Paul M. Kitney, PhD BALLINGAL INVESTMENT ADVISORS

paul@ballingal.com +852 2733 1000 (Main) +852 2733 1031 (Direct) +852 6975 8444 (Mobile)

The Animal Spirits Report - Asia Pacific Investment Strategy September 28, 2016

ANIMAL SPIRITS™ REPORT: Greater China View - China “Goldilocks”, HK “Revival” & Taiwan “Bond-Proxy” Investment Conclusions • Our macro baseline scenario is positive on emerging markets (EM) in Q4,

2016. We see improvement in commodities demand-supply balances, a normalization of inflation expectations and a Fed that is prepared to run the US economy "hot" for longer to allow the former to develop. China is our top pick in APAC in the context of our "EM Goldilocks" scenario.

• Animal Spirits prefers to "overweight" China and Hong Kong and is "neutral" on Taiwan, within APAC portfolios.

• iShares MSCI China (ETF) (MCHI US) is an ETF play on the MSCI China index, which is our preferred benchmark for China. In Hong Kong, we like the iShares MSCI Hong Kong ETF (EWH US) as a macro investment vehicle.

• The sectors we are "overweight" include IT, consumer discretionary and financials and "underweight" are utilities, industrials, and consumer staples.

Thematic Focus and Strategist's Top Picks: 1. Consumer Discretionary - Secular transition, policy and wealth effects from

renewed property price rises • e-Commerce - Tencent Holdings Ltd (700 HK) • Telecom - China Unicom Hong Kong Ltd (762 HK) • Gaming and Tourism - Galaxy Entertainment Group Limited (27 HK), Wynn

Macau Ltd (1128 HK) and MGM China Holdings Ltd (2282 HK) 2. Financials, oil prices, and yields - China Life Insurance Co H (2628

HK) and Bank Of China Ltd (H) (3988 HK) Summary of Our Investment Thesis • Valuation Analysis - There is a clear case for China but not so much the A-

shares. There is notionally high value and yield in Taiwan but it lacks catalysts. Beware "bond proxy" equities and "bond proxy" markets, such as Taiwan if bond yields rise, which is our baseline scenario in early 2017. Hong Kong valuation is in line with developed market (DM) peers.

• Earnings Profile - China, Hong Kong, and Taiwan are tracking the global earnings recovery but we see more upside surprises in China and Hong Kong. High earnings volatility in Taiwan explains the apparent valuation discount.

• Economic Policy - a) Chinese policy is very accommodative, b) China NPL problems are not in play for the tactical (3-6 month) view, and c) there are limited policy choices for Hong Kong and Taiwan.

• Macro - The Chinese economy has likely hit bottom in the June Quarter for this cycle - Policy effects are kicking in - Manufacturing pricing power is up due to the RMB trade-weighted basket policy. Taiwan and Hong Kong PMIs are on a recovery path. Hong Kong and Macau tourism are recovering while Taiwanese tourism is suffering from the ill effects of RMB depreciation.

is owned by Paul M. Kitney, PhD, licensed to Ballingal Investment Advisors

and is pending registration.

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GREATER CHINA EQUITY STRATEGY OUTLINE 1. Valuation Analysis 2. Earnings Profile 3. Economic Policy 4. Macroeconomic Drivers 5. Summary of Investment Thesis 6. Investment Conclusions 1. VALUATION ANALYSIS As usual, Animal Spirits starts with valuation as the first element in our country evaluation matrix. This is summarized in Table 5 at the end of this note. Our valuation methodology is outlined in ANIMAL SPIRITS REPORT 2: APAC Valuation and Earnings Snapshot and the matrix-based country evaluation in ANIMAL SPIRITS™ REPORT 3: APAC Country Outlook Summary. Based on our approach, China and Taiwan score well, while Hong Kong earns a passing grade on valuation as an investment criterion. For the purposes of valuation analysis, we separate China for comparison work with appropriate emerging market (EM) peers, while Taiwan and Hong Kong are grouped within a suitable cohort of developed markets (DM). China Valuation - Clear case for China but not so much the A-shares There is a solid valuation argument for Chinese equities versus its APAC EM peer group and it is also attractive compared to global EM, especially when adjusting for margins, returns, and financial leverage. However, there is a premium in the A-shares, which is not justified by underlying company fundamentals in our opinion. • MSCI China ("China") is trading at roughly a 20 percent discount to MSCI

China A ("China A") based on PER, PBR, and EV/EBITDA. Using the same metrics China's discount to APAC peer India is even greater (Table 1).

• China's superior EBIT margins and ROE (and lower net financial leverage) to MSCI World EM, explain the EV/EBITDA premium but the comparable PER and PBR multiples indicate some relative value in China (Table 1).

• China's dividend yields are higher than China A, India and dividend coverage is excellent (Table 1).

• The heat map (upper panel) in Table 2 shows a wider cross-section of EM peer valuation comparison, demonstrating relative value on several measures. When considering the valuation percentiles (lower panel), China is trading cheaply relative to its own history on PBR but not EV/EBITDA.

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Table 1 - Selected China Valuations and Financials with Large Emerging Market Comps Source: MSCI, Bloomberg, Ballingal Research. Note: Data as of 9/23/2016. Note: We included MSCI Asia ex-Japan as a regional benchmark, despite being a blend of EM and DM. Earnings estimates are based on Bloomberg consensus.

Table 2 - Emerging Market Heat maps - Cross-section Multiple Comparison and Valuation Percentiles Source: MSCI, Bloomberg, Ballingal Research. Note: Valuation Multiple data as of 9/23/2016. Valuation Percentiles based on monthly data. Date ranges are from 08/2001 to 08/2016 except for Europe PER (from 03/2005), Hong Kong PER (from 12/2001). Note: Due to the relatively high weighing in VNM, we have used VNINDEX instead of MSCI Vietnam in this analysis, to avoid outlier effects.

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Hong Kong and Taiwan Valuation - Superficial value and yield in Taiwan but lacks catalysts Hong Kong is best characterized as fair-value with potential growth drivers and Taiwan as more of a value and yield play, absent of any meaningful catalysts. • Beware "bond proxy" equities and "bond proxy" markets, such as Taiwan

and Singapore if bond yields rise. Our baseline macroeconomic scenario is that yields will start rising by the end of 2016, ANIMAL SPIRITS REPORT 1: Macro Backdrop - Base Jumping the Fed with Oil and Inflation Expectations. To be sure, Taiwan has a high dividend yield with above average (not as high as Japan or EM) dividend coverage in DM but it lacks earnings growth drivers, so rising bond yields should undermine valuations further (like a bond).

• Taiwan trades at lower valuation multiples than Hong Kong (Table 3) but this is largely explained by a higher volatility of earnings (Figure 3) due to a high dependency on global sectors, in our opinion.

• Hong Kong (see heat maps in Table 4) is, on balance, in line with DM peers and its own valuation history, based on the cross-section comparison and percentile rankings.

Table 3 - Selected Hong Kong and Taiwan Valuations/Financials with Developed Market Comps Source: MSCI, Bloomberg, Ballingal Research. Note: Data as of 9/23/2016. Note: We included MSCI Asia ex-Japan as a regional benchmark, despite being a blend of EM and DM. Note: MSCI World is the Developed Market Index

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Table 4 - Developed Market Heat maps - Cross-section Multiple Comparison and Valuation Percentiles Source: MSCI, Bloomberg, Ballingal Research. Note: Valuation Multiple data as of 9/23/2016. Valuation Percentiles based on monthly data. Date ranges are from 08/2001 to 08/2016 except for Europe PER (from 03/2005), Hong Kong PER (from 12/2001).

2. EARNINGS PROFILE - China, Hong Kong, and Taiwan are tracking the global earnings recovery but we see more upside surprises in China and Hong Kong. • Following a deeper trough in 2016 than China A, China's 15 percent

consensus earnings growth outlook for 2017 takes it back to 2011 growth rates (Figure 1). Based on our baseline macro scenario of inflation re-emerging in Q1 2017, we see upside to the consensus as the risks to growth forecasts have shifted to the upside in our opinion.

• While earnings revisions in China and China A are running behind global emerging markets and India, the momentum has recently improved markedly (Figure 2). The improvement in earnings momentum is related to the combined effects of monetary stimulus, the re-emergence of infrastructure spending as a policy tool and the effective use of foreign exchange intervention. We elaborate on these issues in the coming sections of this note.

• The degree of global cyclicality in the Taiwanese earnings structure is apparent in Figure 3. Lower earnings quality (predictability) counts against the case for valuation multiple expansion.

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• Meanwhile, the momentum of earnings revisions for both Taiwan and Hong Kong are tracking global developed markets (Figure 4). We include Singapore as a regional peer to both Taiwan and Hong Kong and it is clear that the island nation is underperforming in the current earnings recovery we are witnessing globally. Conversely, Animal Spirits sees upside to earnings revisions in Hong Kong based on the postponing of credit tightening in the US, recent increases in inbound tourism numbers and the general improvement in economic activity in China.

Figure 1 - Corporate Earnings Growth History and Forecast (Net Profit) - MSCI China and China A Source: MSCI, Bloomberg, Ballingal Research. Note: Data as of 9/23/2016. Notes: Bloomberg Consensus Estimates

Figure 2 - China and China A Earnings Revisions Versus Regional and Global EM Peers Source : MSCI, Bloomberg, Ballingal Research, Data as of 9/23/2016. Note: Earnings revisions are based on a 3 period moving average of monthly changes in FY 2016 net profit estimates

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Figure 3 - Corporate Earnings Growth History and Forecast (Net Profit) - Hong Kong and Taiwan Source: MSCI, Bloomberg, Ballingal Research. Note: Data as of 9/23/2016. Notes: Bloomberg Consensus Estimates

Figure 4 - Hong Kong and Taiwan Earnings Revisions Versus Regional and Global DM Peers Source : MSCI, Bloomberg, Ballingal Research, Data as of 9/23/2016. Note: Earnings revisions are based on a 3 period moving average of monthly changes in FY 2016 net profit estimates

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3. ECONOMIC POLICY - a) Chinese policy is very accommodative, b) China NPL problems are not in play for the tactical (3-6 month) view, and c) there are limited policy choices for Hong Kong and Taiwan China credit growth and NPLs background - Animal Spirits highlights the need to balance the longer term risks against the tactical opportunity presenting itself in the next 3-6 months One of the more aggressive policy initiatives in China during the Global Financial Crisis (GFC) was the creation of a credit boom (more like an explosion). From the end of 2008 into 2011, bank lending growth (See M1 in Figure 5) accelerated from around 10 percent to over 30 percent. Concurrently, FAI infrastructure spending growth rose from 10 percent to well over 40 percent during the same period, as such spending required easy access to credit. It is unlikely that during the high credit growth period that credit quality screening standards kept pace with the rapid expansion in bank lending. The author’s concern during 2009 was that this was a harbinger for an NPL problem in the future, most likely uncovered if and when the Chinese economy slowed sufficiently. NPL data is delayed and opaque in China and this has a lot to do with the shadow banking system and other practices the regulators will surely target as part of prudential control in the coming years. The official China Banking Regulatory Commission (CBRC) figure for the total banking system NPL ratio is 1.75 percent as of 6/30/2016 (Figure 5). Needless to say, this figure is probably understated. No one knows the precise quantity but the true NPL ratio is probably multiples of the official number. In a "normal" World, prudent macro-prudential policy would be to: 1. own up to full extent of the NPL issue; 2. impose restraint on bank lending via the use of stricter loan to value rules for housing loans; 3. improve credit screening standards and 4. create vehicles such as "bad banks" to use to dispose of bad loans so as to as quickly and efficiently as possible get the financial system back on a healthy footing before re-starting a new credit cycle. We are obviously not living in a "normal" World since there is denial about the extent of the problem, loan to value ratios have actually been relaxed to permit new lending and the issue of dealing with NPLs in China has officially been punted down the road. As shown in Figure 5, M1 is accelerating fast, "Social Financing" is growing sharply and infrastructure spending growth has started accelerating again. Contrary to what should be prudent macro-prudential policy-making, the near-term needs for macro stabilization have won out unanimously. China is creating a new credit cycle before digesting the NPLs from the post-GFC credit expansion. Consequently, there is a systemic financial risk in China that may have outsized negative implications for the economy at "some point in the future". So much for five-year plans under a command economy system, this is prima facie Western short-term pragmatism. These are the longer-term issues. Let's now focus on our tactical view, which is the next 3-6 months ahead.

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Figure 5 - Chinese Credit Growth and NPLs - A Very Important Chart!

Source: National Bureau of Statistics, Bloomberg, China Banking Regulatory Commission and Ballingal Research, Quarterly Data as of 6/30/2016.

Animal Spirits China policy view for our tactical outlook (3-6 Months) • NPL problems surface and cause problems when an economy is either in

recession or at least stagnating. China's growth outlook (see next section) is improving so we do not expect a non-performing loan crisis in the next 6-months at the very least, as we are positive on growth momentum in China and the World Economy.

• Chinese monetary and fiscal policy are unambiguously accommodative.

• China has been surreptitiously targeting a trade-weighted basket of currencies in a politically savvy (by not incurring the ire of the US) foreign exchange policy to improve the trade account, which is working (Figure 6). As shown in the figure below, the BIS CFETS Renminbi has depreciated roughly 1 percent per month since the RMB was including in the IMF SDR basket last November.

• Therefore, China scores well on economic policy drivers in our matrix scorecard (Table 5)

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Figure 6 - Chinese Renminbi Versus BIS Trade Weighted Remimbi Basket Source: BIS, Bloomberg, Ballingal Research, Data as of 9/14/2016. Note: Currency indices have been indexed at 100 from 11/30/2015.

Limited policy choices for Hong Kong and Taiwan • The new Taiwanese government under Tsai Ing-wen released its first budget

in August which included modest fiscal spending of 1.1 percent for 2017, including TW$186.9 billion on public works. The policy focus is fiscal austerity and demonstrates that monetary policy will be the go-to tool for demand management. The net effect of policy drivers is "neutral", in our opinion (Table 5).

• In Hong Kong, we see no change in the conservative macro-prudential controls on housing loan to value ratios and HIBOR will be driven by US Fed policy. Given inflation is running at 4.3 percent (August, Census and Statistics Department, Hong Kong), there is little likelihood of accommodative policy in Hong Kong. However, Hong Kong will surely be a beneficiary of easy monetary and fiscal policy in China, especially since rising Chinese property prices are yielding wealth effects, which should boost consumer discretionary spending, which should spill over to tourism in Hong Kong and Macau and more generically through the trade account.

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4. MACROECONOMIC DRIVERS Chinese economy has likely hit bottom in the June Quarter for this cycle - Policy effects are kicking in - Manufacturing pricing power is up due to RMB trade-weighted basket policy The first observation in Figure 7 is the relationship between the China composite PMI (blue) and the China manufacturing PMI (red). At the release of the second quarter real GDP growth figure in June (6.7 percent, 6/30/2016, Source: National Bureau of Statistics), the manufacturing sector PMI was below 50 and underperforming the broader economy. Note that the last figure for July was 50.0 and the release date for August is September 29 (Source: Markit, Bloomberg). The stronger performance of the non-manufacturing sector, more specifically services, has been a testament to the Chinese policy of transitioning the economy to a more balanced growth profile, reducing the influence of the external environment on activity. Turning to the short-term, since June there has been a meaningful jump in both manufacturing and the composite PMI, which for both indices are at their highest level since Q1 2015. Macro stabilization policy via fiscal and monetary policy (see the previous section) have broadly been responsible, in our opinion. However, for export market focused manufacturers, the improvement in pricing power that has come from the ongoing depreciation (1 percent per month) in the trade-weighted RMB basket (Figure 6) is a key driver for manufacturing sector performance. Importantly, Animal Spirits expects this dynamic to be a positive driver for earnings and near-term earnings revisions. While GDP is a lagging indicator of activity is has likely hit bottom in June for the current cycle. Figure 7 - China, Hong Kong, and Taiwan PMI Indices Source: Bloomberg, Markit, Ballingal Research. Note: Data range is 9/30/2014 to 8/31/2016

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Taiwan and Hong Kong PMIs on a Recovery Path The Greater China industrial cycle is being led by the mainland as shown in the above chart of the respective PMIs (Figure 7). Taiwan and Hong Kong (with a lag) are tracking the Chinese led recovery path. In Taiwan, a meaningful component of the PMI improvement has been electronic exports, which account for around a third of the total, due in a large part to iPhone 7 related component demand. In Hong Kong, the slowdown in the property sector has moderated, exports have normalized to some degree due to the stable USD/HKD and inbound tourism is starting to see something of a recovery. Significantly, Hong Kong is also a beneficiary of the US Fed decision to run the US economy "hot" over the coming months (see ANIMAL SPIRITS REPORT 1: Macro Backdrop - Base Jumping the Fed with Oil and Inflation Expectations), which has given breathing room for the property market and has avoided any adverse terms of trade arising from a stronger USD/HKD. Tourism - Hong Kong and Macau Recovering while Taiwan suffers from RMB depreciation While Taiwanese inbound tourism numbers from the mainland are hamstrung by China-Taiwan political issues and a weak RMB, Chinese outbound tourist numbers to Macau for the June quarter (6/30/2016, Source: China Outbound Tourism Research Institute, Bloomberg) were up 0.9 percent YOY. This follows five quarters of consecutive YOY decline. Similarly, Hong Kong visitor arrivals from China are recovering, as shown in Figure 8. Both Hong Kong and Macau are winners from the secular trend towards promoting domestic demand and in particular a focus on discretionary spending. Near term, both SARs benefit from recent mainland Chinese policy accommodation, that is once again generating higher property prices and associated wealth effects which have positive spin-offs in discretionary spending, which include tourism, gaming, retail and e-commerce. Figure 8 - Hong Kong Visitor Arrivals from China (YOY %) Source: Hong Kong Tourism Board, Bloomberg, Ballingal Research. Note: Data from 7/30/2014 to 7/31/2016

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5. SUMMARY OF INVESTMENT THESIS • Valuation Analysis - There is a clear case for China but not so much the A-

shares. There is notionally high value and yield in Taiwan but it lacks catalysts. Beware "bond proxy" equities and "bond proxy" markets, such as Taiwan (and Singapore) if bond yields rise, which is our baseline scenario in early 2017. Hong Kong valuation is in line with developed market (DM) peers.

• Earnings Profile - China, Hong Kong, and Taiwan are tracking the global earnings recovery but we see more upside surprises in China and Hong Kong. High earnings volatility in Taiwan explains the apparent valuation discount.

• Economic Policy - a) Chinese policy is very accommodative, b) China NPL problems are not in play for the tactical (3-6 month) view, and c) there are limited policy choices for Hong Kong and Taiwan.

• Macro - The Chinese economy has likely hit bottom in the June Quarter for this cycle - Policy effects are kicking in - Manufacturing pricing power is up due to the RMB trade-weighted basket policy. Taiwan and Hong Kong PMIs are on a recovery path. Hong Kong and Macau tourism are recovering while Taiwanese tourism is suffering from the ill effects of RMB depreciation.

6. INVESTMENT CONCLUSIONS Macro, Index, and Sector Views • Our macro baseline scenario is positive on emerging markets (EM) in Q4,

2016. We see improvement in commodities demand-supply balances, a normalization of inflation expectations and a Fed that is prepared to run the US economy "hot" for longer to allow the former to develop. China is our top pick in APAC in the context of our "EM Goldilocks" scenario.

• Animal Spirits prefers to "overweight" China and Hong Kong and is "neutral" on Taiwan, within APAC portfolios.

• iShares MSCI China (ETF) (MCHI US) is an ETF play on the MSCI China index, which is our preferred benchmark for China. In Hong Kong, we like the iShares MSCI Hong Kong ETF (EWH US) as a macro investment vehicle.

• In sectors, we are "overweight" information technology, consumer discretionary and financials and "underweight" utilities, industrials, and consumer staples.

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Thematic Focus and Strategist's Top Picks 1. Consumer Discretionary - The long-term plan for transitioning the Chinese

economy from one dependent on manufacturing to more balanced growth model with a greater emphasis on domestic demand, particularly consumption is well understood and is progressing well. Recent PMI data (Figure 7) show the recent outperformance of the services sector. We have discussed the accommodative policy environment in Section 3 and this is clearly positive for consumption. Related to the recent credit creation seen in Figure 5, is a renewed property price inflation and the associated wealth effects, which are positive for consumer discretionary spending. Therefore, from both a tactical and long-term perspective, Animal Spirits prefers a heavy weighting in portfolios towards consumption.

• e-Commerce - Tencent Holdings Ltd (700 HK) - This is our top internet play. It trades at 39x FY16 earnings (Source: Bloomberg estimates, 9/27/2016), with a 43 percent increase in operating profit (H1 2016 over H1 2015) and a 41 percent operating margin (Source: Tencent, August 2016). This is reasonable valuation in our opinion, given the scalability of the revenue model. Tencent is a winner in the disruption of the PC gaming market by mobile games. It also has the potential for strong advertising revenue growth. These are strong points in the company's favor, in our opinion.

• Telecom - The second consumer discretionary play that we like is China Unicom Hong Kong Ltd (762 HK) . This is a turnaround story. Pricing pressure and high sector-wide CAPEX have compressed margins. However, network sharing with China Telecom is helping reduce CAPEX and the mobile data business is growing with total handset data usage up 102.1 percent (H1 2016 on H1 2015) driven by 4G. (Source: China Unicom, Interim Results, August 2016). It trades at 3.84x EV/EBITA versus China Mobile at 4.76x for FY16 (Source: Bloomberg, 9/27/2016).

• Gaming and Tourism - In Section 4, we mentioned the recovery in mainland tourist visitors to Hong Kong and Macau. In recent years there has been a slump in gaming spend and traffic in Macau, due at least in part to digestion of new capacity. This is still going to take some time to resolve but tactically we see some change of sentiment towards the sector that may make company forecasts in the sector a little too pessimistic. We believe in the long-term potential for Macau as low penetration rates, rising incomes and wealth in China, combined with an innate love for gaming, provide a growth story for the future. Infrastructure projects such as the Hong Kong-Zhuhai-Macau bridge support the longer term story. However, we are very mindful of the capacity supply issue to resolve but are taking a tactically positive view on the sector for the next quarter.

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Galaxy Entertainment Group Limited (27 HK) has long-term potential for development as it has a meaningful amount of its Cotai Strip landbank undeveloped and according to the interim results (August 2016), occupancy at Star World Macau in the second quarter was 97 percent. The shares trade at 23.48x FY17 earnings (Source: Bloomberg, 9/27/2016). Wynn Macau Ltd (1128 HK) and MGM China Holdings Ltd (2282 HK) also fit the thematic profile of Galaxy and are trading at 21.92x and 27.49x FY17 earnings (Source: Bloomberg, 9/27/2016). 2. Financials, oil prices, and yields - Based on our macro baseline scenario (ANIMAL SPIRITS REPORT 1: Macro Backdrop - Base Jumping the Fed with Oil and Inflation Expectations) of rising inflation expectations and bond yields likely during the period of November 2016 to May 2017, coinciding with an oil price base effect we have become more positive on banks globally. This is because our scenario allows for a rise in the slope of the yield curve, which should enhance bank NIMs and the rising bond yields are positive for insurer's embedded values. 'Consequently, in the Chinese insurance sector, we have chosen China Life Insurance Co H (2628 HK) and we like Bank Of China Ltd (H) (3988 HK).

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Table 5 - Animal Spirits APAC Equity Tactical Views (3-6 Months)

Source: Ballingal Research, MSCI, Bloomberg. Note: Benchmark used is MSCI AC Asia Pacific Index. Note on symbols in table: single green (positive view) , double green (very positive view), red (negative view), double red (very negative view), blue (neutral)

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