INSIGHTS

GLOBAL MACRO TRENDS

VOLUME 6.3 MAY 2016

China: Mounting Macro

Paradox

China: Mounting Macro

Paradox

KKR GLOBAL MACRO & ASSET

ALLOCATION TEAM
HENRY H. MCVEY
Head of Global Macro & Asset Allocation
+1 (212) 519.1628
henry.mcvey@kkr.com
DAVID R. MCNELLIS
+1 (212) 519.1629
david.mcnellis@kkr.com
FRANCES B. LIM
+61 (2) 8298.5553
frances.lim@kkr.com
REBECCA J. RAMSEY
+1 (212) 519.1631
rebecca.ramsey@kkr.com

A recent visit to China gives us more assurance that there

is a base rate of economic growth that the government
using a variety of monetary and fiscal tools will work
hard to achieve in 2016. As such, we have boosted our
2016 GDP forecast for China to 6.5% from 6.3%. However,
our bigger picture conclusion remains that the Chinese
economy is structurally slowing, driven by disinflation,
declining incremental returns, demographic headwinds,
and the law of large numbers. If we are right, then China
needs not only to bring nominal lending growth more in
line with nominal GDP, but it also needs to start to shift
its existing debt load away from the corporate sector and
towards the consumer sector. How these transitions unfold
have major implications not only for China, but also for a
world economy that now relies on one country, China, for
almost one-third of total global GDP growth.

JAIME VILLA
+1 (212) 401.0379
jaime.villa@kkr.com
AIDAN T. CORCORAN
+ (353) 151.1045.1
aidan.corcoran@kkr.com

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LAO TZU
6TH CENTURY B.C. PHILOSOPHER

When my colleague Frances Lim and I arrived in Beijing in late April,

it just felt different than recent visits to China. Sentiment was generally upbeat, corporate executives talked constructively about their
business outlooks, and even the smog overhang had subsided.
Without question, this positive backdrop stood in stark contrast to the
downbeat and somewhat overwhelming experience I had with some
of my KKR colleagues in the countrys capital at year-end 2015. During that visit both investors and CEOs talked begrudgingly about their
business prospects, and one needed a heavy duty environmental
mask to even walk out of the hotel to fight the dense smog and winds
afflicting Chinas capital city before the holidays.
Overall, our most recent time in both Beijing and Hong Kong was well
spent, and we walked away with what we believe are important shortterm and long-term investment conclusions. They are as follows:
1. As it relates to the short term, we are lifting our 2016 GDP
forecast for China to 6.5% from 6.3%. This change represents
our first uptick in forecasted Chinese GDP growth since we arrived at KKR in 2011. The primary catalyst for the increase is the
governments renewed commitment to achieving its 6.5% growth
target for 2016 via robust liquidity injections into the economy. As
one might sense, the recent decision to substantially boost more
credit creation appears to run counter to the governments original reform agenda of targeting a less levered, more market-based
economy. Meanwhile, our inflation forecast for 2016 in China
moves to 2.0% from 1.7%. The primary driver of the change
is the aforementioned slightly higher growth, which results in
slightly higher core inflation.
2. Longer-term, however, we do not think that the recent stimulus
can help the Chinese economy to re-establish a higher sustained growth rate. In fact, growth in residential property and
infrastructure both areas that are already suffering from excess
capacity in many parts of the country were the two primary
stimulants of growth during 1Q16 (Exhibit 1). Including liquidity
added to these two areas, a total of RMB 7.5 trillion (U.S.$1.2
trillion) of stimulus was injected into the economy during the first
quarter, which fully equates to 47% of total GDP on an annualized basis, according to work done by Goldman Sachs in April of
this year. Not surprisingly, we view these types of stimulus initiatives as unsustainable for an economy that already has a total
debt to GDP ratio of 245%.
3. Corporate credit growth remains outsized relative to GDP,
which has implications for among others the countrys
banks, insurers, and brokers. Investors hoping for a big bang
write-off in the banking sector, however, are likely to be disappointed in the near-term. From what we can tell, its not coming.
Rather, during our visit there was a lot of discussion amongst
bank executives, investors, and CEOs around more measured
approaches. For example, there was quite a buzz about the
proposed introduction of debt to equity swaps for corporations
with large loans outstanding, which should theoretically provide
some form of equity capital relief for banks. Another big initiative
to improve the situation in the banking sector is a program that
allows debt from local government funding vehicles (LGFVs) held
by banks to be refinanced through the municipal bond market at

lower rates and capital charges as well as for longer durations.

Unfortunately, we view both the debt for equity swap strategy
and the replacement of LGFV debt with municipal debt somewhat
more cautiously than the consensus because neither actually
represents a true injection of external equity. Moreover, we still
wrestle with the fact that credit is growing more than 13% yearover-year, which is nearly twice the pace of nominal GDP (Exhibit
24). If current trends persist, my colleague Frances Lim forecasts
that debt to GDP will reach 300% or greater by 2020.
4. There is no One China anymore, as the countrys economy is
undergoing a massive transition. Importantly, though, we are not
talking purely about the transition from manufacturing towards
services. In our view, this economic hand-off has been somewhat
overhyped. The reality is that fixed investment as a percentage
of GDP is now higher than any period in recent memory largely
the compliment of outsized government stimulus in recent years.
Rather, we are talking about the significant transition that Chinas
millennials, many of whom are quite Internet savvy, are driving
across the economy, particularly in the countrys retail, travel and
leisure, consumer finance, sports, and healthcare/wellness sectors.
5. To offset the slowdown in global trade and flows, China is
also repositioning its export economy to take market share in
higher value-added services. Some of this transition is linked to
internally building a fast follower strategy in certain sectors,
but the lions share of executives with whom we spoke indicated
that the number one priority was to acquire overseas firms with
customer knowledge, global supply chains, distribution networks,
and superior intellectual property. If we are right, then we should
expect more outbound global M&A by China in the near-term as
well as more global pricing cuts in the long-term.
6. China Inc.: Coming to a theater near you. Without question,
this trips dominant view centered on the desire by many Chinese
business leaders to acquire companies, properties, and experiences
outside of China. Getting assets outside of China is clearly a major
focus after the August devaluation. There is also some sound
industrial logic too. For example, there is clearly a growing desire
to shift excess capacity from the countrys domestic economy to
new markets, the U.S. in particular. In addition, some CEOs with
whom we spoke wanted to acquire high-end expertise across
technology and healthcare. Finally, some Chinese businesses
want to learn more about consumer behavior in developed markets, so that they can bring that expertise back home or be more
prepared when the local Chinese market becomes more mature.
Over time, we see really only one path forward for Chinas long-term
prospects: It must shift some of its credit creation away from the local
government and corporations towards consumers and the central government. This process has started, but as with any process there
are lots of vested interests and roadblocks along the way. However, if
this strategy is not pursued more vigorously, then we believe it will be
nearly impossible for China to achieve 6.0-6.5% growth over the next
five years due to ongoing misallocation of resources. Simply stated,
investing more in loss-making businesses creates a notable drag on
productivity, and as labor force growth slows further in China, productivity improvement will quickly become the only catalyst for boosting
longer-term growth.
KKR

INSIGHTS: GLOBAL MACRO TRENDS

EXHIBIT 1

EXHIBIT 3

Recent Monetary Stimulus Has Certainly Worked to

Bolster Animal Spirits

Chinas GDP Growth Will Rise and Fall With Stimulus,

but the Trend Is Downward Sloping

China: Existing House Price Index: January 2010=100

Tier 1

170

Tier 2

China: Nominal GDP Growth Y/y, %

Tier 3+
12%
Mar-16
160

160
150
140

Growth stronger than

expected providing some
support for reform

10%
8%
6%

120
110

107
102

100
90

10

11

12

13

14

15

4%

Dec-15
6.0%
12

13

14

16

EXHIBIT 4

China Has Already Had a Hard Landing In Nominal

Terms, We Believe

EXHIBIT 2

But There is Now a Bigger Issue in China: As Credit as

a Percentage of GDP Rises, Real GDP Growth Falls

China Real vs. Nominal GDP Growth, Y/y, %

2Q11

15
13
12
11

1Q16
19.6%

2007

14
China: Real GDP Y/y, %

15

Data as at March 31, 2016. Source: China National Bureau of Statistics,

Haver Analytics.

16

Data as at March 31, 2016. Source: China National Bureau of Statistics,

Haver Analytics, KKR Global Macro & Asset Allocation analysis.

9.9%

1995

-32%
6.7%

-64%

7.1%

10
9
8
China: Real GDP Y/y

7
2015

6
5
100

120

140

160

180

200

220

Data as at 3Q15. Source: BIS, China National Bureau of Statistics, Haver

Analytics.

Corporate credit growth remains

outsized relative to GDP, which
has implications for among
others the countrys banks,
insurers, and brokers.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

China: Nominal GDP Y/y

Data as March 31, 2016. Source: China National Bureau of Statistics,

Haver Analytics.

240

China: Credit as a % of GDP

Mar-16
7.1%

Growth weaker than

expected resulting in
stimulative policy response

130

So, despite our decision to boost our 2016 GDP forecast, our bigger
picture conclusion remains that the Chinese economy is structurally slowing, driven by disinflation, declining incremental returns,
demographic headwinds, and the law of large numbers. Importantly,
though, whenever Chinas growth trajectory falls too far below
trend, the government periodically re-embraces its well documented
playbook of stimulating fixed investment to smooth growth and
improve confidence. Our growing concern with this strategy is that
the incremental return on credit is falling each time the government
re-stimulates the economy via rapid credit creation (Exhibits 2 and 6).
We also think the ongoing decline in returns and growth in credit is
inconsistent with a currency that is being asked to trade in a narrow band (estimates during our trip were from one to three percent
depreciation during the next 12 months).

EXHIBIT 5

EXHIBIT 7

Credit Has Increased by More Than 100 Percentage

Points of GDP Since 2000
%
260

Other Credit % GDP

240

China: Total Social Financing % GDP

Chinas Overall Manufacturing and Export Machine Has

Slowed
China: LTM Fixed Asset Invt Y/y, %

245

China: Bank Loans & GDP

220

40

China: LTM Exports Y/y, %

China: LTM Retail Sales Y/y, %

30

200
20

180
160
140

148
134

10

120

100
80

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Data as at 3Q2015. Source: BIS, PBoC, China Bureau of National

Statistics, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

EXHIBIT 6

11

12

13

China: Credit per Unit GDP

15

16

Data as at March 31, 2016. Source: China National Bureau of Statistics,

China Customs, Haver Analytics.

But Within Its Export/Industrial Sector, Profitability Is

Surging in Its Higher Value Industries
China Industrial Profits, Y/y, %

4.7

5.0

35

Waste/Materials Recovery

4.5
4.0
3.5

3.1 3.2

3.0 2.5
2.5

3.3

3.5

2.1

2.0
1.3
1.2 1.2
1.1

1.4

1.6

Agricultural & Food Processing

15

Food Manufacturing

15

Special Purpose Equip

13

Beverage Manufacturing

12

Medical & Pharma Products

10

1.0

Ferrous Metals Mining

0.5

Coal Mining

0.0

14

EXHIBIT 8

Diminishing Returns: Credit per Unit of GDP Growth in

China Remains on an Upward Trajectory

1.5

-10

03 04 05 06 07 08 09 10

11

12

13

14

15

Data as at December 31, 2015. Source: China National Bureau of

Statistics, Bloomberg.

Beyond the credit overhang, China bears will also argue that the
country is now caught between ceding the low-end manufacturing
activity to its Southeast Asia and African peers without the necessary increases in high-end manufacturing market share to create
a smooth transition. We certainly saw examples of this squeeze
happening, but we think this perspective ignores that China is making
huge inroads in terms of profitability and growth in some of the more
value-added segments of the global economy (see Exhibit 8). Regardless of where one comes down on the China debate, this bull versus
bear script will still take time to play out, and in the interim, we think
the economy will give both sides enough food for thought to keep
things quite volatile well into 2017.

-19
-111
-186

Petro, Coking & Nuclear Fuels

Petroleum & Natural Gas

-234

Data as at February 29, 2016. Source: China National Bureau of

Statistics, Haver Analytics.

In terms of investment opportunities, we left with similar takeaways

as from our prior trips. Specifically, we continue to eschew the
Chinese public equity markets, which are heavily skewed towards
large banks (Exhibit 9). By comparison, in the private markets we still
continue to see more interesting opportunities, albeit we believe one
has to be more valuation disciplined than in the past. In particular, we
continue to favor the high value-added segments of the market that
are direct plays on rising GDP-per-capita, not just rising GDP (which
is what we think the public markets in aggregate represent). This
opportunity set includes healthcare, consumer finance, food safety,
KKR

INSIGHTS: GLOBAL MACRO TRENDS

and mobile/Internet penetration. We also continue to see growing opportunities in sports and wellness. On the other hand, while
environmental investment plays appear theoretically attractive,
the space now feels overcrowded, including increased government
participation.
EXHIBIT 9

Financials Continue to Represent a Large Percentage of

the MSCI China Index; By Comparison, Consumer Is
Quite Small
MKT CAP

CONSENSUS EPS GROWTH

CHINA

WEIGHT %

2016

2017

TOTAL MARKET

100.0

2.9

14.0

CONS DISCR

7.3

6.0

26.7

CONS STAPLES

2.7

8.7

8.5

ENERGY

7.0

-44.6

147.9

FINANCIALS

31.7

-1.7

5.8

HEALTH CARE

1.9

9.7

16.2

INDUSTRIALS

6.7

15.2

12.3

INFO TECH

29.0

35.3

29.0

MATERIALS

1.3

67.4

29.4

TELCO

9.1

2.5

10.3

UTILITIES

3.3

8.6

4.1

Data as at April 28, 2016. Source: JPM Research Emerging Markets

Strategy Dashboards dated April 28, 2016.

EXHIBIT 10

Revisions In China Continue to Be on a Downward

Trajectory
China: FY2 Earnings Revision, %
15
10
5

Jun-15

0
Apr-16
-12.4

-5
-10
-15
-20
-25
-30

10

11

12

13

14

Data as at April 30, 2016. Source: Factset.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

15

16

Separately, we spent a lot of time on the non-performing loan

(NPL) opportunity this trip. On the surface, the opportunity appears
significant, as NPLs have increased for 17 consecutive quarters, and
in the last year total non-performing assets on bank balance sheets
in China increased to 1.3 trillion RMB, a full 51% increase year-overyear (Exhibits 27 and 28). We are by no means experts in this area,
but our base conclusion is that this opportunity could take more
time to ramp up than the current consensus now thinks. True, the
government is cracking down on off-balance sheet lending structures
that shield NPLs, as well as increasingly pushing banks to dispose
of problem assets. However, we did not sense that we are on the
cusp of a crisis moment, nor did we leave Beijing under the impression that there would be a policy change that dramatically favored
foreign capital players in terms of loan workouts. Also (and somewhat ironically), the governments recent decision to boost liquidity
has actually helped many weak corporations and property players
to stay the course, not restructure the way they potentially should.
Finally, returns across many deals we discussed were not as high as
one might think, particularly relative to what we are now seeing in
regions like Europe.
Looking at the bigger picture, we still think that the global capital
markets remain in Adult Swim Only mode. As we saw with the
Bank of Japans recent decision to refrain from more stimulus, there
is a lot of confusion and anxiety around negative interest rates.
Meanwhile, aggregate global EPS growth continues to disappoint,
as nominal revenues are falling amidst higher debt expenses. This
combination is somewhat worrisome, though we are sticking to our
teams base view that the next global recession likely occurs in late
2017/early 2018.
Against this backdrop, our major macro and asset allocation themes
remain largely unchanged. Specifically, we continue to favor an
overweight positon in private credit, including direct lending, mezzanine, and asset-based lending. Year-to-date, these markets have
represented some of the best risk-adjusted returns, we believe.
Importantly, our work shows that private equity tends to outperform
public equities at this point in the cycle. Within private equity, we
favor consumer facing businesses more than industrial/export related
franchises. Key to our thinking is that 1) globally, we just shifted $2.7
trillion in value from commodity producing nations to consumer-oriented ones and 2) global trade and global flows continue to disappoint, which we view as a secular, not cyclical, phenomenon. Finally,
within real assets, we remain bullish on our Yield and Growth thesis,
which leads us to infrastructure, broken energy stories with upside
optionality, and dislocated real estate credit.

DETAILS
GDP Update/Putting China in Perspective
As we indicated above, we have boosted our 2016 GDP forecast for
China to 6.5% from 6.3%. This increase is important for all global
investors because, as we show in Exhibit 11, China accounts for about
one-third of total incremental global growth in nominal USD terms. If
we are using purchasing power parity as a measuring stick, then Chinas contribution is even larger. That said, as Exhibit 12 shows, strong
absolute growth in China has not led to strong growth in profits and/
or returns on shareholder equity. We link this disconnect between

strong GDP growth but weak profits to the reality that nominal GDP
as well as nominal revenues in China have fallen sharply at the same
time that corporate debt service burdens have increased dramatically. In addition, some of this GDP growth has come from loss making
industries with excess capacity.
EXHIBIT 11

In 2016, the U.S. and China Will Be the Major

Contributors to Global Growth in U.S.$ Terms
Contribution to 2016 Global Real GDP Growth
Weighted by Nominal U.S.$ GDP, %
3.5

1.0

3.2

3.0
2.5

0.6

2.0

1.0

1.5
1.0

A heightened focus in recent years on value-added growth markets

such as high-speed rail, nuclear reactors, and new energy vehicles
has been instrumental to growing overall market share, we believe.
Meanwhile, on the low-end, the country has thoughtfully and willingly
forfeited share in areas where Chinese wages are no longer competitive (e.g., toys, leather, and shoes) and/or competitive devaluations
by other EM peers have affected Chinas long-term market position.
The other key change that the country has made to help its overall
export initiative is to insource the production of more immediate
goods. One can see this in Exhibit 14. Besides improving cost and
supply chain management, insourcing has boosted the countrys current account, which is ultimately a much needed potential tailwind for
its currency.
EXHIBIT 13

As China Rebalances Towards Higher Value-Added

Exports, It Continues to Grow Its Share of Global Exports
at the Expense of Japan, Germany, and the U.S.

0.6

0.5
0.0

market to players like Vietnam, Africa, and Mexico (Exhibit 15). All
told, Chinas proportion of global exports rose to 13.8 percent last year
from 12.3 percent in 2014, the highest share any country has enjoyed
since the United States in 1968.

U.S.

China

Other EM

Other

World

Share of World Exports, 12mma, %

Data as at April 12, 2016. Source: IMF, Haver Analytics, KKR Global
Macro & Asset Allocation.

Korea

China

Japan

Germany
14

EXHIBIT 12

Despite Strong GDP Growth, Corporate Returns Remain

Lackluster in China
LTM Trailing ROE
20

U.S.

China

17
16

16

Apr-16
13.5 15

14

14

12

13

10

12.8

8
07

08

09

10

11

12

13

10

14

15

16

6
4
2
0

82

86

90

94

98

02

06

10

14

Data as at December 31, 2015. Source: IMF, Haver Analytics.

12
11

06

12

8
18

18

U.S.

10

Data as at April 30, 2016. Source: MSCI, Factset.

Despite our increasing concern about the trajectory of debt levels in

China as well as the ability of this economy to translate GDP growth
into profits, we see three important, positive economic trends from
our trip that we think are worth highlighting. First, China has been
using its growing strength in high-end exports to drive increased
market share, despite an overall slowing export environment. In fact,
China has actually been gaining share in total net exports in recent
years (Exhibit 13) at the time it has been ceding the low-end of the

Our bigger picture conclusion

remains that the Chinese economy
is structurally slowing, driven by
disinflation, declining incremental
returns, demographic headwinds,
and the law of large numbers.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

EXHIBIT 14

EXHIBIT 16

China Is Maintaining Share by Exporting More High-End

Goods. However, It Is Also Importing Less as It Builds
Local Competitive Advantages

But Services Are Now Growing Nicely

China GDP Composition (as a % of GDP)
Secondary Industry (Manufacturing & Construction)

China Share of World Trade, 12mma, %

China Imports

Dec-15
13.8

14

9.5

37.5

35
30
25

20

70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15

Data as at March 31, 2016. Source: China National Bureau of Statistics,

Haver Analytics.

2
90 92 94 96 98 00 02 04 06 08 10 12 14

EXHIBIT 17

Data as at December 31, 2015. Source: IMF, Haver Analytics.

Second, the country has also done a solid job of building out its services platform, which has been important to offset the ongoing slowdown in the countrys manufacturing and construction industries.
One can see elements of this transition in Exhibit 16. All told, services
now accounts for 56.9% of Chinese GDP, compared to just 37.5% for
manufacturing and construction. Growth in healthcare, travel, and
financial offerings are representative of key drivers of this significant
shift in the countrys economy.
EXHIBIT 15

The Traditional Made in China Export Economy Is in

Secular Decline
China % Total Exports, 12mma
Ordinary Trade (Higher Value Add)

60

Reexports (Lower Value Add)

55

Mar-16
53.9

50
45

Private Consumption Is Growing Rapidly in China, a

Trend We Expect to Continue
CONSUMPTION U.S.$ TRILLIONS
2015

2020

% CHG

U.S.

12.3

15.0

22%

CHINA

4.1

6.1

47%

JAPAN

2.5

2.9

16%

GERMANY

1.8

2.2

18%

UK

1.8

2.1

14%

FRANCE

1.3

1.6

16%

INDIA

1.2

1.9

59%

ITALY

1.1

1.2

13%

BRAZIL

1.1

1.1

-1%

CANADA

0.9

1.0

12%

CONSERVATIVE ASSUMPTIONS STILL LEAD TO NEARLY 50% GROWTH.

IF CONSUMPTION AS A % OF GDP GREW BY JUST 100BP A YEAR, 2020
CONSUMPTION WOULD RISE TO $7.3 TRILLION OR A 70% INCREASE

40
Mar-16
34.5

35
06

07

08

09

10

11

12

13

14

15

16

Data as at March 31, 2016. Source: China National Bureau of Statistics,

Haver Analytics.

50

40

10

30

Mar-16
56.9

55

45

12

Tertiary Industry (Services)

60

China Exports

KKR

INSIGHTS: GLOBAL MACRO TRENDS

Data as at April 12, 2016. Using 2014 ratio of Consumption % GDP

against IMF estimate of nominal GDP. Source: IMF, Haver Analytics.

EXHIBIT 19

EXHIBIT 18

Chinas Tech Sector Is Now Bigger Than Europes

China Has More Researchers Than the U.S.

Number of Researchers in R&D, Millions

Market Cap in U.S.$ Billions

3,753

China

1.8

U.S.

Euro Area

1.6
1.4
1.2
486

399

1.0

502

0.8
Alibaba +
MSCI Europe
Tencent + Baidu Information
+ JD.com
Technology
Sector

MSCI China
Information
Technology
Sector

S&P 500
Information
Technology
Sector

Data as at April 27, 2016. Source: Bloomberg.

Third, China has become a major force in advancing technology

change. To review, in 2006 the government set a goal of turning
China into a science powerhouse by 2020 by raising R&D spending to 2.5% of GDP, compared to 1.4% at the time. Already, R&D has
increased to 2.0% of GDP, while the number of local researchers
in China has increased 32% to 1.5 million from 1.1 million in 2005
(Exhibit 19). Not surprisingly, there has been a surge of patent applications by China, increasing 5.4 fold to 928,000 in 2014 (latest data)
from 173,000 in 2005 and now 60% more than the U.S. (Exhibit 20).
Meanwhile, as we show in Exhibit 18, Chinese companies have been
translating this technological innovation into market capitalization
growth. Just consider that four Chinese technology companies have
a greater market capitalization than the entire European technology
sector. This successful transition from private start-ups to large,
profitable public companies is important, because these companies
can use their highly valued equity currencies to acquire early-stage
companies both inside and outside of the Chinese mainland. As a result, we believe that China is now in a much better position than other
countries against which it competes for talent and ideas to create a
virtuous cycle of technological advancement.

0.6
0.4

96

98

00

02

04

06

08

10

12

14

Data as at December 31, 2013. Source: World Bank, Haver Analytics.

EXHIBIT 20

And Now Files 60% More Patents Than the U.S.

Patent Applications, Thousands
China

U.S.

Euro Area

1,000

928

900
800
700
600

579

500
400
300
200
105

100
0

96

98

00

02

04

06

08

10

12

14

Data as at December 31, 2013. Source: World Bank, Haver Analytics.

To offset the slowdown in global

trade and flows, China is also
repositioning its export economy
to take market share in higher
value-added services.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

EXHIBIT 21

The 25-34 Year Old Age Bracket Is Driving Online

Spending Growth in China
Online Spending per Month by Age Group,
RMB Millions and % of Total
Online Spending

% of Total Online Spending

37.9

40

40%

35

35%

30

30%
24

25

23.9

20%

15

15%
8.1

6.2

10%
4.2

5
0

6-14

15-24

25-34

35-44

45-54

5%
0%

55+

Data as at June 30, 2015. Source: China Internet Network Information

Center (CNNIC), Credit Suisse Live and Breathe the Internet 2015
Investment Guide.

EXHIBIT 22

World Internet Penetration: China Stands at a 49%

Penetration Rate, Suggesting More Running Room
Global Internet Penetration
Canada

While we applaud Premier Lis recent call to arms, we think that

there are at least three other strategies the government should
consider to promote more stable long-term growth. For starters, we
would argue that the aforementioned SOE reform cant achieve its
desired effect unless weakened competitors across industries with
excess capacity are allowed to fail. To do so, however, credit creation
growth must trend down below nominal GDP growth. To date, however, the exact opposite has been true, as nominal lending growth is
now running more than six hundred basis points above nominal GDP,
one of the widest gaps ever (Exhibit 24). As such, while China is
ruthlessly bring(ing) down capacity in some areas, excess credit is
allowing absolute overcapacity in other areas of the economy.

92%

South Korea

92%

Japan

91%

U.S.

87%

Singapore

82%

Russia

71%

Malaysia

68%

Poland

68%

Brazil

58%

South Africa

49%

China

49%

Mexico

49%

Average

46%

Indonesia
0%

Beyond the changes we described above in exports, services, and

technology, the Chinese government is also making a significant push
towards reforming its state-owned enterprises (SOEs). Indeed, as
Premier Li Keqiang stated in a December 2015 meeting with top advisors We must summon our determination and set to work, for those
zombie enterprises with absolute overcapacity, we must ruthlessly
bring down the knife.3

95%

U.K.

India

But Still More Balance Is Needed

25%

20

10

Against this backdrop of accelerating technological change, industries

are being redefined and in some instances at an alarming pace.
For example, online sales in China are now growing around 40%
year-over-year, compared to just six to seven percent for bricks and
mortar offerings1. As such, online sales as a percentage of total sales
are expected to be 15.4% in 2017, compared to just 10.4% in 20142.
Driving significant growth in online sales are both the rising number
of online millennial shoppers as well as rising income within this
demographic. One can see this in Exhibit 21. Rough estimates are that
millennials account for one-third of the Chinas total population, but
now account for two-thirds of total e-commerce.

31%
3%
50%

By 1H15, the number of

Internet users in China
grew to 668m (49%
penetration). IDC
projects this number to
reach 70% by 2017
(53% rural, 73% urban)

100%

Data as at June 30, 2015. Source: Internet World Stats, Credit Suisse
Live and Breathe the Internet 2015 Investment Guide.

The country has thoughtfully

and willingly forfeited share in
areas where Chinese wages are
no longer competitive and/or
competitive devaluations by other
EM peers have affected Chinas
long-term market position.

1 Data as at June 30, 2015. Source: China Internet Network Information Center
(CNNIC), Credit Suisse Live and Breathe the Internet 2015 Investment Guide.
2 Data as at January 15, 2016. Source: Credit Suisse, iResearch.
3 Data as at February 29, 2016. Source: FT, Chinas State-Owned Zombie
Economy.

10

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INSIGHTS: GLOBAL MACRO TRENDS

EXHIBIT 23

Loss-Makers Form an Increasing Share of SOEs

Profit and Loss-making SOEs, RMB Billions

Profits of Profit-making
Losses of Loss-making

4,000
3,000

particular. In addition, by providing access to a segment of the market

that has traditionally had an extremely high savings rate, it would
further drive consumption at the expense of fixed investment, which
is what is really required to rebalance the economy. If there is good
news, many of the banking executives and officials with whom we
spoke seem supportive of this game plan. The bad news is that this
rebalancing is moving slowly; in fact, consumer credit still now only
accounts for about 25% of total loan growth4.
EXHIBIT 25

China Has Too Much Corporate Debt

2,000

Total Debt as a % of GDP

1,000

Government

Corporate

Household

Existing LGFV debt classied as

corporate will ultimately need to be
transferred to the government sector

377

-1,000
245
-2,000
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013

43
164

Data as at December 31, 2013. Source: China Finance Ministry, Ibid. 1.

38

EXHIBIT 24

China

Nominal Credit Growth Is Still Running Way Above

Nominal GDP; Reform Cant Happen Unless This
Relationship Changes, We Believe
Total Social Financing Y/y
China: Nominal GDP Growth Y/y %

30

93

91

70

103

101

78

60

65

US

Euro Area

Japan

China Needs to Encourage More Consumer Borrowing,

Not Savings, at This Point In Its Economic Cycle

Debt to GDP still

climbing

50

20
15

Mar-16
13.4

30

Mar-16
7.1

20

35

31.4

07

09

11

13

15

Data as at March 31, 2016. Source: Peoples Bank of China, China

National Bureau of Statistics, Bloomberg, Haver Analytics.

Another option for the government to consider is to facilitate more

credit creation from the consumer segment of the market versus the
existing strategy of re-stimulating an already over-leveraged corporate sector. If done properly, we believe this strategy would help to
make China less reliant on its old economy sectors, manufacturing in

25.3

23.2

25

18.7

15
10

05

Household Savings Rate, %

Equivalent to $5 trillion of government,

corporate, and household savings relative
to just $3.3 trillion in the U.S.

46.0

45
40

10

210

EXHIBIT 26

Gross National Savings Rate, %

25

255

Data as at 3Q15. Source: Bank for International Settlements, Statistical

Office of the European Communities, Cabinet Office of Japan, Bureau of
Economic Analysis, China National Bureau of Statistics, Haver Analytics.

Credit growth
growing in line
with nominal
GDP growth

35

242

6.5
2.2

5
0

China

Euro Area

Japan

5.0
U.S.

Data as at December 31, 2015. Source: IMF, OECD Net Household

Savings Rate, Bureau of Economic Analysis, China National Bureau of
Statistics, Haver Analytics.

4 Data as at December 31, 2015. Source: Bloomberg, Haver Analytics.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

11

The final potential change that we think warrants consideration is an

increasing focus on building out a credible bond market, one that is
transparent enough to attract foreign capital on a sustained basis. We
see several positives to this strategy. First, in a world of zero interest
rates, we think that Chinas bond market if run properly could
act as an attractive destination for foreign capital seeking returns.
Just consider that only 17% of the $48 trillion Barclays Multiverse
Aggregate Index currently yields north of three percent5. By comparison, there are hundreds of quality companies in China with corporate
debt yielding five percent or more6. Second, in terms of balancing the
capital account, we think a credible local bond market in China would
potentially help to offset the ongoing desire by locals to remove capital from the mainland. Given our view that capital flight is likely one
of the biggest risks to the China story, we think ensuring a greater
source of alternative inflows into the country warrants attention at
this point in Chinas capital markets liberalization strategy. Finally,
we believe the development of a credible bond market, so early in
Chinas capital market development, could ultimately become a competitive advantage versus other markets like Japan and Europe, both
of which still rely heavily on a concentrated bank market for credit
creation.
China: The Ultimate Macro Paradox?
After enjoying its Golden Era of growth during the 2000-2010 period, the China macro narrative has become much more complicated,
one today that is filled with a series of ongoing policy trade-offs
that often end up being more intertwined and sometimes conflicting than one could ever imagine. Indeed, too many times on this
trip it felt like we heard the refrain that on the one handbut on the
other Just consider the following points:
On the one hand, we heard continuously that the Chinese
government has pledged more serious SOE reform, including
more competitive and profitable global industries. On the other
hand, the government is again boosting domestic credit growth
to more than 13% year-over-year. At such a high level above
nominal GDP, the recent pace of credit growth all but ensures
that many of the countrys weakest corporate entities sidestep
bankruptcy and/or avoid default, which is ultimately at odds with
improving competitiveness and productivity.
Amidst low inflation and bumpy growth, China has continued
to lower rates further to ease financial conditions. Importantly,
more easing is likely needed, as the countrys GDP deflator hovers near zero. On the one hand, if the Peoples Bank of China
does ease further, then it will certainly give a much needed
boost to the corporate sector, which appears to be lumbering under the weight of excess debt service burdens. On the
other hand, if the central bank does lower rates, it could have a
negative impact on the currency, which could create significant
capital markets volatility inside and outside of China.
Meanwhile, a weaker currency could be good for exports, but
it would undermine some of the credibility achieved by China
gaining admission to the Special Drawing Right (SDR). A weaker
5 Data as at April 30, 2016. Source: Bloomberg.
6 Data as at April 21, 2016. Source: Citigroup.

12

KKR

INSIGHTS: GLOBAL MACRO TRENDS

currency would also make it more expensive for consumers

to import things and for companies to acquire abroad, both of
which appear to be strategic priorities for the country. On the
other hand, if the currency were to re-adjust downward towards
what we view as fair value, then the recent bout of capital flight
might finally subside if locals felt that there was less downside
risk to the local currency.
Why does it feel like there is a surge in Chinese macro-related inconsistencies? We see at least three reasons, all of which are inter-related. First, the current Chinese government is being forced to make
some unnatural concessions as it attempts to fulfill the partys original mandate to double GDP between 2010 and 2020. Given more
challenging demographics and the recent slowing of global trade, the
government now needs to run the economy even hotter than normal
to achieve the annual growth it requires to fulfill its long-term GDP
mandate. This mandate in turn leads to a need to boost credit growth
towards double-digit levels to overcome the offsets linked to structurally slower growth. And because credit growth is so strong, the
country is obliged to clamp down on its capital account to prevent
this growth in capital from fleeing the system.
Second, while the government wants to boost productivity to drive
growth, rapid credit growth to aid the old economy actually hurts
long-term efficiency. The third challenge is that there appears to be
somewhat of a conundrum between the governments desire to support growth and to consolidate power via anti-corruption initiatives.
In fact, a number of local people we met thought that recent reform
initiatives were only hurting, not helping, growth. While we agree that
reform often requires painful adjustments, it also represents the most
credible path forward to longer-term sustainable growth in China, in
our view.

The recent pace of credit growth

all but ensures that many of
the countrys weakest corporate
entities sidestep bankruptcy
and/or avoid default, which is
ultimately at odds with improving
competitiveness and productivity.

Every time I visit with a bank executive in China I am reminded of

that famous Mark Twain quote that, The reports of my death have
been greatly exaggerated. To be sure, with total debt as a percentage of GDP at 245% and nominal lending growing nearly two times
the pace of nominal GDP, investors have been theoretically right
to approach the banking sector in China with caution (Exhibit 24).
However, despite multiple apocalyptical predictions about the sectors demise in recent years, the average bank in China has continued
to deliver both earnings growth and book value per share growth. A
key reason is that actual stated NPLs are now at just 1.7%, on average, for the sector, though they have started to increase in recent
quarters. One can see this in Exhibit 27. Meanwhile capital ratios still
appear solid, with the sectors Capital Adequacy Ratio at 13.5% and
Tier 1 ratio at 11.3%, respectively7.

But NPLs Have Not Kept Pace With Loan Growth

China: Major Commercial Banks
Loan Growth, Y/y
Non-Performing Loan (NPL) Ratio
Jun-09
34.4

40

14

35
30

12

25

10

Mar-16
14.7

20
15

Sep-08
5.49

10

05 06 07 08 09 10 11 12 13 14 15 16

8
6
4
2
0

Data as at March 31, 2016. Source: China Banking Regulatory

Commission, Haver Analytics.

EXHIBIT 29

And If China Keeps On Growing Credit At 13%, Then

Credit to GDP Will Reach 300% By 2020
China: Credit as a % of GDP
If TSF Grows at 13% and Nominal GDP at 9%
If TSF Grows at 9% and Nominal GDP at 9%

The NPL Ratio Has Risen as GDP Growth Has Fallen

China: Commercial Bank: NPL Ratio (L)
China: Real GDP (R)
1.8

10.0
9.5

1.6

9.0

1.4

8.5

1.2

8.0
7.5

1.0

7.0
11

Dec-15
1.67

5
0

EXHIBIT 27

0.8

16
Non-Performing Loans Ratio, %

Banking: the Slow Burn

EXHIBIT 28

Loan Growth, %

Our bottom line in assessing the China global macro landscape is

that, if it feels a little confusing, it probably should. Why? Because
there are so many crosscurrents at work. In our view, the good news
is that the government appears to be working hard to communicate
with folks both inside and outside of China. Central bank Governor
Zhou Xiaochuan has certainly raised his profile with international
investors, and we left Beijing with the distinct impression that the
government seems more committed to more clearly articulating its
strategy around growth, anti-corruption, and liberalization initiatives
to both internal and external constituents. If we are right, then this
could be an important positive relative to some of the misunderstandings we have seen around the Chinese stock market, currency, and
reform initiatives during the past few quarters.

12

13

14

15

16

6.5

Data as at March 31, 2016. Source: China Banking Regulatory

Commission, Haver Analytics.

7 Data as at March 31, 2016. Source: China Banking Regulatory Commission,

Haver Analytics.

If TSF Grows at 4% and Nominal GDP at 9%

320
300
280
260
240
220
200
180
160
140

300
250
200

06

08

10

12

14

16

18

20

TSF = Total Social Financing. Data as at December 31, 2015. Source: BIS,
China National Bureau of Statistics, Haver Analytics.

We cant vouch for the loan books of the Chinese banking sector, but we
do have some insights into why the capital ratios still appear robust, despite rising NPLs. First, our research shows that many LGFVs recently
paid back their bank loans, then immediately began swapping their liabilities into local municipal debt securities. This corporate finance baton hand-off is significant because municipal debt tends to be longer in
duration and has a capital charge of 20% versus 100% for LGFV loans/
bonds. As such, banks enjoyed essentially an overnight re-equitization,
though no actual capital has been injected into the banking system in
some instances. Second, many banks are now on track to swap corporate debt obligations into equity positions, which improves the capital
structure of the business and prevents in the near-term what could
KKR

INSIGHTS: GLOBAL MACRO TRENDS

13

have been a significant impairment that a bank would have had to otherwise taken. Third, because loan growth remains so robust in China, it is
actually hard for reported non-performing loans as a percentage of total
bank assets to actually catch-up.
Even with these accounting tailwinds, certain banks, particularly the
smaller ones, are seeing notable deterioration in their loan books.
Moreover, a real NPL market is beginning to form. Indeed, using publicly available data, we believe that commercial banks in China have
around RMB 1.3 trillion of official NPLs, while loans that warrant
special attention now total RMB 2.9 trillion. Collectively, this RMB 4.2
trillion of souring assets (Exhibit 30) is now sufficiently larger than the
RMB 1.6 trillion of asset management equity (note that RMB 200 billion has been raised, but it can be levered 8:1 for RMB 1.6 trillion).
Moreover, these reference points do not tell the entire picture, as the
aggregate loan market is actually about RMB 111 trillion (Exhibit 31). If
we assume loss ratios of eight or nine percent (which many analysts
believe is more realistic) versus the current reported number of one
to two percent for normal commercial bank loans, then the total capacity needed to digest NPLs across multiple asset classes is closer
to RMB 10 trillion, or 15% of GDP in China.

EXHIBIT 31

Including Non-Commercial Bank Financing, the Total

Loans Outstanding Is Roughly RMB 111 Trillion
China: Total Domestic Credit, RMB Trillion
NPL Ratio
8%
9%
10%

Implies NPLs Of:

RMB 8.9 trillion
RMB 10.0 trillion
RMB 11.1 trillion

16

111

13

10

133

18
72.0

1.3

Normal
Comm'cl
Bank
Loans

Ocial
NPLs

2.9

76

Special Total
Mention Comm'cl
Loans
Bank
Loans

Other
Trust &
Total
Other Claims on Total
Bank Entrusted Loans Financing Govt DomesticLoans
Loans
Credit

Data as at 4Q15. Source: China Banking Regulatory Commission, Haver

Analytics.

EXHIBIT 30

Total NPLs in China Are Running at RMB 4.2 Trillion

or an NPL Ratio of 5.5% After Including Special
Mention Loans

4.2

Overall, we left Beijing with the impression that the banking sector, including its asset management companies (AMCs), are likely to
slowly bleed these losses out over time. As such, investors looking
for a 2007/2008 shock to the system similar to what happened to
the U.S. banking sector that leads to huge overnight asset sales are
likely to be disappointed in the near-term. Rather, we believe we will
see more of a Japanese bank style, sluggish unwind of NPL portfolios.

Total
NPLs
5.5%

We also do not think the current NPL cycle in China will look anything like it did during the last NPL clean-up around the turn of the
century. Key to our thinking is that the current macro environment
is just less conducive than it was 15 years ago. For starters, GDP
growth is now slowing, not increasing. Coupled with higher corporate
debt levels, the environment gives banks less wiggle room to take
write-offs and move on. Moreover, asset management companies no
longer are buying the assets at book value because they have their
own shareholders, not just the government (which was the case
during the prior cycle). Finally, return profiles appear more muted in
some instances than what was earned in the past.

China: Commercial Banks

Non-Performing Loans, RMB Trillion

2.9

0.5

0.2

1.3

Loss
Loans

Ocial
NPLs
1.7%

0.6

Substandard Doubtful
Loans
Loans

Special
Mention
Loans

Data as at 4Q15. Source: China Banking Regulatory Commission, Haver

Analytics.

China has become a major force

in advancing technology change.

14

KKR

INSIGHTS: GLOBAL MACRO TRENDS

So, our bottom line is that a significant opportunity for NPL restructuring has formed, but access to quality product, particularly for nonlocal players, is likely more challenging than the current consensus
now thinks. It also requires boots on the ground to source the opportunity, to directly deal with the major AMCs, the growing number of
provincial AMCs, and the variety of large and small banks that define
the financial services system in China. Finally, as we mentioned
earlier, the recent shift back towards short-term economic growth
strategies using outsized credit creation versus President Xi Jinpings stated focus on reform could actually be a net negative for the
China NPL story in the near-term, as it again delays the inevitable by
temporarily revitalizing many of corporate sectors weakest links.

China Inc. Is Headed Overseas

When we go to China and do a series of meetings over a few days,
there is always a lot of debate around key issues/topics. Will the
government stimulate more, what is the direction of the currency, are
the NPLs understated? Then there is a consensus that forms around
one or two big ideas. Without question, this trips consensus view
centered on the desire by many Chinese business leaders to acquire
companies, properties, and experiences outside of China. Getting assets
outside of China is clearly a major focus after the August devaluation.
There is also some sound industrial logic too. For example, there is
clearly a growing desire to shift excess capacity from the countrys
domestic economy to new markets, the U.S. in particular. In addition,
some CEOs with whom we spoke wanted to acquire high-end expertise across technology and healthcare. Finally, some Chinese businesses want to learn more about consumer behavior in developed
markets, so that they can bring that expertise back home or be more
prepared when the local Chinese market becomes more mature.
Regardless of the reason, the demand side of the aforementioned
equation is surging. One can see this in Exhibits 32 and 33. What
does this mean for investors? It likely means that Chinese companies
will now compete more aggressively against strategic and private
equity investors on the acquiring side of deals, but could provide a
logical buyer of choice on exits. Second, once a company has been
acquired, investors should be wary if Chinese management competes
aggressively on price. Beyond the impact at the company and the
industry levels, increased price competition could likely add a deflationary backdrop to what is already a disinflationary global macro
environment and add further downward pressure on interest rates.
Finally, China will need to manage its currency base firmly in other
areas (i.e., prevent further outflows) if M&A volumes do in fact
tick up from current levels.

EXHIBIT 32

Chinas Influence Has Risen to 25% of Global M&A,

Exceeding That of the U.S.
2014 Cross-Border M&A by Purchaser U.S.$B

United
States
22%

Other
19%

Middle East
3%

Europe
8%
Greater
China
25%

Canada
12%

Japan
11%

* Greater China = China + Hong Kong + Taiwan. Data as at December 31,

2014. Source: United Nations Conference on Trade and Development.

EXHIBIT 33

China Is on a Mega Buyout Spree

China: Cross-border Announced M&A Volumes
By Deal Size

US$B

160

341

>$1B
500m-1B
100m-500m
<$100m
Average Deal Size (R)

140
120

20
0

Without question, this trips

consensus view centered on the
desire by many Chinese business
leaders to acquire companies,
properties, and experiences
outside of China.

0
2
3

2
4

2
5
7

169
147
49 43

200

12
17 21
13
5 12
31
10 25
24 25
16 20
10
3 13
18 21 20
10
12
15
9 11 16 15 11 15 14 10 10 11
5

100

18

51

150

22

250

79

88

60
40

350
300

100
80

US$m

17

55

43
23 10

45

19

01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

50
0

2016 data is YTD; annualized deals in U.S.$ terms < 100m = 16, 100m to
500m = 36, 500m to 1B = 30, >1B = 263 totaling 345B with an average
deal size of 1,023. Data as at May 2, 2016. Source: Dealogic, UBS.

KKR

INSIGHTS: GLOBAL MACRO TRENDS

15

EXHIBIT 35

Chinas Role in the Recent Commodity Spike

As has been well documented in the press, commodity prices have
surged in recent months. For our nickel, we see the current price
action as a cyclical bounce in what we still view as an ongoing
structural bear market. However, given how far prices have fallen in
absolute terms and for how long in duration (Exhibits 34 and 35), we
think this bounce could potentially provide an investable opportunity.
EXHIBIT 34

Commodities Have Experienced, on Average, a 66% Price

Correction in Recent Years
Peak-to-Trough Correction to Date, %
Post 2009 High
Gold
Aluminum
Copper
Lead
Tin
Platinum
Zinc
Silver
Coal
Crude Oil
Iron Ore
Uranium
Nickel
Nat Gas

Average correction
from all time
-52
high is 66%

All Time High

-39

-55
-56
-57
-58

-80

-60

-40

-20

A significant opportunity for

NPL restructuring has formed,
but access to quality product,
particularly for non-local players,
is likely more challenging than
the current consensus now thinks.

KKR

Start of Recent Correction

Number of Years Since All Time High
10.4

Nat Gas
Zinc
Nickel
Lead
Iron Ore
Platinum
Coal
Crude Oil
Aluminum
Uranium
Copper
Tin
Silver
Gold

9.1
8.8
8.1
7.8
7.7
7.5
7.5
7.3
7.0
4.9
4.8
4.8
4.3
2

10

12

Data as at March 31, 2016. Source: World Bank, IMF, Haver Analytics.

Data as at March 31, 2016. Source: World Bank, IMF, Haver Analytics.

16

Duration of Correction to Date, Years

-65
-67
-72
-77
-79
-79
-84
-87

-100

Which Has Lasted Between Four and Ten Years

INSIGHTS: GLOBAL MACRO TRENDS

We see several forces at work. First, as we show in Exhibits 36 and

37, respectively, research done by my colleague Frances Lim shows
that major initial declines are subsequently followed by counter trend
rallies that can produce returns of 41-110%. Second, we do think that
Fed policy has changed in recent months towards being more accommodative, which is dollar bearish and commodity bullish. Importantly,
though, we think that the current dollar pause lasts only 12-18
months, which is consistent with our view that commodities are
enjoying a cyclical bounce, not a fundamental, long-term resurgence
in prices across the complex.

EXHIBIT 36

Real Prices Tend to Hit an Initial Trough After Five Years,

But The Full Cycle Might Be As Long As 40+ Years
Commodity Price Peaks and Troughs

60-75% correction
in real prices over 5
years or so

Sharp rally over

a relatively
short period of
a few years

Initial
cyclical rally

Overall, commodity
corrections tend to
be very long tailed

First trough
(Feb 2016)

Final trough
could be as
long as a few
decades from
the peak

Data as at March 22, 2016. Source: KKR Global Macro & Asset
Allocation.

Third, our time in China leads us to conclude that many local Chinese
investors, particularly those who have gained an appreciation for
how much stimulus entered the system during 1Q16, have shifted
significant investment profits out of stocks and real estate and into
commodities. For example, as we show in Exhibits 38 and 39, respectively, iron ore trading volumes are up 106% in three months ending
April 2016 and over 360% in the twelve months, while steel rebar
futures trading volumes are up 142% and 197%, respectively, during
the same periods.
To put this surge in trading volume in context, the current 30-day
average daily trading volume in iron ore futures of 600 million tons
per day is equal to 63% of Chinas total iron ore imports of 950 million tons for all of calendar 20158. Taken together, the nascent iron
ore and steel rebar markets have recent daily trading volume that on
some days is equal to the notional U.S. dollar volume of the S&P 500
futures, the largest and most liquid global equity index future contract. Not surprisingly, the Dalian exchange just recently announced
that it would be increasing margin requirements and transaction
costs on iron ore futures.
EXHIBIT 38

Of Late, There Has Been a Surge in Both Prices and

Trading Volumes of Iron Ore

EXHIBIT 37

Iron Ore Price vs. Futures Volumes

An Initial Rebound In Commodities Can Be Sizeable,

Running Up 41-110% in Real Terms, Before Falling to
New Lows Again
Real Price Rally O the First Trough, %
120%

110%

900

700
600

Iron Ore Prices Are Up 66%

and Trading Volumes Up 106%
in the Last Three Months (and
360% in 12 Months)

700

500
400

600
300

500

Feb-16

20%

Nov-15

Aug-15

200

May-15

100

Nov-13

40%

300
Feb-15

41%

200

400

Nov-14

72%

Aug-14

69%

May-14

55%

61%

Feb-14

80%

0%

Tons Traded 30D Avg. (MMs; RHS)

800

100%

60%

Iron Ore Price (RMB/ton; LHS)

1,000

Data as at April 25, 2016. Source: Goldman Sachs Research, Bloomberg.

Oil: 1980 Iron Ore: Copper: Iron Ore: Copper: Oil: 1864
1880
1916
1957
1966

Data as at March 22, 2016. Source: USGS, BP Statistical Review, Yale/

Robert Shiller data, Statistical Abstract of the United States, History
of the Great Lakes, Federal Reserve Bank of Minneapolis: Handbook of
Labor Statistics, NBER, BLS, IMF, World Bank.

8 Data as at April 30, 2016. Source: Bloomberg.

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INSIGHTS: GLOBAL MACRO TRENDS

17

EXHIBIT 39

EXHIBIT 40

While Steel Rebar Futures Are Up 56% Over the Same

Three Months

The Path Down Takes Much Longer Than the Path

Upwards

Steel Rebar Price vs. Futures Volumes

Duration of Cycles, Years

Boom: Trough to Peak

Steel Rebar Price (RMB/ton; LHS)

4,000

Tons Traded 30D Avg. (MMs; RHS)

3,500

50

140

45

120

Daily Trading
Volume up 142%
in Three Months

3,000

160

100

2,500

80
60

2,000

40
1,500

Feb-16

Nov-15

Aug-15

May-15

Feb-15

Nov-14

Aug-14

May-14

Feb-14

Nov-13

1,000

20
0

46
The path down
takes much longer
than the path up

40
35
30

26

25

18

20
15
10

Bust: Peak to Final Trough

15

5
0

Oil

Copper

Iron Ore

Data as at March 22, 2016. Source: USGS, BP Statistical Review, Yale/

Robert Shiller data, Statistical Abstract of the United States, History
of the Great Lakes, Federal Reserve Bank of Minneapolis: Handbook of
Labor Statistics, NBER, BLS, IMF, World Bank.

Data as at April 25, 2016. Source: Goldman Sachs Research , Bloomberg.

Given heightened levels of speculative trading on Chinese commodity

exchanges and changing central bank policy in the U.S., we think that
commodity prices could run further in the near-term. That said, our
longer-term view is more cautious; in fact, we do not believe that we
will actually see the final long-term trough in the commodity cycle
until fundamentals are better aligned with inventories as well as
ongoing supply trends. To date, however, our research indicates this
realignment has not occurred. Indeed, as once can see in Exhibits 42
and 43, respectively, both crude oil and copper inventories continue
to build on a global basis. As such, our base line remains that, after a
sharp counter trend rally, prices could fall back potentially further
than where they were when this recent rally started. If we are right,
then we think some of the recent speculation around commodity
trading in China could endure a similar fate to what happened in the
Chinese stock market after margin requirements were lifted further
in 2014.

EXHIBIT 41

A Final Peak-to-Trough Real Price Correction Is Roughly

70-85%. However, the First Trough Normally Occurs After
Five Years and a 60-75% Correction
Real Price Correction, %
Peak-to-First Trough
0%
(10%)
(20%)
(30%)
(40%)
(50%)
(60%)
(70%)
(80%)
(90%)

We do not believe that we will

actually see the final long-term
trough in the commodity cycle
until fundamentals are better
aligned with inventories as well as
ongoing supply trends.

18

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INSIGHTS: GLOBAL MACRO TRENDS

Peak-to-Final Trough

Copper:
1916

Oil:
1864

Oil:
1980

Copper: Iron Ore: Iron Ore:

1966
1957
1880

Data as at March 22, 2016. Source: USGS, BP Statistical Review, Yale/

Robert Shiller data, Statistical Abstract of the United States, History
of the Great Lakes, Federal Reserve Bank of Minneapolis: Handbook of
Labor Statistics, NBER, BLS, IMF, World Bank.

EXHIBIT 42

Conclusion

We Do Not Believe That Copper Inventories Have Yet

Peaked
COMEX + LME + SFE Copper Inventories (000 mt)
1000
800
600
400
200
0

04

06

08

10

12

14

16

COMEX = Commodity Exchange, LME = London Metals Exchange,

SFE = Shanghai Futures Exchange. Data as at April 30, 2016. Source:
Bloomberg.

EXHIBIT 43

And Hard to Call a Peak in Oil Inventories When

Global Production Is Currently Running at a 1.9% Surplus
to Demand
Global Production Surplus/(Deficit)
3Q86

4Q98

1Q09

3%
1.9%

2%

4Q15
Oil balance not
expected to move into
decit until 3Q16

1%

Our belief has never been higher that to have conviction on the
overall global macro landscape one has to spend more time understanding the big trends occurring in China. Importantly, it is not
just the massive growth contribution that China makes to the global
economy. The direction of Chinas currency too has huge implications
for global capital markets stability; in addition, its M&A and export
strategies can also materially influence the pace and absolute rate of
global trade and inflation.
The good news is that our most recent visit gives us assurance that
there is a base rate of growth likely around 6.5% in our view that
this government will work hard to achieve in 2016. As such, we
believe investors should take comfort that some of the fundamental
weaknesses that we saw in the Chinese economy during the last
quarter of 2015 has stabilized and potentially even reversed. We
are also encouraged that it appears the government is reflecting more
deeply about how it handled its involvement in the stock market and
currency events that occurred in recent quarters.
The bad news is that near-term gains in growth come at the expense
of long-term sustainability. At some point, a country, particularly
an emerging one, cant continue to run with nominal lending growth
rates so far above nominal GDP for so long. Also, while the government has done a good job of plugging its capital account, this is not a
long-term solution for a country that wants to move towards more of
a markets-based environment.
Against this backdrop, we continue to expect more volatility, and
amidst that volatility, we believe that equity investors should consider migrating their investment dollars towards high-value services,
including healthcare, consumer services, travel, and leisure. The push
towards the Internet, particularly by a dynamic millennial cohort, is
also another important theme on which to focus for both offensive
and defensive reasons.

0%
-1%
-2%
-3%
-4%

-4

-3

-2
-1
0
1
2
3
# Quarters (Before)/After WTI Trough

Dotted line represents KKR GMAA estimates based on IEA global demand
growth estimates (+1.7 MM B/d in 2015e and +1.2 MM B/d in 2016e), IEA
non-OPEC supply growth estimates (+1.4 MM B/d in 2015e and -0.6 MM
B/d in 2016e), and assumption that OPEC supply has peaked at current
level. Data as at January 22, 2016. Source: IEA, Haver Analytics, KKR
Global Macro & Asset Allocation analysis.

The good news is that our most

recent visit gives us assurance
that there is a base rate of growth
likely around 6.5% in our view
that this government will work
hard to achieve in 2016.

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INSIGHTS: GLOBAL MACRO TRENDS

19

On the debt side, we think now is the time to start to position oneself
to take advantage of the significant transfer of credit assets that will
ultimately occur from banks to private investors. However, this opportunity is likely a walk, not run, one in the near-term unless there
is a more blatant directive from the government that foreign capital
has emerged as the most efficient solutions provider to the growing
NPL issue (not our base view).
Overall, though, we believe that the higher risk premiums now
required to invest in China are likely to persist. Key to our thinking
is that nominal credit growth continues to grow too rapidly relative
to nominal GDP, and much of this credit growth is still occurring in
sectors of the economy where debt levels need to be reduced, not
increased. Besides rising debt loads in many parts of the economy,
investors now must also face a more challenging exit environment
for their capital, particularly given the recent downdraft in reserves
as well as the recent uptick in expansionary M&A. Finally, given that
many other economies have stalled in the developed world, it feels
like China has been asked to take on too much responsibility for driving global growth amidst its own internal economic repositioning. In
our view, this burden unfortunately is leading to excesses in several
sectors of the Chinese economy, particularly if the mandate to double
GDP between 2010 and 2020 is maintained. As such, then our base
view remains that it is Adult Swim Only across the global capital
markets, China in particular.

Regardless of where one comes

down on the China debate, this
bull versus bear script will still
take time to play out, and in the
interim, we think the economy
will give both sides enough food
for thought to keep things quite
volatile well into 2017.

20

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INSIGHTS: GLOBAL MACRO TRENDS

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INSIGHTS: GLOBAL MACRO TRENDS

21

22

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INSIGHTS: GLOBAL MACRO TRENDS

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