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10 June 2013

China Market Strategy

Outlook 2H13: Auguries of Turbulence (A Preview)
To see a world in a grain of sand, and a heaven in a wild flower. -- William Blake

Hao Hong, CFA

The surge in US 10-year yield is approaching inflection; significant risk-off events looming in 2H: The US 10-year yield is of singular importance for global markets. Indeed, the ebbs and flows of the 10-year yield have been a chronicle of global crises and recoveries. It is hardly surprising the Fed remains the central bank of the world and the lender of last resort during crises. A surge in 10-year yield shows a drain in global liquidity, and serves as the finest risk-off signal. Indeed, the 87 Black Monday, 94 Mexican Crisis, 97 Asian Crisis, 00 TMT bubble and 08 Great Recession were all concurrent with a dramatic surge in the 10-year yield (Focus Chart 1). Recently, the surge in 10-year yield is once again in focus. We believe the surge in 10-year yield is nearing inflection, even though the market is still besieged by concerns about Feds tapering. But leading indicators are rolling over and inflation is tamed, and yields should fall, if history is a guide. The other time the Feds balance sheet was at ~20% of GDP was in the early 40s, and the World War II helped normalize it. Once it is clear that the Fed cannot immediately quit, yields will fall together with the dashed hopes for a strong recovery. And the rally underpinned by the chimera of growth will soon falter, with the aftermath rippling through the global markets (Focus Chart 2). If we were wrong and yield continued to surge, the advent of a crisis similar to 1997 or 2011 would simply be sooner rather later. Chinas liquidity inflow reversing; rate cut wont help: The inflow of speculative capital disguised under export trades has plunged. The crackdown on suspicious trades, as well as a change in expectation of RMB appreciation must have disrupted some carry trades. After all, the most important element of carry trade is the stability in basis difference, but it is vanishing. And overseas risk-off events can exacerbate funds outflow and drain system liquidity when it is most needed. In the past few days, Chinas interbank market has been under the worst strain since the China bubble burst in October 2007, and stocks have plunged, offering a glimpse of what is to come. With deflationary risk looming, the PBoC could opt to cut interest rates. But excess capacity and significant leverage in private sectors make the economy insensitive to the level of interest rates, and worry about the level of debt instead. And the fact that 9 trillion yuan of total financing YTD has done little to spur growth evidences that even rate cuts wont help. That said, lower rates can alleviate the debt service burden. At this juncture, deficit spending may work, yet the public sectors leverage also makes this a difficult choice. It is an impasse that China is facing. Stocks will struggle amid slowing growth and inflation; a capitulation can see 20% downside; stay put: The Chinese and the US economies are a symbiosis, as shown by their highly correlated interest rates (Focus Chart 3). If the US stumbles, China will, too. And vice versa. The drag from slowing investments on Chinas economic growth is now evident. Many have been advocating a structural reform, but are not prepared for the interim pain. As such, market sentiment remains elevated despite a series of economic setbacks (Focus Chart 4). In a highly leveraged economy, companies should be valued by their capacity to service debt, rather than their earnings growth potential. After all, companies could succumb to heavy debt load before their potentials are even realized. Even estimates of replacement value such as P/B will not serve as a reliable benchmark, as there will be no market to render a fair price during liquidation. We would use the P/EBITDA ratio instead, as it measures debt servicing capacity. This ratio is still ~20% above its 2005 and 2008 lows, hinting at further market dislocations ahead. As global risk-off events are looming large, investors should stay put for now, and resist the temptation of oversold rebounds. Dont fret about an impending capitulation. It will be a sale that one wouldnt want to miss. (This is a preview of our second half outlook to be published on June 26, 2013.)

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China Market Strategy

10 June 2013

Focus Chart 1: US 10-year yield is a chronicle of global crises and recoveries.

18 18


'81 Oil Crisis






10 '73-'74 Severe Bear Market 8 '70 Recession '71 Bretton Woods 6

'87 Black Monday '89 S&L Crisis '94 Mexico Crisis '97 Asian Crisis '00 TMT Bubble



6 '07 Subprime '93 '10 US Relapse '98 4




'11 EU Crisis

'08 QE1

'13 QE3

1-62 1-67 1-72 1-77 1-82 1-87 1-92 1-97 1-02 1-07 1-12

Source: Federal Reserve, Bank of Communications (Intl)

Focus Chart 2: The surge in 10-year yield is about to turn; EM and China will face looming headwinds.
10yr Yi el d (Y/Y Chg, LS) HSI (Y/Y%) MSCI EM (Y/Y%)


2 1 -



0 (1) (2) -50

(3) -100 6-93 6-94 6-95 6-96 6-97 6-98 6-99 6-00 6-01 6-02 6-03 6-04 6-05 6-06 6-07 6-08 6-09 6-10 6-11 6-12 6-13
Source: Federal Reserve, MSCI, HKSE, Bank of Communications (Intl)

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China Market Strategy

10 June 2013

Focus Chart 3: The US and Chinas interest rates are closely correlated.
US 10-yr Yi el d (Y/Y Chg, LS)

Chi na 10-yr IRS (Y/Y Change )

1.5 1.0 0.5 -

2.0 1.0 0.0

-0.5 -1.0 -1.5 -2.0 -2.0 -2.5 Jun-06 -3.0 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 -1.0

Source: Federal Reserve, PBoC, Bank of Communications (Intl)

Focus Chart 4: Our proprietary Chinese Market Sentiment Index is elevated, suggesting China has not yet bottomed.
8 7 6 5 4 3 2 1 (1) (2) (3) (4) (5) (6) (7) (8) 10-08 8.2 8.1 8.0 7.9 May-4-12 7.8 7.7 7.6 7.5 Oct-31-08 7.4 10-08 1-09 4-09 7-09 10-09 1-10 4-10 7-10 10-10 1-11 4-11 7-11 10-11 1-12 4-12 7-12 10-12 1-13 4-13 7-13 7.4 Jul -2-10 Sep-30-11 Ja n-6-12 Feb-8-13 7.8 7.7 7.6 7.5 Apr-15-11 SH Se nti me nt SHCOMP(Log Scal e, RS) Jul -31-09 Apr-15-11 Ma y-4-12 8.0 Feb-8-13 8.4



7.6 Jan-6-12 Oct-31-08 Jul -2-10 Sep-30-11 Aug-31-12 7.4

7.2 1-09 4-09 7-09 10-09 1-10 4-10 7-10 10-10 1-11 4-11 7-11 10-11 1-12 4-12 7-12 10-12 1-13 4-13 7-13 8.2 8.1 8.0 7.9

SHCOMP (Log Scal e ) Jul -31-09

Source: Bank of Communications (Intl)

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10 June 2013

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10 June 2013

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10 June 2013

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