Global Markets: The Short View

CFA Society of Nashville January 22, 2015

James ChanosKynikos Associates

2

Risks Are Rising…

• Market No Longer Cheap

• Leverage At Record Levels Throughout System

• Bull Market Driven By Questionable Earnings and Buybacks

• Market Speculation Has Returned In Force

• Geopolitical Tensions Rising

• Market Complacency Reigns

• Central Bankers No Longer Predictable

• China Risk Increasing

US Market Reaching New Valuation Highs

3

S&P 500 Median EV/Sales Multiple

Source: Goldman Sachs, Compustat

Equities At Highest Percentage Of GDP Since Early 2000

4

Corporate Equities in % of Nominal GDP

Source: Federal Reserve Bank of St. Louis

A Market Fueled By Cheap Credit

5Sources: NYSE, Bloomberg

The World Has Not Really Delevered

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• US domestic nonfinancial debt as a percent of GDP was 233% at 3Q14 compared to 217% at Year End 2007

• Other debt is growing rapidly– Global debt markets have grown to

$100T in mid-2013 from $70T in mid-2007

– Governments have been the largest debt issuers reaching $43T in June 2013, up close to 80% since mid-2007

– Debt of non-financial corporations has grown at a similar rate

• Debt investors are more local– The share of debt held by cross-border

investors has fallen to 26% in late 2012 from 29% in early 2007

– Non-financial issuance has been primarily domestic

• Emerging market and high yield credit are benefiting from search for yield

Sources: Credit Suisse, Federal Reserve, Bank for International Settlements – March 2014 Quarterly Review, IMF, Dealogic, Euroclear, Thomson Reuters, Xtrakter

Estimated Size Of Global Debt Securities Market

FI = financial corporations; GG = general government; II = international institutions; NFI = non-financial corporations; NPISH = non-profit institutions serving households

Sustainable Earnings?

Profit Margins At Record Levels

Sources: Federal Reserve Bank of St. Louis, Deutsche Bank7

Can Record Corporate Buybacks Continue?

8Sources: BoA Merrill Lynch, FactSet, Bloomberg

S&P 500 Buybacks Vs. US IPOs And Secondary Offerings

Hype Rules The Day Once Again

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• Experts everywhere

– Big name investors tweet new ideas

– Chasing market ‘celebrities’

– Business Insider presents the “20 Under 20” list of young investors

– Market price targets are continuously being raised

• Hype vs. fundamentals

– Concept stocks with top-line growth go parabolic

– Wider adoption of non-GAAP metrics

– JOBS Act IPOs

• Silicon Valley/Tech back in vogue

– Tesla’s peak valuation at 67% of GM, despite vehicle sales of only 0.3% of GM for the 12 months through September 2014

– Alibaba, GoPro IPOs and other tech frenzies

– Uber valued at $41B in latest funding round with competing services launched

Sources: CNBC, Business Insider

• IPO Volume

– 648 IPO deals priced in North America

– Total value of $128B

• Valuation Metrics

– Subscriber/user growth

– Mobile monetization

– Revenue growth, not profits

• Market Darlings

– Apple’s peak $700B valuation

– Facebook’s current $215B valuation

– Twitter’s first day $25B valuation

• Social velocity alerts drive stock momentum

• IPO Volume

– 665 IPO deals priced in North America

– Total value of $85B

• Valuation Metrics

– Number of page views

– Click-through rate

– Revenue growth, not profits

• Market Darlings

– Yahoo’s peak 2000 $145B valuation

– Cisco’s peak 2000 $557B valuation

– Time Warner buys AOL for $164B

• Yahoo message board ‘experts’

Bubble Déjà Vu

January 1999 – March 2000 January 2013 – January 2015

Source: BloombergSource: Bloomberg10

Sources: 1) “The Greens, like Ukip, are good for politics”, The Telegraph, January 19, 2015; 2) “Unprecedented in France: Front National's Le Pen tops presidential poll for first time”, The Guardian, September 8, 2014; 3) “Spain’s surging Podemos party rushes to get to the top”, Financial Times, November 21, 2014; European Free Alliance

Geopolitical Tensions Rising

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• European elections no longer routine– Syriza leads Greek polls

– UK elections could be influenced by the Green Party and UKIP1

– Front National leader Marine Le Pen prominent in French President polls2

– Podemos Party surging in Spain3

• Reaction to Islamist terrorism and immigration

• Military confrontation in Ukraine and escalation across Europe

• Syria and Iraq as recurring geopolitical hotspots

• China increasingly assertive in pursuing territorial claims

Nations And Regions Of European Free Alliance Parties

12

Energy Complex Upended

• High oil prices and cheap credit fuelled ramp in energy exploration and production

– Shale in the US

– Large Liquefied Natural Gas (LNG) projects in Asia and Africa

• OPEC cracks

– Saudi Arabia launches price war

– Politics pressuring economics

• Tensions rise as budgets are under pressure

– Higher breakeven costs for government promises

– Social stability at risk

• A challenge to global growth

– Petrodollar economies

– Reduced capital for investment

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Who, Me Worry?

Sources: 1) “2020 Vision: Long Live the Expansion”, Morgan Stanley, September 2, 2014; Bloomberg; Yardeni Research

Investors Intelligence Sentiment Index

• Bears close to ‘extinction’

– Percentage of bears in investors intelligence sentiment index at 14.9% on December 30, 2014

– 2014 showed lowest levels since 1987

• Blinded strategists’ optimism

– “Why this stock market will never go down”1 reflects euphoria

– MS believes that an S&P peak near 3,000 is possible as “this expansion is different”1

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Global Short Opportunities

• Remote Computing Revolution

• All Things Digital

• Shale Explosion

• State Of Big Oil

• Commodity Super Cycle Peak

• China Risk Increasing

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Remote Computing Revolution

• The proliferation of mobile devices pressures PC demand

– Mobile devices have same key capabilities as PCs

– Market share not dominated by just Apple and Samsung after the rise of Xiaomi

– Apple shipped 16% more iPads in the 12 months through September 2014 than the largest vendor shipped PCs

– Shipments of tablets increased by 14% in the 12 months through September 2014

– Shipments of PCs decreased by 3% in the 12 months through September 2014

– IDC expects PCs to decline through 2018

• Adoption of mobile devices pressures PC margins

– iPad bill of materials is ~50% lower than average notebook PC

– Tablets and smartphones change traditional Wintel/PC relationship

• Cloud services allow users to be device-agnostic

– Eliminates need for PC as a mass storage device

– Functionality migrating to the Cloud. Target market expanding with US Department of Defense and CIA embracing the Cloud

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Death Of The PC

Sources: Barclays, IDC

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Mobility Is King

Sources: Gartner, IDC, Strategy Analytics

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PC Decline Continues

Source: Gartner. Note: Split of PC shipments between Notebook and Desktop based on Bloomberg Industries data

Mainframe Computers Of Today?

• Global PC manufacturers in a vice

– Unit declines exacerbated by increasing price pressures from Chromebooks and similar devices with reduced functionality

– Windows XP upgrade cycle provided temporary lift

– Original design manufacturers forced to transition to mobile devices

– Large commercial customers developing white box solutions

– Hardware-driven services less critical

• Changing priorities disrupt component suppliers

– Saving power, not processing speed is now paramount

– Miniaturization drives component changes

– Remote storage reduces need for traditional localized storage via hard disk drives (HDD)

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All Things Digital

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Physical Distribution Disaggregated

• Retail stores now a liability?– Online shopping on mobile devices enables instant price comparison

– Retail profit margins face continual pressure from price matching

– Physical stores cannot offer same diversity of products

– Best Buy struggling to avoid becoming Amazon’s showroom

• Videogame industry driving transition to digital gaming– Digital downloads of new games will further reduce physical purchases

– Profitable distribution of used games faces eventual extinction

– EA’s CFO estimates that full-game downloads account for as much as 20% of respective game purchases

• Physical media an endangered species?– Music now transitioning from digital downloads to streaming

– Video rapidly moving away from physical media

– Airlines now streaming in-flight entertainment to smart devices

– HMV and Blockbuster: early victims of digitization

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Digital Cannibalization Of Physical Media

Source: The Digital Entertainment Group

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Twilight Of The Gatekeepers

• Marginal cost to transmit and/or store digital content approaches zero

• Video rapidly transitioning to digital distribution– Proliferation of digital video distribution outlets, including over-the-top video on

demand and streaming services like iTunes, Netflix and Amazon Prime Instant Video

– Internet-ready television and mobile devices, such as tablets and smartphones, are accelerating the shift to digital video consumption

– Emerging battle for the digital home with Amazon Fire TV, Roku and Apple set-top box agreements

• Video bundling at risk– Increasing viewership via streaming and/or DVR

– Time shifting of viewing habits away from scheduled programming

– Technology enabling greater selection of desired content

• Content/distributors fee disputes occurring with greater frequency

• US pay-TV companies lost 222k subscribers in the 9 months through September 2014 compared to 167k subscribers lost in 2013 and 13k subscribers gained in 20121

Source: 1) “Pay-TV ‘Cord Cutting’ Accelerates”, WSJ, November 6, 2014

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Digital Money Changing Payment Landscape

• Customers increasingly “pay by click”

– Online/mobile purchasing made easier through stored personal data

– Transition driven by vendors such as Apple, Amazon Prime, PayPal, Google Wallet etc.

– Improving biometrics technology to accelerate digital payments by eliminating keyed passwords

• Financial institutions driving adoption of digital services

– Aggressively marketing services such as instant deposit or online banking

– Implementing new systems to process digital payments and fund transfers

• Disruption at the point of sale

– Current terminal network system bypassed by tablets, dongles and apps

– Secure smartphones (Apple Pay) may eventually eliminate the need for card-swipe and chip-and-pin devices

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Shale Explosion

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US Shale Revolution

• Shale revolution is a game changer– Crude oil production in the United

States rose by 39% between 2009 and 2013

– Net crude imports fell by 14% between 2009 and 2013

– The US will be the world’s largest oil producer in 2015

• Companies large and small seduced by shale bonanza

• Fracking disadvantage is aggressive decline in production rates– Wells can see production declines

by 70% in year 1, 50% in year 2 and 30% in year 3

– Creates need to invest continually

Source: EIA and Baker Hughes via Bloomberg

Shale Production Boom

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Dark Side Of The Boom: Levered US Shale

• Shale exploration and production (E&P) in the US is an unconsolidated sector with little control over production and pricing– There are few barriers to entry

– Largely funded in leveraged finance market

– A typical horizontal well costs less than $15M over its lifetime

– Sector lacks economies of scale with full cost method of accounting inflating EBITDA

• Decline in oil and gas prices made worse by shale market dynamics– Production continues even with capex cuts

– Held by production lease agreements drive continued development

– Natural gas is often a by-product of shale oil wells

– US energy infrastructure enables operators to easily capture natural gas

• US oil and gas supply currently cannot tap global demand– Federal approvals beginning for exporting limited quantities of US oil

– LNG processing facilities in the US remain on the horizon

The Displacement Of US Thermal Coal

• Natural gas price declines lead to increasing viability as alternative power source from coal

• Since 2009, relative prices have become the driver for coal and gas consumption

• Coal companies increasingly exposed

– US coal demand and pricing declined

– Free cash flow at mining companies deteriorated

– Balance sheets increasingly stretched

28Sources: EIA, Bloomberg

Share of US Electricity Generation(% of Total US Net Generation)

LNG Under Pressure

• Decline in oil prices have upended global LNG economics

• Capacity is growing

– High oil prices and Asian demand led to increase in investment

– Projects from 2010/11 ready to come online

• US LNG no longer as competitive

– Spread between US and Asian LNG has fallen by 50%

– Arbitrage now negative with $6.50/mcfe liquefaction and shipping

• Questions arise regarding viability of most proposed US LNG plants actually being built

Sources: The Australian, Bloomberg, DOE, JPMorgan, World Bank, Bernstein

Gas And Oil Price Comparison

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Impact On Costly LNG Projects

• Massive Australian projects built for market of triple digit oil prices

– Budget for Gorgon is $54B and Wheatstone at $30B as of June 2014

– Australia has $200B invested in top 7 LNG projects with total capacity of 62Mtpa

• With new energy price paradigm, questions arise for LNG project assumption of 12% internal rate of return (IRR)

• Investors must contemplate implication of 50% price declines

• LNG projects beginning to get shelved

– Excelerate Energy reviewing LNG export terminal 10 months after applying for permits

– British Columbia reassessing 18 proposed LNG projects

Major LNG Projects – Break-Even Prices($/mmBtu FOB)

Sources: Wood Mackenzie / Macrobusiness, Bernstein, Bureau of Resources and Energy Economics, Australia, Oxford Institute30

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State Of Big Oil

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Big Oil Under Pressure

Source: Citi

Global Oil Demand Forecast (m b/d)

1) Big 5 include BP, Chevron, Royal Dutch Shell, Total, ExxonMobil

Sources: Citi, Macquarie

• Downstream is not a true hedge

• In 2013, four of the Big 51 showed YoY earnings declines and all but one had production declines

• Spending more to find less– Big 51 exploration and development

costs were $134B in 2013, 59% higher than in 2010 and 85% higher than in 2008

– Big 51 organic reserve additions totalled 5,100mboe in 2013, 7% lower than the average additions seen over the previous five years

• Searching in more volatile regions

• Demand growth putting top line under pressure– Technology gains

– Slowing global economic activity

Total Cashflows 2009 - Q3 2014, ($bn)

BP Chevron RDS Total Exxon

Operating cashflow 130.3 190.7 192.1 145.3 271.0

Capex (123.4) (160.5) (175.6) (134.9) (181.3)

Free cashflow 6.9 30.1 16.5 10.4 89.7

Dividends and buybacks (42.8) (53.1) (58.1) (40.7) (156.2)

FCF post distributions (35.9) (23.0) (41.6) (30.2) (66.4)

Total reserves CAGR, 2009-2013 (0.4%) 0.4% 5.0% 1.6% 3.6%

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Integrated Oil Companies (“IOCs”) As Self-Liquidating Trusts

The IOCs as Self-Liquidating Trusts

• “Cheap” oil now resides in government hands

– Heads-I-win/Tails-you-lose contracts with many governments controlling vast resources

– Rising nationalism regarding state oil reserves

• Easy oil has most likely been found already

– Costly venues like Canadian tar sands or Siberian Arctic resulting in ever-increasing capital expenditures

– Promising reserves often in politically unstable regions around the world

– $50B Kashagan project in the Caspian Sea is two years behind schedule

• Cash flow after distributions appears permanently negative

– Distributions support stock price

– Debt funding the gap

• Global overcapacity in downstream creates even more pressure on IOCs

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National Oil Company: For The Benefit Of The State?

• From China to Brazil, quasi-public is the new model for national oil companies (NOC)– Step 1: Retain a majority stake

– Step 2: Push ambitious and costly investment strategy

– Step 3: Keep pump prices low to appease citizens

• China shows how it’s done– Big three oil companies are theoretically public

– Overpaying for overseas reserves

– Downstream margins often negative

• Brazil remains a troubling prospect for outside investors– Infrastructure is approximately 2% of GDP – barely covering depreciation

– Prosperity has bred complacency and reform has slowed 

– Widespread corruption with massive projects comes to light elections

• Mexico as the next LatAm play– Mexico’s energy reform ends Pemex’s 75-year monopoly

– Foreign expertise needed for offshore and onshore shale

• Domestic priorities supersede economics– Bente Nyland, Director of the Norwegian Petroleum Directorate: "We are doing the socioeconomic

calculations and we are working with a 4 percent rate of return but when the industry is working with 6-8-10-12 percent, then we have a real problem”.1

– NOCs continue investment in face of price declines

Source: 1) “Oil firms demand excessive returns offshore Norway: directorate”, Reuters, November 19, 2014

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Commodity Super Cycle Peak

First Came The Demand

• China’s growth model is primarily fixed asset investment driven

• Commodity intensity of Chinese growth is relatively high

• Created a sharp acceleration in global demand for commodities such as iron ore, coal, and copper

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Production of Key Chinese ConstructionInputs (Index: 100 = 2001)

Sources: NBS, CISA

Then Came The Investment

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• 1990 – 2001: global mining capital expenditure grew to $14B from $5.7B, a CAGR of 9%

• 2001 – 2012: China’s fixed asset investment boom sees global mining capital expenditure grow to $123B from $14B, a CAGR of 22%

• Mining equipment manufacturers direct beneficiaries of boom – one third mining capital expenditure is spent on equipment

• 2012 to mark the peak in the capital expenditure cycle

Global Mining Capital Expenditure ($B)

Source: Citi

Supply/Demand Analysis 2012 2013 2014E 2015EIron oreIron ore supply, seaborne Mt 1,159 1,272 1,428 1,522 % change, year-on-year 9.7% 12.3% 6.6%Iron ore imports Mt 1,142 1,240 1,364 1,428 % change, year-on-year 8.6% 10.0% 4.7%Annual surplus/(deficit) 17 32 64 94

CopperCopper supply kt 19,881 20,650 21,647 22,310 % change, year-on-year 3.9% 4.8% 3.1%Copper demand kt 19,710 20,565 21,445 22,287 % change, year-on-year 4.3% 4.3% 3.9%Annual surplus/(deficit) kt 171 85 202 23

• Following years of multi-billion dollar investments, new supply of key input commodities is becoming available

• Iron ore and copper remain oversupplied

• Commodity prices should weaken as supply grows faster than demand

• Market expectations are muted with adjusting target prices

Supply Is Poised To Exceed Demand

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Growing Commodity Oversupply

Sources: CLSA

• Chinese economic growth is slowing

• With China’s desire to rebalance away from investment towards consumption, this will further decrease commodity demand

• Supply growth is set to accelerate as new multi-billion dollar mines are finally commissioned

• A reversion to the mean

– Retracing commodity prices

– Deteriorating operating cash flows for mining companies

– Reductions in mining capital investment

– Lower demand and pricing for mining equipment manufacturers

The End Of The Rainbow: Winding Down The Mining Super Cycle

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Iron Ore Price ($/dry metric ton)

Sources: Global Financial Data, Bloomberg

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China Risk Increasing

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The Illusion Of China

• Seduction of 1.3B customers

• Growth potential is unlimited

• Rising middle class

• Command Economy gets it done

• Government solves all

• Confidence in massive Forex reserves

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The Economic Reality

• Driver of global economic growth– China accounted for 12% of global

GDP in 2013, up from 8% in 2009

– Over half of German GDP growth in 2013 estimated to be driven by exports to China1

• The world’s factory– Bred in excess labor

– Developed expertise and logistics

– Squeezed by increasing costs

• The ultimate consumer of commodities– Underpins bulk commodity capex

‘super cycle’

– Soft commodity driver as well

• Desire to dominate– Persistent overinvestment

– Trolling for international technology and expertise

Source: W-T-W FinanceSources: 1) “Eurozone on cusp of triple-dip recession as German exports crumble”, The Telegraph, October 10, 2014; World Bank

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Where Are We Five Years Later?

• Rapid economic growth is tapering

• Investment continues to lead the way

• Property market is wobbling

• Credit growth is evolving

– Still robust

– Shift towards more opaque finance

• Sectors are being squeezed

– Limited liquidity

– Cost of capital is prohibitive

• Still waiting for economic reform

Source: National Bureau of Statistcs

Chinese GDP Growth

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Capitalism With Chinese Characteristics

• GDP economy

– Upholds stability

– Based on inputs instead of outputs

• Relationships drive business

• ‘Winners’ are selected

– Defend local companies

– Promote national champions

• Changing playing field

– Local partners and joint ventures

– Technology transfers

– Polymorphic rules

• Corporate priorities

– Top-line focus

– Cash costs vs. economic returns

– Know your price, ‘The China Price’

Source: Wikipedia

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Giants On The Landscape

Source: Ministry of Finance, Credit Suisse, HSBC

• State-Owned Enterprises (SOEs) dominate the economy– Total SOE assets represented

183% of GDP in 2013 up from 151% in 2009

– In 2013, total revenues of SOEs ex-financials were 83% of GDP, up from 71% in 2009

• Core Chinese constituency – Party appoints key positions

– Revolving door between senior business and political positions

• Champions in ‘strategic’ sectors– Party picks winners

– Support for major industries

• Corporate goals not always economic

Chinese SOE Net Profit Margin By Sector

Source: HSBC

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The Investment-Driven Economy

Sources: Nomura, Morgan Stanley, UBS, Civil Aviation Administration of China, Global Insight, Reuters

• Long-awaited shift to consumption has not occurred

– Household consumption accounted for 37% of GDP in 2013 compared to 36% in 2009 and 42% in 2003

– Gross fixed capital formation accounted for 47% of GDP in 2013 compared to 46% in 2009 and 39% in 2003

• Calls for stimulus every time a number disappoints

– 25,000 airports built since 2009

– Combined railway and highway fixed asset investment (FAI) increased to RMB 2.7T in 2013 from RMB 1.7T in 2009

– NDRC approved RMB 693B of infrastructure projects between October 16 and November 5, 2014

• Production capacity expansion even with calls for rationalization

– Autos 12% CAGR from 2009 to 2014e

– Cement 9% CAGR from 2009 to 2014e

– Steel 7% CAGR from 2009 to 2014e

Gross Fixed Capital Formation And Household Consumption/China GDP

Source: BNP Paribas

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Stretching The Boundaries Of Investment

• Buildings bloom– Ghost cities and districts

– One skyscraper to be completed every five days in the next decade1

• Vanity projects– Statues and monuments

– International cities and ‘duplitecture’

• Reign of water– As of 2013, China has built 87k dams

– South-North Water Diversion and other megaprojects

– Nearly 60% of China’s underground water is polluted

• Foreign adventures– Rail in Africa

– New Nicaragua canal

– Stake in British high speed rail

– Bid for Mexican high speed rail

Three Gorges Dam

Source: WSJSources: 1) “China making room for 800 skyscrapers in next decade”, Want China Times, September 4, 2013, The Guardian, International Rivers

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China Real Estate: The Bubble Gets Larger

• 2008 China urban housing stock was near the beginning of the danger zone

– 2008 urban housing stock value estimated at RMB 68T

– 2008 GDP was RMB 31T

– Urban housing stock to GDP ratio was 217%

• 2013 China urban housing stock value now in the bubble danger zone

– 2013 urban housing stock value estimated at RMB 141T

– 2013 GDP was RMB 57T

– Urban housing stock to GDP ratio was 248%

• Aggregate real estate value reaching historic proportions

Source: CEIC

Residential Gross Floor Area Under Construction (k sqm)

Source: CEIC

*90 sqm average unit size assumed for estimation of number of homes

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Oversupply Becoming Undeniable

Source: Company filings

• Oversupply in the market place continues to grow

– Top developer inventory balances increased to RMB 267B at the end of 1H14 from RMB 48B at the end of 1H09

– Developers cutting prices to move stale inventory

• At the same time, developers’ total on-balance sheet debt now exceeds total equity

– 1H09 Total Debt: RMB 241B

– 1H09 Total Equity: RMB 260B

– 1H14 Total Debt: RMB 1,015B

– 1H14 Total Equity: RMB 805B

Completed Properties Held For Sale (RMB k)

Source: Company filings

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Unrelenting Credit Growth

Sources: CEIC, South China Morning Post, PBOC, Macquarie, BoA Merrill Lynch

• China has not stopped stimulating over the past five years

• Recognized Total Social Financing (TSF) as of December 2014 comprises 211% of GDP vs. 159% in 2009

• New credit development has averaged 29% of GDP annually over the past five years

• Bank and non-bank lending continue to be elevated

– New bank lending remains elevated with new loans of RMB 10.2T during 2014

– New non-bank lending of RMB 6.2T during 2014, an 86% increase from RMB 3.4T in 2009

• New debt increasingly paying off old debt and financing losses

Total Social Financing As % Of GDP

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Domestic Capital Allocation

• Banks directed to lend

• Political vs. business needs

– Government relationships

– Uneconomic lending

• Facing growing pressure

– Yu’E Bao siphons off deposits

– Non-performing loans (NPLs) as a political decision

• Increasing capital via preference issues

• Insurance companies expanding alternative investments

Annual New Bank Loans (RMB B)

Sources: PBOC, Macquarie, BoA Merrill Lynch

52

Shadow Financing Steps Into The Light

• China’s credit growth is not limited to bank lending

• There is a growing cocktail of credit products

– Wealth management products (WMPs)

– Trust loans

– Entrusted loans

– Trade loans

• SOEs dominate bank borrowing while other businesses scramble for credit

• Once perceived as riskless, there are growing wobbles in the shadow banking sector

• Banks, insurance companies, and SOEs are key buyers

• The systemic interconnection is unknown

Annual New Social Financing

Sources: PBOC, Macquarie, BoA Merrill Lynch

53

The Quiet Credit Crunch

• Lending growth masks underlying reality

• Borrowing is typically short duration– WMPs four to six month maturity– Trusts two year maturity

• High-profile bailouts of trusts and key borrowers

– Unwillingness to take losses– Local governments protect own

interests

• Consistent stories of lack of liquidity across industries

– Macau junkets– Property– Steel

• Preparing for the fallout– Huarong Asset Management Company

(AMC) raising capital and rumored for potential IPO

– New regional AMCs formed

Source: Bloomberg Sources: Wind, BoA Merrill Lynch

Monthly Trust Product Maturities (RMB B)

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A Quest For Foreign Capital

Sources: Bond Radar, Bloomberg, WIND

• Bulls find comfort in huge Forex reserves

• Chinese cash needs continue to grow

• Increasing external financing

– Foreign bond issuance

– Bank borrowing in HK and other markets

– Selected equity issuance

• Drawing in foreign investors

– Qualified Foreign Institutional Investor (QFII) program

– Shanghai-Hong Kong ‘Through Train’

• Proposed Free Trade Zones

Chinese Offshore Corporate Bond Issuance ($B)

Source: BoA Merrill Lynch

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Local Money Exiting

Sources : 1) BoA Merrill Lynch; “net capital outflows” defined as FX reserve change – FDI – trade surplus;2) Global Financial Integrity “Illicit Financial Flows from Developing Countries: 2002 – 2011”; Trading Economics

• Estimated outflow of money

– Chinese net capital outflows at $468B in 2014 vs. net inflows at $69B in 20091

– $3.8T cumulative illicit outflows from 2000 through 20112

• Foreign property demand

– More than marginal buyers

– Dominate sales in key cities including Vancouver, San Francisco and New York

• Chinese swamp foreign passport programs

• Affinity for luxury

– Gambling in Macau and Las Vegas

– Active in art market

– Growing taste for vineyards

Château de Gevrey-Chambertin

Source: Groupe Centre France

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The Macau Microcosm

Sources: Gaming Inspection and Coordination Bureau of Macau, company filings, MS, CLSA

• Outlet for China

– Domestic relief valve

– Avenue for capital flight

• Gaming capacity continues to grow

– 4,770 tables in 2009

– 5,711 tables as of 4Q14

– 7,325 tables forecasted for 2016

• Tipping point arrived on gross gaming revenue (GGR) growth

– VIP GGR growth turned negative in 2Q14

– Mass GGR growth turned negative in 4Q14

• Long term prospects in question both from mainland economy and politically

• Collateral damage of anti-corruption campaign

Macau GGR January 2009 To December 2014

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Recent Backlash: Anti-Corruption Campaign

• Corruption crackdown serves two purposes

– Purge political opponents

– Restore Party legitimacy

• Popular with the masses

• More widespread than expected

– Targeting ‘tigers and flies’

– Finding corruption in all corners

– SOEs being examined

• Selected disclosure

– Targets for a purpose

– Crackdown on popular participation

• Consequences

– Declines in luxury and other sectors

– Corrupt officials becoming more creative

• Fears for reversion after investigation

Source: Bureau National Interprofessionnel Du Cognac

Cognac Bottles Sold In China (M)

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Rise Of The New Paramount Leader

Source: 1) “Why Xi Jinping Is China’s Putin”, The Diplomat, July 15, 2014

• Defender of the Party and China’s national interests

• An unexpected strong leader

– Rapid consolidation of power

– Openly challenging rival factions

– Reaching for social control

• Fortifying leadership

– Chairs key committees

– Replacing senior leaders

• Personal allegiance pledge from People’s Liberation Army (PLA)

• A princeling portrayed as a man of the people

• Xi to Putin: “I feel our personalities are quite similar”1

Source: ZUMAPRESS.com via WSJ

59

Re-Emerging Global Power

• Many in China view the nation’s rise as reasserting its rightful place

• Increasing nationalist foreign policy

– Confronting neighbors

– Redrawing boundaries

• Quest for raw materials expands horizon

– Silk road strategy

– Foreign military bases

• Overt support of key industries

– Protect access to raw materials

– Indigenous technology development

– Price manipulation investigations of foreign companies

• Active financing and building of foreign projects

Source: The Economist

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Projecting And Protecting China’s Interests

Sources: 1) “More than half of Chinese believe China could go to war with Japan: poll”, South China Morning Post, September 10, 2014;Global Security, US Department of Defense

• Rising military spending– Chinese defense budget increased

68% to RMB 808B in 2014 from RMB 480B in 2009

– US defense budget decreased 6% to $649B in 2014 from $694B in 2009

• More active and confrontational military

– Participation in international efforts

– Assertive in its own neighborhood

• Advanced weapons development– Accelerated building programs

– International knockoffs

• Embracing cyberspace– Government hacking

– Corporate espionage

• Poll shows 53% of Chinese and 29% of Japanese can see military confrontation1

Source: Davegranlund.com

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Increasingly Divided Society

• Wealth gap continues to grow

– Elites accumulate wealth and privileges

– Masses feel the Chinese Dream is unattainable

• Urbanization

– Rural vs. urban divide defines opportunities

– Long touted as next growth vehicle

• Tensions are apparent

– Strife in Xinjiang

– Labor demonstrations dismissed as ‘criminal attacks’

• Quality of life concerns

– Healthcare

– Pollution

– Food quality

• Aging will be an issue

– One-child policy limits support for retirees

– Excess labor an asset of the past

Source: ReutersSource: SCMP

62

The Law Makes The Party More Powerful

Source: Quartz

• Internet and media crackdown

– Expansion of real name registration

– Foreign reporter visa restrictions

• Widespread surveillance

• Police has higher budget than military

– 2013 planned police budget of RMB 769B

– 2013 planned military budget of RMB 720B

– Police budget disclosure discontinued in 2014

• Irrational safety rules

• ‘The Party solves all’

Source: Wired

63

Thank You to the

CFA Society of Nashville

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