.3 20.8 (1.5) 13.0 26.0 6.1 31.6 24.4 7.1%

MSIL IN Maruti Suzuki India Automobiles O/P Amit Mishra INDIA 19,216 4,200.00 (2.5) 19.9 (2.2) 8.8 24.3 22.2 20.9 16.4 -0.3%

288 HK WH Group Ltd. (HK) Food Products N/R N/R HONG KONG 11,537 N/R N/R 14.4 2.1 4.0 8.3 6.8 12.3 10.3 6.2%

1044 HK Hengan Personal Products O/P Linda Huang HONG KONG 10,374 76.00 12.2 23.9 (0.7) 17.4 4.8 (2.3) 18.4 22.4 0.2%

GCPL IN Godrej Consumer Products Ltd. Personal Products O/P Amit Mishra INDIA 8,396 1,550.00 (1.8) 24.1 0.8 13.0 17.9 20.4 37.3 27.6 4.1%

EIM IN Eicher Motors Ltd. Machinery O/P Amit Mishra INDIA 7,906 23,360.00 19.7 39.8 (1.5) 9.7 28.5 0.7 29.8 21.4 11.6%

669 HK Techtronic Industries Co., Ltd. Household Durables N/R N/R HONG KONG 7,861 N/R N/R 18.2 0.1 7.6 15.9 11.4 16.8 13.5 4.4%

2313 HK Shenzhou International Textiles Apparel & Luxury GoodsO/P Terence Chang HONG KONG 7,168 44.80 9.1 20.3 (0.1) 19.4 17.3 2.0 16.7 10.7 0.8%

600066 CH Zhengzhou Yutong Bus (A) Machinery O/P Zhixuan Lin CHINA 6,872 28.00 29.9 28.4 (1.8) 11.3 7.7 5.7 11.7 11.2 3.5%

1193 HK China Resources Gas Gas Utilities O/P Candice Chen HONG KONG 6,594 25.00 8.0 17.3 1.5 10.6 10.5 0.4 14.4 17.9 -0.4%

1999 HK Man Wah Household Durables O/P Timothy Lam HONG KONG 3,029 12.30 5.7 29.3 (1.0) 18.3 14.7 16.5 14.6 11.0 13.9%

5347 TT Vanguard Semiconductors & Semiconductor EquipmentNeutral Patrick Liao TAIWAN 2,764 52.50 (4.7) 20.6 (3.5) 22.6 26.4 10.0 15.2 13.2 6.2%

HTHT US China Lodging Group Hotels Restaurants & LeisureO/P Timothy Lam CHINA 2,604 48.80 25.7 16.9 (3.0) 10.0 26.4 5.6 25.2 26.0 9.9%

Simple average 32,579 23.8 (1.0) 16.5 17.1 10.3 20.5 17.8

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40

Fig 110 Macquarie –Global ‘Quality’ stock list (July-2016 edition)

Source: FactSet, Macquarie Research, July 2016; Fundamental data based on FactSet consensus estimates including covered stocks; Priced as of close of 14-July 2016

Ticker Company Name GICS L3 Name Reco. Analyst Name CountryMarket Cap

(US$M)

Target price

(Listing crncy)

Upside /

Downside

(%)

ROE ('16E)

Net debt /

EBITDA

('16E)

EBITDA

mgns

('16E)

Earnings

CAGR '15-

17

3M, perf

(LC), %

PER-12m

fw

PER-Avg

12M fw

(since'10)

% change

in 12m fw

EPS vs 3M

ago

GOOGL US Alphabet Internet Software & ServicesO/P Ben Schachter UNITED STATES 459,151 890.00 22.0 18.0 (2.7) 33.1 17.0 (4.2) 19.9 17.6 1.7%

MSFT US Microsoft Software Neutral Sarah Hindlian UNITED STATES 413,382 51.00 (4.7) 27.6 (2.9) 23.3 1.9 (2.6) 18.4 12.7 -3.0%

JNJ US Johnson & Johnson Pharmaceuticals N/R N/R UNITED STATES 338,137 N/R N/R 25.1 (1.1) 25.4 4.8 12.2 18.0 14.4 2.8%

FB US Facebook Internet Software & ServicesO/P Ben Schachter UNITED STATES 272,508 150.00 28.4 20.9 (2.7) 40.0 46.4 6.6 28.7 40.4 20.3%

700 HK Tencent Internet Software & ServicesO/P Wendy Huang HONG KONG 218,305 204.00 12.6 31.1 (1.8) 30.5 29.6 13.1 31.4 27.6 5.1%

ORCL US Oracle Software O/P Sarah Hindlian UNITED STATES 168,125 48.00 15.8 24.1 (1.2) 30.4 4.0 2.5 14.8 12.7 0.8%

DIS US The Walt Disney Company Media Neutral Tim Nollen UNITED STATES 162,212 95.00 (4.9) 21.3 1.7 17.1 5.6 2.9 16.4 16.2 0.5%

V US Visa Inc. Class A IT Services N/R N/R UNITED STATES 145,755 N/R N/R 22.7 (0.3) 45.9 9.1 (1.3) 24.7 20.3 3.0%

2330 TT TSMC Semiconductors & Semiconductor EquipmentO/P Patrick Liao TAIWAN 136,910 180.00 6.8 23.8 (1.2) 33.9 5.6 7.9 13.2 12.6 3.2%

AMGN US Amgen Inc. Biotechnology N/R N/R UNITED STATES 120,330 N/R N/R 28.3 1.4 37.3 5.4 2.1 13.8 12.9 4.3%

NOVOB DC Novo Nordisk A/S Class B Pharmaceuticals N/R N/R DENMARK 111,387 N/R N/R 77.2 (0.6) 33.9 10.4 2.5 22.8 21.7 2.0%

OR FP L'Oréal Personal Products Neutral Toby McCullagh FRANCE 107,652 172.00 (1.0) 14.9 (0.5) 14.1 8.2 12.3 25.8 21.5 1.6%

MA US MasterCard Class A IT Services N/R N/R UNITED STATES 95,700 N/R N/R 65.1 (0.8) 36.6 6.1 (4.1) 23.4 20.2 4.1%

BAYN GR Bayer AG Pharmaceuticals N/R N/R GERMANY 84,713 N/R N/R 23.2 2.5 12.6 8.2 (9.2) 12.2 13.3 1.9%

MC FP LVMH Textiles Apparel & Luxury GoodsO/P Daniele Gianera FRANCE 77,106 185.00 32.9 15.7 0.7 10.9 10.8 (5.8) 16.7 16.4 0.0%

NKE US NIKE Textiles Apparel & Luxury GoodsO/P Laurent Vasilescu UNITED STATES 75,667 75.00 29.3 33.1 (0.7) 11.7 10.6 (0.8) 23.8 20.9 0.9%

ST SP SingTel Diversified Telecommunication ServicesO/P Prem Jearajasingam SINGAPORE 49,969 4.42 3.8 15.5 2.2 23.3 5.8 16.8 16.6 14.0 0.2%

ADP US Automatic Data Processing IT Services N/R N/R UNITED STATES 43,340 N/R N/R 29.6 (1.6) 12.9 9.3 5.2 25.6 21.3 3.0%

AIR FP Airbus Group SE Aerospace & Defense N/R N/R NETHERLANDS 42,846 N/R N/R 37.3 (3.0) 3.7 7.9 (6.9) 14.1 15.7 0.3%

FDX US FedEx Air Freight & Logistics O/P Kelly Dougherty UNITED STATES 42,172 200.00 24.7 21.7 3.4 6.1 8.1 (3.1) 13.2 14.6 1.5%

INFO IN Infosys Limited IT Services N/R N/R INDIA 40,174 N/R N/R 23.8 (2.7) 21.0 12.5 (0.5) 17.4 17.7 2.5%

CON GR Continental AG Auto Components N/R N/R GERMANY 38,541 N/R N/R 21.6 1.0 7.4 8.3 (4.0) 11.3 10.9 1.2%

4503 JP Astellas Pharma Inc. Pharmaceuticals N/R N/R JAPAN 34,171 N/R N/R 15.5 (2.4) 14.9 4.2 15.9 17.4 17.6 -1.2%

ADS GR adidas Textiles Apparel & Luxury GoodsO/P Andreas Inderst GERMANY 30,008 140.00 6.7 15.0 0.7 4.7 18.5 27.0 27.6 17.0 11.2%

4452 JP Kao Corp. Personal Products N/R N/R JAPAN 28,968 N/R N/R 17.4 (1.4) 8.1 14.0 6.4 23.0 21.8 3.6%

WPP LN WPP Media O/P Tim Nollen UNITED KINGDOM 27,949 18.50 9.9 17.1 2.4 10.7 8.8 1.9 15.1 12.9 3.9%

NVDA US NVIDIA Semiconductors & Semiconductor EquipmentO/P Deepon Nag UNITED STATES 27,779 45.00 (14.7) 24.2 (3.5) 20.1 7.5 47.3 33.4 18.8 10.4%

6981 JP Murata Mfg Electronic Equipment Instruments & ComponentsO/P George Chang JAPAN 24,082 15,000.00 22.4 13.8 (2.2) 14.8 (1.5) (12.9) 14.4 18.9 -13.2%

EA US Electronic Arts Software O/P Ben Schachter UNITED STATES 23,860 80.00 3.1 30.9 (3.6) 23.1 12.7 26.3 21.4 19.2 4.8%

ILMN US Illumina, Inc. Life Sciences Tools & ServicesN/R N/R UNITED STATES 20,555 N/R N/R 24.2 (1.6) 20.2 9.7 (13.1) 40.3 43.2 -2.9%

MSIL IN Maruti Suzuki India Automobiles O/P Amit Mishra INDIA 19,216 4,200.00 (2.5) 19.9 (2.2) 8.8 24.3 22.2 20.9 16.4 -0.3%

HO FP Thales SA Aerospace & Defense N/R N/R FRANCE 17,950 N/R N/R 18.1 (2.3) 6.0 10.3 1.7 17.2 11.8 3.9%

COLOB DC Coloplast A/S Class B Health Care Equipment & SuppliesN/R N/R DENMARK 15,304 N/R N/R 72.3 (0.5) 25.1 13.6 6.8 27.1 22.4 1.0%

CAP FP Cap Gemini SA IT Services N/R N/R FRANCE 14,552 N/R N/R 12.5 1.3 7.0 22.5 (3.5) 14.5 14.2 1.6%

7741 JP HOYA Health Care Equipment & SuppliesO/P Damian Thong JAPAN 14,337 4,385.00 16.0 13.7 (4.1) 14.1 (4.8) (9.5) 17.8 16.7 -13.2%

8035 JP Tokyo Electron Semiconductors & Semiconductor EquipmentO/P Damian Thong JAPAN 14,120 9,700.00 11.1 14.2 (2.8) 12.1 2.3 24.8 16.3 22.7 11.2%

IPG US Interpublic Group Media O/P Tim Nollen UNITED STATES 9,662 26.00 7.6 25.8 0.8 6.8 8.0 5.7 17.2 16.0 2.9%

EIM IN Eicher Motors Ltd. Machinery O/P Amit Mishra INDIA 7,906 23,360.00 19.7 39.8 (1.5) 9.7 28.5 0.7 29.8 21.4 11.6%

669 HK Techtronic Industries Co., Ltd. Household Durables N/R N/R HONG KONG 7,861 N/R N/R 18.2 0.1 7.6 15.9 11.4 16.8 13.5 4.4%

2313 HK Shenzhou International Textiles Apparel & Luxury GoodsO/P Terence Chang HONG KONG 7,168 44.80 9.1 20.3 (0.1) 19.4 17.3 2.0 16.7 10.7 0.8%

Simple average 89,738 25.9 (0.8) 18.6 11.2 5.1 20.2 18.3 2.5%


15 July 2016 41

2. ‘Thematics’ – We continue to recommend Thematics as a powerful investment

strategy that should be able to exploit some of the above discussed long-term

structural shifts. Whilst in the past Thematics focused on a range of topics that

emphasized longer-term convergence (such as middle class creation, emerging

markets, etc.), we believe that the new themes are far more likely to thrive on

growing economic divergence rather than convergence. It is likely to emphasize

stagnant productivity; lack of global trade recovery and shrinkage of supply and value

chains; increasing the trend towards de-globalization and emphasis on protection of

domestic markets.

Arguably, most of these new trends are driven by the above described structural

shifts associated with a complex interaction of the Third Industrial Revolution and

self-inflicted wound of over leveraging and over capacity, with an overlay of multi-

decade transfer of wealth and returns to owners of capital. For a much more detailed

discussion on Thematics as an investment strategy refer What caught my eye? v.59 -

In praise of Thematics, 7 June 2016.

Our basic investment rationale is that most positive investment themes over the last

three decades are likely to weaken considerably. Instead, themes that will come to

the fore will be far more constraints-based (or negative). The idea of this portfolio is

to maximize the power of constraints rather than opportunities.

We run a Global as well as Asia ex Japan Thematics portfolio with most of the

themes overlapping between the two. Note that these portfolios tend to be long-

term portfolios where we disregard valuations and quality criteria completely, with the

central thesis that these stocks should be driven by genuine themes as opposed to

changes in Global Central Bank policies. The list is based either on a poll of our on-

the-ground fundamental analysts, or based on our judgement of the largest and most

well known stocks that are likely to be beneficiaries of respective themes.

Our long-term Asia ex JP ‘Thematics’ portfolio has managed to outperform MSCI

Asia ex Japan US$ index by 3% since inception in Oct-2014 despite having no

quality or valuation filter. YTD thematic portfolio has underperformed ASXJ by 5%.

As far as Global Thematics portfolio is concerned, whilst it is just over a month

since launch (June 2016), the portfolio has managed to stay above MSCI AC World

Index (US$, TR basis) and is up by 150bps.

Fig 111 Macquarie – Asia ex Japan ‘Thematics’ portfolio performance relative to MSCI Asia ex JP (since inception Oct-2014 until July 2016)

Fig 112 Macquarie – Global ‘Thematics’ portfolio performance relative to MSCI AC World (June-2016 until July 2016)

Source: Bloomberg, Macquarie Research, July 2016: Note – Equal weighted portfolio; Returns are dollar returns including dividends; Excludes transaction costs; Past performance is not a guarantee of future performance; Until close of 11 July 2016

Source: Bloomberg, Macquarie Research, July 2016: Note – Equal weighted portfolio; Returns are dollar returns including dividends; Excludes transaction costs; Past performance is not a guarantee of future performance; Until close of 11 July 2016

Summarised on next page are our current Asia ex Japan and Global Thematic

portfolios (last rebalanced in April-2016) with no changes in this review.

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Jun

-16

Asia ex "Thematics" portfolio (rel to MSCI ASXJ, $ TR basis)

-6.0

-4.5

-3.0

-1.5

0.0

1.5

-8

-6

-4

-2

0

2

7-J

un

-16

9-J

un

-16

11

-Ju

n-1

6

13

-Ju

n-1

6

15

-Ju

n-1

6

17

-Ju

n-1

6

19

-Ju

n-1

6

21

-Ju

n-1

6

23

-Ju

n-1

6

25

-Ju

n-1

6

27

-Ju

n-1

6

29

-Ju

n-1

6

1-J

ul-

16

3-J

ul-

16

5-J

ul-

16

7-J

ul-

16

9-J

ul-

16

11

-Ju

l-1

6

Excess returns (RHS) "Global Thematics" returns MXWD $

...uncorrelated

Thematics


15 July 2016 42

Fig 113 Macquarie – Asia ex Japan ‘Thematics’ portfolio (April 2016 edition)

Source: Macquarie Research, July 2016

Fig 114 Macquarie – Global ‘Thematics’ portfolio (June 2016 edition)

Source: Macquarie Research, July 2016


Security, Prisons and Bullets Robots, Industrial, Automation and Technology

2357 HK AviChina China 300124 CH Shenzhen Inovance China

002415 CH Hikvision China HOLI US HollySys Automation Tech. China

2634 TT Aerospace Industrial Development Taiwan 002241 CH GoerTek China

047810 KS Korea Aerospace Industries Korea 2049 TT Hiwin Technologies Taiwan

079550 KS LIG NEX1 Korea 2308 TT Delta Electronics Taiwan

STE SP ST Engineering Singapore 1590 TT AirTAC Taiwan

Educational & Training services Shifts in manufacturing migration/competitiveness

EDU US New Oriental Education & Tech. China 2333 HK Great Wall Motor Company China

XRS US TAL Education Group China 600066 CH Zhengzhou Yutong Bus (A-Share) China

NORD US Nord Anglia Education China 600031 CH Sany Heavy Industry China

Environmental Constraint 425 HK Minth Group China

2208 HK Xinjiang Goldwind China 2382 HK Sunny Optical China

2688 HK ENN Energy China 1766 HK CRRC Corp Ltd China

3800 HK GCL-Poly Energy China 2313 HK Shenzhou International China

257 HK China Everbright International China 1476 TT Eclat Textile Taiwan

1193 HK China Resources Gas China 600741 CH Huayu Automative China

958 HK Huaneng Renewables China 3606 HK Fuyao Glass China

SIIC SP SIIC Environment Singapore Demographics

EDC PM Energy Development Philippines 2628 HK China Life Insurance China

MWC PM Manila Water Philippines 300015 CH Aier Eye Hospital Group Co. Ltd. China

Entertainment Services GE SP Great Eastern Holdings Ltd Singapore

1970 HK IMAX China China RFMD SP Raffles Medical Group Singapore

002739 CH Wanda Cinema China BDMS TB Bangkok Dusit Medical Services Thailand

700 HK Tencent China BH TB Bumrungrad Hospital Thailand

NTES US Netease.com China IHH MK IHH Healthcare Bhd Malaysia

GENM MK Genting Malaysia Malaysia KPJ MK KPJ Healthcare Malaysia

079160 KS CJ CGV Korea FORH IN Fortis Healthcare India


Theme 1: "Replacing Humans": Robots, Industrial Automation & AI Theme 4: "Bullets and Prisons": Defense, Security, Prisons/Correction Centres

ABBN VX ABB Ltd. Switzerland 047810 KS Korea Aerospace Industries, Ltd. South Korea

300024 CH SIASUN Robot & Automation A China 002415 CH Hangzhou Hikvision Digital A China

6506 JP Yaskawa Electric Corp. Japan LMT US Lockheed Martin Corporation United States

ISRG US Intuitive Surgical, Inc. United States RTN US Raytheon Company United States

SIE GR Siemens AG Germany NOC US Northrop Grumman Corporation United States

HON US Honeywell International United States HO FP Thales SA France

6503 JP Mitsubishi Electric Corp. Japan ESLT IT Elbit Systems Ltd Israel

6645 JP OMRON Corporation Japan CXW US Corrections Corporation of America United States

300124 CH Shenzhen Inovance Tech. A China GEO US GEO Group Inc United States

1590 TT AirTAC Taiwan Theme 5: "Education & Skilling"

NVDA US NVIDIA Corporation United States PSON LN Pearson PLC United Kingdom

MLNX US Mellanox Technologies, Ltd. Israel JW/A US John Wiley & Sons, Inc. Class A United States

Theme 2: "Augmenting Humans": Genome/Biotechnology/DNA sequencing EDU US New Oriental Education & Tech. Sp ADR China

AMGN US Amgen Inc. United States XRS US TAL Education Unspons. ADR Class A China

BIIB US Biogen Inc. United States NORD US Nord Anglia Education, Inc. Hong Kong

ABBV US AbbVie, Inc. United States WKL NA Wolters Kluwer NV Netherlands

ILMN US Illumina, Inc. United States Theme 6: "Demographics": Funeral Parlours and Psychiatric Centres

Theme 3: "Opium of the people": Games, Casinos/Virtual Reality 1448 HK Fu Shou Yuan International Group Ltd. China

700 HK Tencent Holdings Ltd. China SCI US Service Corporation International United States

ATVI US Activision Blizzard, Inc. United States UHS US Universal Health Services, Inc. Class B United States

EA US Electronic Arts Inc. United States ACHC US Acadia Healthcare Company, Inc. United States

NTES US NetEase, Inc. Sponsored ADR China Theme 7: "Disruptors & Facilitators"

7974 JP Nintendo Co., Ltd. Japan AMZN US Amazon.com, Inc. United States

LVS US Las Vegas Sands Corp. United States TSLA US Tesla Motors, Inc. United States

1928 HK Sands China Ltd. Macau FB US Facebook, Inc. Class A United States

002241 CH GoerTek Inc. Class A China CRM US salesforce.com, inc. United States

NFLX US Netflix, Inc. United States

GOOGL US Alphabet Inc. Class A United States


15 July 2016 43

3. ‘Sustainable Yields’: For investors looking for Yield ideas, our ‘Sustainable

Dividends’ model portfolios for Global and Asia ex Japan are the ideal vehicles to

take exposure of ‘lower for longer’ interest rate thematic.

Our yields portfolios are designed to be true income-yielding portfolios with the

underlying assumption of ‘low for longer’ interest rates globally and therefore a

continued chase for yields. However, the key differentiation in our yield portfolios (vs

conventional quant-driven screens) is additional overlay of quality and sustainability

of dividends growth. In other words, we attempt to avoid ‘yield traps’ and identify

companies that have a history of paying dividends and the ability to sustain them

given stronger than average fundamentals.

Summarised below are April-2016 editions of our ‘Sustainable Yields’ portfolio where

we have made no changes in this review. We look to do a thorough review of

these portfolios at the end of the year.

Fig 115 Macquarie – Asia ex JP ‘Sustainable Dividends’ stocks (last stock review – April 2016)

Fig 116 Macquarie – Global ‘Sustainable Dividends’ stocks (last stock review – April 2016)

Source: Macquarie Research, July 2016; For details refer ‘Rights, Wrongs & Returns - 2016 – Year of Living dangerously - sequel’, 13 April 2016


4. ‘Anti-Quality’ portfolio: For the brave investors who are willing to chase the low

quality rally, we also run a screen of what we call ‘Anti-Quality’ stocks in Asia ex

Japan. This is in essence a reverse of our ‘Quality Portfolios’ and highlights stocks

with high leverage, negative cash flow trends and low ROEs.

As highlighted above, a scenario where the global economy moves into ‘socialist

paradise’ with CBs and governments accelerating monetary and fiscal policies to

stimulate growth, it is quite likely that investors might gravitate towards ‘low quality’

stocks, in our view. As discussed above, we believe that the investors’ acceptance of

new macro strategies should become a general investor consensus call. For details,

including key screening criteria, refer Rights, Wrongs & Returns - Year of Living

dangerously – sequel, 13 April 2016.

As far as the ‘Anti Quality’ Portfolio is concerned, we have seen some retracement in

performance recently (in line with the return to the ‘Quality’ trade) after a brief period

when it significantly outperformed during the ‘trash rally’ of Feb-May 2016. Since

inception (Sep-2015), the portfolio is down ~2% against benchmark (see chart below).

Code Company Name Country

600104 CH SAIC Motor (A-Share) China

2333 HK Great Wall Motor Company China

5347 TT Vanguard Taiwan

600741 CH Huayu Automotive (A-Share) China

ST SP SingTel Singapore

600066 CH Zhengzhou Yutong Bus (A-Share) China

GLO PM Globe Telecom Philippines

000333 CH Midea Group (A-Share) China

2020 HK Anta Sports China

2317 TT Hon Hai Precision Taiwan

DELTA TB Delta Electronics (Thailand) Public Co.Thailand

1999 HK Man Wah China

2330 TT TSMC Taiwan

TLKM IJ PT Telkom Indonesia

T MK Telekom Malaysia Malaysia

1216 TT Uni-President Enterprises Taiwan

1044 HK Hengan China

021240 KS Coway Korea

Ticker Company Name Country Ticker Company Name Country

NXT LN Next plc UK ABBV US AbbVie, Inc. US

BKG LN Berkeley Group Holdings UK 7202 JP Isuzu Motors JP

TEL NO Telenor ASA NO MO US Altria Group, Inc. US

2333 HK Great Wall Motor HK KNEBV FH Kone Oyj FIN

TW/ LN Taylor Wimpey plc UK 2330 TT TSMC TW

DAI GR Daimler AG GE ROG VX Roche Holding Ltd Genusssch. SWZ

ST SP SingTel SP 9201 JP Japan Airlines Co. JP

BMW GR Bayerische Motoren Werke GE PAYX US Paychex, Inc. US

2020 HK ANTA Sports Products HK DRI US Darden Restaurants, Inc. US

2317 TT Hon Hai Precision TW ELUXB SS Electrolux AB Class B SWD

SKAB SS Skanska AB SWD WPP LN WPP Plc UK

7270 JP Fuji Heavy Industries JP ULVR LN Unilever PLC UK

7203 JP Toyota Motor Corp. JP GIVN VX Givaudan SA SWZ

RAND NA Randstad Holding NV NL UPS US United Parcel Service, Inc. US

SIE GR Siemens AG GE TGT US Target Corporation US

EZJ LN easyJet plc UK JNJ US Johnson & Johnson US

SAN FP Sanofi FR PUB FP Publicis Groupe SA FR

There soon could be

time for “Anti

quality” or “Follow

the Government”

portfolios


15 July 2016 44

Fig 117 Macquarie – Asia ex ‘Anti-Quality’ strategy performance relative to MSCI Asia ex JP (since inception from Sep-15 until July 2016)

Fig 118 Macquarie – Asia ex Japan ‘Anti-Quality’ list (last stock review April-2016)

Source: Bloomberg, Macquarie Research, July 2016: Note – Equal weighted portfolios; Returns are dollar returns including dividends; Excludes transaction costs; Past performance is not a guarantee of future performance; Priced at close of 11-July 2016


85

87

89

91

93

95

97

99

101

103

105

Sep

-15

Oct

-15

Oct

-15

No

v-1

5

De

c-1

5

De

c-1

5

Jan

-16

Feb

-16

Mar

-16

Mar

-16

Ap

r-1

6

May

-16

May

-16

Jun

-16

Jul-

16

"Anti Quality" portfolio (rel to MSCI ASXJ, $ TR basis)

Code Company Name Country

1211 HK BYD Company Class H Hong Kong

1898 HK China Coal Energy Class H Hong Kong

2039 HK China Int. Marine Containers H Hong Kong

TATA IN Tata Steel Limited India

078930 KS GS Holdings Corp. South Korea

JSTL IN JSW Steel Limited India

69 HK Shangri-La Asia Limited Hong Kong

139480 KS E-Mart, Inc. South Korea

OLAM SP Olam International Limited Singapore

363 HK Shanghai Industrial Holdings Hong Kong

RCOM IN Reliance Communications India

ADANI IN Adani Power Limited India

1833 HK Intime Retail (Group) Co. Ltd. Hong Kong

MRT SP Smrt Corporation Ltd Singapore

001740 KS SK Networks Co., Ltd. South Korea

2603 TT Evergreen Marine Corp. (Taiwan) Ltd.Taiwan

1208 HK MMG Ltd. Hong Kong

BAB MK Bumi Armada Bhd. Malaysia


15 July 2016 45

Appendices

Fig 119 Index performance, (Local currency, unless stated otherwise), %

Note : Priced as of close of 12 July 2016 Source: MSCI, Thomson, Macquarie Research, July 2016

Fig 120 Index performance by MSCI countries and sectors (local currency) – Last three months, %

Note : Priced as of close of 12 July 2016 Source: MSCI, Thomson, Macquarie Research, July 2016

MSCI Indices - 1W - 1M - 3M - 1Y - 3Y - 5Y YTD Index

MSCI AC Asia ex JP (LC) 0.2 1.3 2.5 -7.6 3.9 -1.2 1.0 629

ASXJ Consumer Discretionary -0.1 0.6 -1.9 -5.5 -17.3 -22.7 -3.9 407

ASXJ Consumer Staples -1.0 1.5 5.7 3.5 15.3 28.1 7.5 512

ASXJ Energy -1.2 -0.8 2.0 -10.1 -22.1 -40.7 9.1 529

ASXJ Financials -0.1 0.5 2.4 -15.4 0.2 -3.5 -4.3 277

ASXJ Health Care 2.1 5.1 2.5 -1.6 44.6 82.9 -1.7 965

ASXJ Industrials -0.1 -1.0 -4.0 -19.1 -6.3 -26.9 -6.7 147

ASXJ Information Technology 1.0 3.5 6.7 3.7 30.3 47.3 7.9 342

ASXJ Materials 0.4 0.6 -1.6 -1.7 -1.6 -35.2 7.0 295

ASXJ Utilities -0.9 -1.7 -1.6 -2.8 6.0 23.8 1.1 222

ASXJ Telecom Svcs 0.4 2.6 5.5 -4.9 2.9 19.8 5.6 143

MSCI AC ASIA EX JP U$ 0.1 1.7 2.2 -9.1 -1.2 -11.0 2.2 511

MSCI CHINA U$ 0.0 1.3 0.0 -18.4 1.1 -15.0 -5.6 56

MSCI HONG KONG U$ -0.6 -0.4 0.9 -10.6 5.4 9.9 -1.2 9,334

MSCI INDIA U$ 1.4 3.5 7.7 -5.1 19.9 -6.5 3.3 475

MSCI INDONESIA U$ 2.8 8.2 6.6 8.4 -13.0 -20.8 16.9 763

MSCI KOREA U$ -0.4 1.2 2.4 0.7 -1.1 -18.1 5.1 374

MSCI MALAYSIA (EM) U$ 0.1 2.8 -6.0 -7.9 -28.5 -25.8 6.0 361

MSCI PHILIPPINES U$ -0.7 2.4 5.9 2.2 16.2 70.0 12.6 598

MSCI SINGAPORE U$ -0.3 2.5 0.7 -13.3 -18.5 -19.5 4.3 3,392

MSCI TAIWAN U$ 0.6 1.2 5.0 -5.4 4.0 -3.5 9.5 291

MSCI THAILAND U$ 0.4 2.7 7.9 -6.3 -15.3 -0.7 20.1 354

MSCI China 0.0 1.3 0.1 -18.3 1.1 -15.3 -5.5 56

MSCI Hong Kong -0.7 -0.5 1.0 -10.5 5.4 9.5 -1.1 13,040

MSCI India 1.3 4.1 8.9 0.6 34.7 41.2 4.9 1,034

MSCI Indonesia 2.5 6.7 6.4 6.7 14.3 21.8 11.1 6,060

MSCI Korea -0.5 -0.4 2.4 2.2 1.1 -11.2 2.8 542

MSCI Malaysia 0.0 0.7 -3.5 -3.1 -9.9 -1.7 -1.5 579

MSCI Philippines 0.3 5.0 8.6 7.2 26.7 87.3 13.1 1,360

MSCI Singapore 0.1 2.0 1.2 -13.4 -13.0 -11.7 -0.7 1,488

MSCI Taiwan 0.6 1.2 4.5 -1.8 12.0 7.7 7.3 328

MSCI Thailand 0.6 2.4 8.1 -3.1 -4.3 15.1 17.3 499

MSCI EMG 0.5 1.8 2.5 -5.5 4.9 -1.0 3.6 46,090

MSCI World (Dev) 1.3 1.4 3.7 -3.7 18.1 40.5 -0.2 1,275

MSCI AC World (All) 1.2 1.5 3.5 -3.9 16.6 35.0 0.1 469

MSCI Japan -0.5 -5.6 -2.0 -22.2 1.8 39.6 -19.6 753

MSCI USA 1.7 2.0 4.8 2.3 27.3 61.2 4.4 2,035

MSCI AC Asiapac x JP ($) 0.3 1.8 3.3 -7.8 -4.3 -12.8 2.5 422

MSCI AC WORLD U$ 0.9 0.9 2.7 -4.4 9.5 19.8 1.4 405

MSCI EM U$ 0.4 2.8 2.8 -9.2 -10.2 -25.9 6.6 847

MSCI WORLD U$ (Dev) 0.9 0.7 2.7 -3.9 12.0 27.5 0.8 1,676

MSCI EM ASIA U$ 0.3 1.9 2.5 -8.6 -0.8 -13.1 2.6 414

MSCI WORLD EX JP ($) 1.1 0.9 2.7 -3.6 13.5 29.4 1.5 1,693

MSCI EUROPE U$ 0.0 -1.8 -3.1 -15.6 -6.2 -4.7 -7.0 1,416

MSCI EMU U$ 0.1 -3.2 -4.9 -16.3 -3.3 -8.5 -8.8 157

MSCI AC Asia ex JP

AC

Asia

ex JP

China HK India Indo Korea Mal Phils Sing TW Thai EMG World

(Dev) Japan

AC

World

MSCI Country Index 2.5 0.1 1.0 8.9 6.4 2.4 -3.5 8.6 1.2 4.5 8.1 2.5 3.7 -2.0 3.5

Cons. Disc -1.9 -5.3 -9.7 17.0 5.8 -5.1 -8.2 8.3 -4.6 -1.7 9.3 0.9 1.1 -3.5 1.1

Staples 5.7 -2.7 4.8 11.9 4.3 7.3 -1.7 -7.6 -7.0 13.3 15.6 4.6 5.9 1.1 5.8

Energy 2.0 7.6 NA -0.0 13.4 -19.0 -13.3 0.0 0.0 -3.9 6.9 1.2 11.4 -5.7 10.2

Financials 2.4 -1.2 5.0 21.4 5.8 -4.7 -4.0 12.3 0.9 1.8 10.1 1.1 0.5 -8.0 0.6

Banks 3.7 2.9 1.1 20.1 4.6 -2.7 -4.1 7.3 1.0 4.8 9.7 3.1 0.2 -5.8 0.8

Real Estate 3.8 -3.8 6.1 NA NA NA 0.4 15.2 0.7 4.8 13.0 1.3 4.4 -7.4 4.2

Health Care 2.5 -0.4 NA 6.6 11.8 0.1 -2.0 NA 0.0 17.2 -4.0 4.1 6.3 0.1 6.2

Industrials -4.0 -6.1 -8.4 9.0 -1.9 -4.2 -3.9 6.2 -5.4 -4.3 5.5 -1.4 3.4 0.5 3.1

IT 6.7 5.5 -9.2 -2.2 NA 14.4 0.0 0.0 0.0 5.9 -20.9 6.8 0.8 -0.2 1.7

Materials -1.6 -1.9 0.0 20.8 -10.8 -11.7 -2.6 0.0 NA -0.8 8.0 1.3 7.9 -1.8 6.9

Utilities -1.6 -11.1 1.7 13.0 -10.1 2.7 -0.8 -0.6 NA NA -3.6 -0.5 6.0 -9.1 5.4

Telecom Services 5.5 0.3 7.2 -3.3 18.4 3.9 -2.0 12.6 15.7 10.7 13.3 2.1 3.9 3.9 3.6


15 July 2016 46

Fig 121 Valuations – Asia ex JP and key comps

Note : Priced as of close of 12 July 2016 Source: MSCI, Thomson, IBES, Macquarie Research, July 2016

Avg since 2010

MSCI Indices PER P/B EPS gr ROE DY PER P/B ROE DY PER P/B PER P/B

MSCI AC Asia ex JP 12.1 1.3 6.7 10.4% 2.9% 12.0 1.6 13.1% 2.9% 11.5 1.5 5% -14%

ASXJ Consumer Discretionary 12.2 1.4 11.6 11.5% 2.3% 11.1 1.8 15.7% 2.4% 11.1 1.8 10% -21%

ASXJ Consumer Staples 21.9 3.0 13.3 13.8% 2.0% 16.2 2.7 15.3% 2.4% 18.9 2.7 16% 11%

ASXJ Energy 13.8 0.9 13.7 6.5% 2.9% 10.0 1.6 14.9% 3.2% 10.3 1.3 34% -34%

ASXJ Financials 8.9 0.9 2.7 9.8% 3.8% 11.9 1.4 11.4% 3.3% 10.3 1.2 -14% -27%

ASXJ Health Care 23.1 3.5 19.3 15.0% 0.9% 18.6 3.2 15.8% 1.1% 21.5 3.2 8% 7%

ASXJ Industrials 12.2 1.0 5.5 8.4% 2.8% 13.1 1.4 10.7% 2.5% 12.6 1.3 -3% -20%

ASXJ Information Technology 14.8 2.0 10.8 13.5% 2.1% 13.2 2.0 15.8% 2.2% 12.0 1.9 23% 6%

ASXJ Materials 13.0 1.0 21.9 7.7% 3.0% 10.3 1.4 13.0% 3.2% 11.7 1.3 11% -22%

ASXJ Utilities 10.4 1.2 -4.3 11.5% 3.6% 12.5 1.4 10.8% 3.3% 13.1 1.4 -21% -15%

ASXJ Telecommunication Services 15.5 1.8 4.5 11.7% 3.8% 13.1 2.0 15.1% 4.1% 13.7 1.9 14% -3%

MSCI China 10.6 1.2 8.1 11.6% 2.7% 11.5 1.8 15.0% 3.0% 9.9 1.5 7% -16%

MSCI Hong Kong 14.1 1.0 3.9 7.2% 3.7% 15.3 1.4 8.8% 3.3% 14.7 1.3 -4% -20%

MSCI India 17.3 2.6 17.0 15.2% 1.7% 14.5 2.6 16.6% 1.6% 15.1 2.4 14% 9%

MSCI Indonesia 15.3 2.5 10.6 16.3% 2.5% 11.4 2.8 22.0% 3.2% 13.7 2.9 11% -15%

MSCI Korea 10.0 0.9 5.9 8.9% 2.0% 9.3 1.2 12.5% 1.7% 9.3 1.1 9% -19%

MSCI Malaysia 15.5 1.6 4.6 10.1% 3.2% 14.3 1.9 13.0% 3.6% 14.7 1.9 5% -18%

MSCI Philippines 19.0 2.5 8.3 13.0% 1.7% 15.0 2.2 14.6% 2.7% 16.8 2.6 13% -4%

MSCI Singapore 11.9 1.0 1.7 8.7% 4.3% 14.0 1.5 10.9% 3.7% 13.2 1.4 -10% -25%

MSCI Taiwan 12.8 1.5 2.8 11.7% 4.3% 14.0 1.7 13.1% 3.9% 13.2 1.7 -3% -11%

MSCI Thailand 14.2 1.8 10.8 12.4% 3.2% 10.9 1.8 16.3% 3.9% 11.8 1.9 20% -6%

MSCI EMG 11.7 1.3 10.3 11.1% 2.9% 10.7 1.6 14.4% 3.3% 10.7 1.4 10% -9%

EMG Consumer Discretionary 13.7 1.7 14.0 12.2% 1.9% 11.1 1.8 15.9% 2.1% 11.6 1.8 19% -9%

EMG Consumer Staples 21.5 3.5 16.2 16.4% 2.3% 16.4 2.9 16.7% 2.6% 19.6 3.2 10% 12%

EMG Energy 9.1 0.7 4.0 7.2% 3.5% 7.7 1.2 13.6% 3.2% 7.4 0.8 23% -23%

EMG Financials 8.2 1.0 4.8 11.8% 4.0% 10.0 1.5 14.4% 3.4% 9.4 1.3 -12% -27%

EMG Health Care 22.0 3.4 19.6 15.5% 1.1% 17.8 3.1 16.3% 1.5% 19.6 3.1 12% 11%

EMG Industrials 13.3 1.2 9.7 9.1% 2.2% 12.0 1.5 12.0% 2.4% 12.9 1.4 2% -16%

EMG Information Technology 14.8 2.0 10.8 13.6% 2.1% 13.1 1.9 15.5% 2.2% 12.0 1.9 23% 5%

EMG Materials 12.7 1.0 80.7 8.1% 2.9% 10.2 1.6 14.9% 3.6% 11.3 1.3 13% -21%

EMG Utilities 9.2 1.0 -0.0 10.5% 4.1% 11.4 1.1 9.1% 3.5% 11.0 1.0 -16% -7%

EMG Telecommunication Services 14.4 1.8 9.9 12.6% 4.0% 12.3 2.2 17.5% 4.2% 12.6 2.0 14% -9%

MSCI World (Dev) 15.5 1.9 8.0 12.3% 2.8% 14.6 1.9 13.6% 2.7% 13.6 1.8 14% 8%

World(Dev) Consumer Discretionary 14.8 2.4 10.2 16.2% 2.3% 16.5 2.0 13.5% 2.0% 14.8 2.2 0% 8%

World(Dev) Consumer Staples 20.5 4.0 8.3 19.5% 2.7% 16.6 3.2 19.2% 2.8% 16.5 3.1 24% 28%

World(Dev) Energy 31.3 1.5 16.0 4.9% 3.8% 13.7 1.8 14.3% 2.8% 14.5 1.5 116% 2%

World(Dev) Financials 11.5 1.0 3.8 8.4% 3.9% 11.9 1.3 10.7% 3.4% 11.5 1.0 0% -7%

World(Dev) Health Care 15.9 3.3 8.6 20.8% 2.1% 15.9 2.9 19.7% 2.3% 14.3 2.8 11% 17%

World(Dev) Industrials 15.3 2.3 13.2 15.0% 2.7% 15.2 2.1 14.5% 2.4% 14.1 2.1 9% 12%

World(Dev) Information Technology 15.8 3.1 9.3 19.7% 1.8% 19.1 2.9 18.2% 1.2% 14.2 2.7 12% 14%

World(Dev) Materials 16.6 1.6 9.8 9.9% 2.6% 13.9 1.8 13.7% 2.4% 13.2 1.7 26% -1%

World(Dev) Utilities 16.5 1.6 -0.7 9.5% 3.8% 14.0 1.6 10.8% 4.2% 14.4 1.4 14% 16%

World(Dev) Telecommunication Services 15.1 2.1 7.7 14.0% 4.2% 19.8 1.8 12.6% 4.6% 13.5 1.8 12% 18%

MSCI AC World (All) 15.0 1.8 8.3 12.1% 2.8% 14.2 1.9 13.7% 2.9% 13.2 1.7 14% 6%

MSCI Japan 12.3 1.0 11.5 8.2% 2.6% 16.8 1.3 8.5% 1.7% 13.6 1.1 -9% -9%

MSCI USA 16.8 2.6 8.3 15.3% 2.3% 15.2 2.3 15.5% 2.1% 14.3 2.2 18% 18%

MSCI Australia 15.4 1.7 6.9 10.8% 4.8% 13.9 2.0 14.4% 4.7% 13.4 1.8 15% -6%

12 Month forward estimates LT Average (12M forward ests) Current vs post-2010 avg


15 July 2016 47

Recent Asia Equity Strategy Research

Investment twilight - Between ignorance & confusion 12 July 2016 Ready for Battle - Macquarie earnings survivors’ guide 6 July 2016 MicroStrategy - Beyond Brexit, back to Asian fundamentals; where to from here? 29 June 2016 Brexit et al - It is all about 2nd derivatives & CBs 24 June 2016 What caught my eye? v.60 - Parallel lives: Japan vs. China 23 June 2016 What caught my eye? v.59 - In praise of Thematics 7 June 2016 What caught my eye? v.58 - Divergence, convergence & confusion 24 May 2016 What caught my eye? v.57 - Portfolios: The case of less is more 17 May 2016 What caught my eye? v.56 - Capital – Time for a vegetarian diet? 11 May 2016 What caught my eye? v.55 - Why are we staying in China & India? 29 April 2016 Ready for Battle - Macquarie earnings survivors’ guide 21 April 2016 Rights, Wrongs & Returns - Year of Living dangerously – sequel 13 April 2016 Central Banks & Markets - Mutually assured destruction 31 March 2016 Global Travel Notes - The blind leading the blind 29 March 2016 MicroStrategy - Earnings season – A letdown so far but there is a silver lining 22 March 2016 What caught my eye? v.54 - Negative rates and the war on savers 2 March 2016 What caught my eye? v.53 - Philippines shelter; CBs calling E.T 23 February 2016 Is it a policy dead-end? - Consistency in an inconsistent world 11 February 2016 What caught my eye? v.52 - Launching global portfolios 4 February 2016 Central Banks - Why insistence on failed policies? 1 February 2016 China’s hard landing - Has it already happened? 27 January 2016 What caught my eye? v.51 - Bulls, Bears and low rates 22 January 2016 What caught my eye? v.50 - The Fed and the need for redemption 11 January 2016 MicroStrategy – Growth it is - Five reasons we prefer Growth over Value 8 January 2016 China choices – narrowing - Between a rock and a hard place 7 January 2016 What caught my eye? v.49 - China’s savings dilemma 4 January 2016 Fed hikes. What now? - Implications for EM equities 17 December 2015 20 YEARS IN ASIA 14 December 2015 Is it Bear Stearns moment? - Year of living dangerously, part II 14 December 2015 Rights, Wrongs & Returns - 2016 - Year of living dangerously 25 November 2015 Policy cross-currents - What would unhinge PBoC? 12 November 2015 Bihar dreaming - On impossibility of reforms 9 November 2015 What caught my eye? v.48- EMs – downside to the upside, 3 November 2015 What caught my eye? v.47- The more they do; the worse it gets, 27 October 2015 What caught my eye? v.46-Equities – irrational exuberance?, 8 October 2015 Time for a policy U-turn? - Back to the future: British Leyland, 18 September 2015 What caught my eye? v.45 - Today is more insidious than 1997, 16 September 2015 Old Friend Deflation is Back - From traders to shareholders, 25 August 2015 EM vs DM Equities - What would the average opinion say?, 20 August 2015 Deflators of the world unite - Impact on the US & Global PPIs, 17 August 2015 China’s dilemma - Between a rock and a hard place, 13 August 2015 Return of deflationary vortex - Commodities – canary in a coalmine?, 10 August 2015 What caught my eye? v.44 - Barbarians at the gate, 5 August 2015 China’s policy response - How different is it to G4 economies?, 20 July 2015 Rights, Wrongs & Returns - 2H–Falling knives & deflating bubbles, 13 July 2015 Are dominos finally falling? - Greece, Puerto Rico, China, 6 July 2015 What caught my eye? v.43 - Why consumer & business reticence?, 29 June 2015 China drama & Greek farce - Are CBs at the end of the road?, 29 June 2015 What caught my eye? v.42 - Resisting China; Asia ex earnings, 17 June 2015 Trade & Cyclicality - Stagnation in both = lower yields, 28 May 2015 What caught my eye? v.41 - China & Global Manufacturing, 27 May 2015 What caught my eye? v.40 - CBs vs deflation: will liquidity win?, 8 May 2015 What caught my eye? v.39 - China & Indonesia: Binary outcomes, 29 April 2015 What caught my eye? v.38 - When size does not matter, 13 April 2015 Rights, Wrongs & Returns - 2Q-3Q’15 - The Hall of Mirrors, 27 March 2015 Global Liquidity Watch - Return of Greenspan’s conundrum?, 10 March 2015 What caught my eye? v.37 - India hope is still intact; travel notes, 5 March 2015 Chasing dividends - No mean reversion = desire for yield, 13 Feb 2015 What caught my eye? v.36 - Secular stagnation & four horsemen, 6 Feb 2015 Global liquidity watch - Liquidity tight but should improve, 27 Jan 2015 What caught my eye? v.35 - Focus on Thailand; CBs’ effectiveness, 26 Jan 2015 What caught my eye? v.34 - Trade & Flow watch; A vs H shares, 8 Jan 2015 Is deflation almost here? - What do DXY & bonds tell us, 6 Jan 2015


15 July 2016 48

Global contagion risks - Commodities: canary in a coal mine?, 17 Dec 2014 China A retail exuberance - Damned if you do and damned if you don’t, 9 Dec 2014 Global Liquidity Watch - Eroded in 3Q’14 & Oct/Nov, 8 Dec 2014 Rights, Wrongs & Returns - 2015 preview: the ‘known unknowns’, 2 Dec 2014 How exposed is Korea? - Yen ‘doomsday machine’, 17 November 2014 What caught my eye? v. 33 - Currency wars & their discontents, 13 November 2014 What caught my eye? v.32 - On social upheavals, schools & robots, 30 October 2014 What caught my eye? v.31 - Is China in a liquidity trap? EM risks, 16 October 2014 What caught my eye? v.30 - EM vulnerabilities; U/W Indonesia, 9 October 2014 What caught my eye? v.29 - China’s city vs global city, 18 September 2014 What caught my eye? v.28 - Unstoppable China; EM equity rally, 9 September 2014 Global Liquidity - Most measures are looking better, 21 August 2014 ASEAN at the crossroads - Complex choices; uncertain outcomes, 18 August 2014 Phils – Fading optimism - ST concerns overshadow LT story, 31 July 2014 What caught my eye? v.27 - Importance of Trust; China’s rerating, 29 July 2014 Trade – Waiting for Godot - Small pick-up but no robust cyclicality, 18 July 2014 Rights, Wrongs & Returns - Higher rates or perhaps no rates, 15 July 2014 What caught my eye? v.26 - Oil, geopolitics & family formation, 3 July 2014 What caught my eye? v.25 - Value - many ways to skin a cat, 23 June 2014 What caught my eye? v.24 - Financial stability & catch 22, 13 June 2014 What caught my eye? v.23 - Reforms: who will & who will not, 30 May 2014 What caught my eye? v.22 - Upgrades and stagflations, 21 May 2014 Coups & Martial laws - Not necessarily a bad choice, 20 May 2014 What caught my eye? v.21 - China tourism; Portfolio update, 12 May 2014 What does FIC market tell equity investors? - All quiet on the Western front, 9 May 2014 What caught my eye? v.20 - Investments & geopolitical risks, 29 April 2014 What caught my eye? v.19 - Liquidity in its various forms, 16 April 2014 Rights, Wrongs & Returns - Policy errors, cyclicality & EM volatility, 28 March 2014 FOMC – Impact on EMs - Higher US$, rates and lower demand, 20 March 2014 Difficult case of Indonesia - Euphoria vs. terms of trade & liquidity, 17 March 2014 What caught my eye? v.18 - Is China unravelling? Not Yet, 11 March 2014 ‘Each unhappy family is unhappy in its own way’ - Ukraine, Thailand, Argentina, et al, 3 March 2014 DM vs. EM push & pull - Beware what you wish for, 26 February 2014 Bond Yields & Equities - The question of foreign demand, 24 February 2014 What caught my eye? v.17 - Is the Philippines for real?, 24 February 2014 What caught my eye? v.16 - Third industrial revolution & its impact, 12 February 2014 What caught my eye? v.15 - Investment Cycles & Funds Flows, 17 January 2014 Liquidity trap vs. Stagflation - China vs India – tough choice, 15 January 2014 What caught my eye? v.14 - Would Indian corporates invest?, 6 January 2014 Tapering is on, so is the put - What is likely to happen to volatilities?, 19 December 2013 Investment Outlook – 2014 - ‘Out with the old and in with the new’ Is it 1998 or 1999 – Buy all

or Sell all?, 11 December 2013 What caught my eye? v.13 - China's savings conundrum & Plenum, 25 November 2013 What caught my eye? V.12- Hardware vs software; China's ‘divide & conquer’ reform agenda?,

6 November 2013 What caught my eye? v.11 - Leading indicators and ‘blind alleys’, 28 October 2013 What caught my eye? v.10 - Corporate leverage – how much of a problem?, 3 October 2013 Asia Strategy - When you rely on asset bubbles, what else do you do?, 19 September 2013 What caught my eye? v.9 - Rmb: How exposed is China?, 18 September 2013 What caught my eye? v.8 - In and out of ‘shadows’, 6 September 2013 What caught my eye? v.7 - If something can not go on forever, it will stop, 22 August 2013 ASEAN 4 – risks & returns - Kaleidoscope of themes, 16 August 2013 What caught my eye? v.6 - China industrial sector – the Good, the Bad and the Ugly, 31 July 2013 Reviewing Tactical Portfolio - Tough choices: damned if you do and damned if you don't in a

slowing world, 10 July 2013 What caught my eye? v.5 - Liquidity – receding tide, 5 July 2013 What caught my eye? v.4 - Central Bank’s ‘chicken run’, 27 June 2013 What caught my eye? v.3 - QEs to eternity whether successful or not, 12 June 2013 What caught my eye? v.2 - Korea - is China or Japan a greater threat?, 29

May 2013

What caught my eye? - Inflation falling everywhere, 22 May 2013 Rights, Wrongs & Returns - Bears and the Investment Clock, 24 April 2013 DXY rises and Yen falls - The pincer movement for EM equities, 8 April 2013 APAC – Competitive Edge - Separating winners from losers, 21

March 2013

Walk on the wild side - Macro threats - what, if and when, 4 March 2013


15 July 2016 49

Important disclosures:

Recommendation definitions

Macquarie - Australia/New Zealand Outperform – return >3% in excess of benchmark return Neutral – return within 3% of benchmark return Underperform – return >3% below benchmark return Benchmark return is determined by long term nominal GDP growth plus 12 month forward market dividend yield

Macquarie – Asia/Europe Outperform – expected return >+10% Neutral – expected return from -10% to +10% Underperform – expected return <-10%

Macquarie – South Africa Outperform – expected return >+10% Neutral – expected return from -10% to +10% Underperform – expected return <-10%

Macquarie - Canada

Outperform – return >5% in excess of benchmark return Neutral – return within 5% of benchmark return Underperform – return >5% below benchmark return

Macquarie - USA Outperform (Buy) – return >5% in excess of Russell 3000 index return Neutral (Hold) – return within 5% of Russell 3000 index return Underperform (Sell)– return >5% below Russell 3000 index return

Volatility index definition*

This is calculated from the volatility of historical price movements. Very high–highest risk – Stock should be

expected to move up or down 60–100% in a year – investors should be aware this stock is highly speculative. High – stock should be expected to move up or down at least 40–60% in a year – investors should be aware this stock could be speculative. Medium – stock should be expected to move up or down at least 30–40% in a year. Low–medium – stock should be expected to move up or down at least 25–30% in a year. Low – stock should be expected to move up or down at least 15–25% in a year. * Applicable to Asia/Australian/NZ/Canada stocks only

Recommendations – 12 months Note: Quant recommendations may differ from Fundamental Analyst recommendations

Financial definitions

All "Adjusted" data items have had the following adjustments made: Added back: goodwill amortisation, provision for catastrophe reserves, IFRS derivatives & hedging, IFRS impairments & IFRS interest expense Excluded: non recurring items, asset revals, property revals, appraisal value uplift, preference dividends & minority interests EPS = adjusted net profit / efpowa* ROA = adjusted ebit / average total assets ROA Banks/Insurance = adjusted net profit /average total assets ROE = adjusted net profit / average shareholders funds Gross cashflow = adjusted net profit + depreciation *equivalent fully paid ordinary weighted average number of shares All Reported numbers for Australian/NZ listed stocks are modelled under IFRS (International Financial Reporting Standards).

Recommendation proportions – For quarter ending 30 June 2016

AU/NZ Asia RSA USA CA EUR Outperform 45.17% 56.00% 36.36% 43.16% 63.39% 45.91% (for global coverage by Macquarie, 6.27% of stocks followed are investment banking clients)

Neutral 36.21% 28.59% 40.26% 50.38% 29.46% 36.96% (for global coverage by Macquarie, 6.33% of stocks followed are investment banking clients)

Underperform 18.62% 15.41% 23.38% 6.46% 7.14% 17.12% (for global coverage by Macquarie, 5.38% of stocks followed are investment banking clients)

Company-specific disclosures: Important disclosure information regarding the subject companies covered in this report is available at www.macquarie.com/research/disclosures.

Analyst certification: We hereby certify that all of the views expressed in this report accurately reflect our personal views about the subject company or companies and its or their securities. We also certify that no part of our compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. The Analysts responsible for preparing this report receive compensation from Macquarie that is based upon various factors including Macquarie Group Ltd total revenues, a portion of which are generated by Macquarie Group’s Investment Banking activities. General disclaimers: Macquarie Securities (Australia) Ltd; Macquarie Capital (Europe) Ltd; Macquarie Capital Markets Canada Ltd; Macquarie Capital Markets North America Ltd; Macquarie Capital (USA) Inc; Macquarie Capital Limited and its Taiwan branch; Macquarie Capital Securities (Singapore) Pte Ltd; Macquarie Securities (NZ) Ltd; Macquarie Equities South Africa (Pty) Ltd; Macquarie Capital Securities (India) Pvt Ltd; Macquarie Capital Securities (Malaysia) Sdn Bhd; Macquarie Securities Korea Limited and Macquarie Securities (Thailand) Ltd are not authorized deposit-taking institutions for the purposes of the Banking Act 1959 (Commonwealth of Australia), and their obligations do not represent deposits or other liabilities of Macquarie Bank Limited ABN 46 008 583 542 (MBL) or MGL. MBL does not guarantee or otherwise provide assurance in respect of the obligations of any of the above mentioned entities. 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Recommendations contained in one type of research product may differ from recommendations contained in other types of research, whether as a result of differing time horizons, methodologies, or otherwise. Before making an investment decision on the basis of this research, you need to consider, with or without the assistance of an adviser, whether the advice is appropriate in light of your particular investment needs, objectives and financial circumstances. There are risks involved in securities trading. The price of securities can and does fluctuate, and an individual security may even become valueless. International investors are reminded of the additional risks inherent in international investments, such as currency fluctuations and international stock market or economic conditions, which may adversely affect the value of the investment. 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15 July 2016 50

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Asia Research Head of Equity Research

Peter Redhead (Global – Head) (852) 3922 4836

Jake Lynch (Asia – Head) (852) 3922 3583

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Conrad Werner (ASEAN – Head) (65) 6601 0182

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Viktor Shvets (Asia, Global) (852) 3922 3883

Chetan Seth (Asia) (852) 3922 4769


Erwin Sanft (China, Hong Kong) (852) 3922 1516

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Conrad Werner (Singapore) (65) 6601 0182

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Gino C Rojas (Philippines) (632) 857 0861

Regional Heads of Sales cont’d

Paul Colaco (San Francisco) (1 415) 762 5003

Amelia Mehta (Singapore) (65) 6601 0211

Angus Kent (Thailand) (662) 694 7601

Ben Musgrave (UK/Europe) (44 20) 3037 4882

Christina Lee (UK/Europe) (44 20) 3037 4873

Sales Trading

Adam Zaki (Asia) (852) 3922 2002

Stanley Dunda (Indonesia) (6221) 515 1555

Sales Trading cont’d

Suhaida Samsudin (Malaysia) (603) 2059 8888

Michael Santos (Philippines) (632) 857 0813

Chris Reale (New York) (1 212) 231 2555

Marc Rosa (New York) (1 212) 231 2555

Justin Morrison (Singapore) (65) 6601 0288

Daniel Clarke (Taiwan) (8862) 2734 7580

Brendan Rake (Thailand) (662) 694 7707

Mike Keen (UK/Europe) (44 20) 3037 4905

This publication was disseminated on 15 July 2016 at 04:27 UTC.

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