THE JASPER CAPITAL NEWSLETTER...6.00 6.50 Jan Feb Mar Apr May Jun Jul Aug Sep Oct 10-Year Treasury Volatility vs S&P 500 ... 4According to the IMF, the world economy underwent a contraction

1 The Jasper Capital Newsletter – Published: November 2018

THE JASPER CAPITAL NEWSLETTER

October 2018 China Market Analysis

By Carlo Passeri, Director of Research and Macro Studies

The Global View October was a tough month for many active managers as most equity markets fellglobally.TheS&P500’snetmonthlydeclinewasbestedonly inAugust2015,amidthemarket volatility following China’s transition to a currency basket.While that episodewasasurprisebyanystandard,lastmonth,itseemsthatmarketsfinallystartedtopricetheslowdowninaggregategrowthandthetighteningpathoftheFederalReserve.

The reality that JeromePowell isnot JanetYellenwas finally recognizedas theFOMChikedthefederalfundsrate,steepenedthepath,andraisedthelong-termneutralrate.Intheirstatementandminutes,theCommitteeexplicitlysignaledthattheeconomyishealthyenoughtowarrantfurtherratehikestoneutral.Weagree.Itistruethatinterestrate-sensitivesectorsoftheU.S.economy,suchashousing,havebeenshowingsignsofstresssince thebeginningof theyear.But this isanaturaloccurrence inaworldwithhigherinterestrates.

Sections:

o The Global View o The China Dimension o The Market’s Tea Leaves


Even if the domestic outlook is diminishing somewhat and financial assets linked toemergingmarketsarefalling,thecurrentdomesticdataremaininfavorofratehikes.Ithas been thismarket repricing and subsequent volatility in interest ratemarkets, notthe nominal change in interest rates (they were range-bound in October), that hasdrivenasignificantportionofthedeclineinU.S.equities,whichmanifestedglobally inthedeclineinrisksentimentandtighteningoffinancialconditions.1

To us, the hawkishness of the Fedwas not a surprise as inflation has been hoveringaround 2% (1.9659% core personal consumption expenditure index for the neurotic

1 Naturally, the markets mispricing of the effects of trade are also a significant contributor, not due to margin compression (third quarter earnings were the strongest they have been in a decade according to most) but rather in the effect trade has had on forward earnings guidance.

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“In short, the economy is as near as it has been in a decade to meeting both of the Fed's dual-mandate objectives…With the economy now operating at or close to mandate-consistent levels for inflation and unemployment, the risks that monetary policy must balance are now more symmetric and less skewed to the downside.” – Richard Clarida, Vice Chair, Federal Reserve Board of Governors 2


among us), and labor market data points to ongoing tightness; clear signs that theeconomycontinuestogrowabovecapacity.Thepersistenceoflabormarketresilienceisalsocontinuingtowitnessanimpulseinto“wagegrowth,”thekeyphrasethathasbeenrepeatedadnauseambytheBoardofGovernorsforthelastfewyears.Whythenwouldthisceasetobethecase?2

We fully appreciate that Janet Yellen choosing to delay normalization in September2015mayhavebeeninterpretedasahesitationduetoglobalmarketvolatility.

ButtheFedminutessuggestedotherwise,and, indeedmanyFedwatcherssince,havestatedthattheFedoverwhelminglytendstoraiseratesduetodomesticfactorsratherthaninternationalconcerns.3

We would also contend that the pause in September 2015 was more attributed toconcernsrelatedtothemoveinthedollarandtheeffectitwashavingonthedomesticeconomy rather than the volatility that was permeating internationalmarkets, whichwasalsoattributedtothemassivemoveinthebroaddollaranditseffectonthepathofprices.43

Similarly,thesurprisingcompressionoftheU.S.-Chinarealgrowthratedifferentialsincethe second quarter, ongoing tightening bias in the U.S., and interest rate spreadbetween the two largest economies (with the U.S. anchoringmuch of theworld andChinaanchoringemergingmarkets)begot, inouropinion, the latest leg in thedollar’sappreciationtrend(9.7%sinceApril).

Globalequitieshavefollowed,astheyalwaysdo,andthisfundamentalcorrelationalsoexplains a significant amount of the underperformance of Chinese equities and oursystematiclong-onlystrategiessofarthisyear.

Naturally,domesticmattersarealsosignificantcontributors.Tothatend,thedollaralsohasanunfavorableeffectonglobalmanufacturing,whichaddstothedomestictroublesinChina.

2 https://www.federalreserve.gov/newsevents/speech/clarida20181025a.htm 3 https://www.federalreserve.gov/newsevents/pressreleases/monetary20150917a.htm 4 According to the IMF, the world economy underwent a contraction in 2015 in dollar-terms. One cannot ignore the effects a strong dollar has on trade, activity, and margins. Haver code: A001NGPD

“Participants indicated that they did not see the changes in asset prices during the intermeeting period as bearing significantly on their policy choice except insofar as they affected the outlook for achieving the Committee's macroeconomic objectives and the risks associated with that outlook.” 3


Finally, to say that the trade war is not a factor would be incorrect, but the exactmechanismishardtodecipheratthispointintime.Sentimentisdefinitelyatthetopofour list of explanations as to why external sector weakness is passing-through toservicesandotherdomestically-orientedenterprisesinvariouscountries,particularlyinChina and Germany (who share similar economic models). The anecdotal evidencecertainlypointstothisphenomenon.

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“Concerns associated with developments in China and other emerging market economies had contributed to a further appreciation of the dollar and declines in prices of oil and other commodities, which were likely to hold down U.S. consumer price inflation in the near term. Some participants were concerned that the downside risks to inflation could be realized if the target range for the federal funds rate was increased before it was clear that economic growth would remain at an above-trend pace and downward pressures on inflation had abated.” 3

“Flash PMI survey data indicated that the eurozone economy grew at the slowest rate for over two years in October as an export-led slowdown continued to broaden-out to the service sector.”

– IHS Markit

2016 2017 2018


Whatisclear,however,isthatthereisagrowingdividebetweensentimenttowardsthecurrentsituationandexpectationsforeconomicgrowth(asdemonstrated inthechartbelow) anchored, at least anecdotally, by the issueof tariffs.Notably, this divergencetendstohappenbeforeinflectionpointsintheglobaleconomyandmarkets.

The China Dimension The story of the Chinese economy has largely occurred in-linewith our expectations.Aggregategrowthcontinuestoslow,investmentisstabilizingbutstilldecelerating,andindustrialprofitsareslowing.Yet,authoritiesareverymuchinclinedtoallowthepathtocontinue.Albeit,thereismarginalsupporttoensurethattheslideisnotuncontrolled.Afterall,Chineseauthoritieshavealwayscravedorderaboveallelse.So,ifthereistobeaslowdown,letitbeorderly.

Arguably,thisshouldhavehappenedyearsago.Betterlatethannever,wereckon.

If necessity is themother of innovation, then this new reality in the economy iswhypolicysupporthasbecomemuchmoresophisticated.Authoritiesarefunnelingsupportto the sectors of the economy thatwill yield the greatest results. This instills in us aprofoundsenseofbullishnessontheChineseeconomyandmarket.Wetaketheviewthat,giventhespeechesandactionsoverthelast18months,authoritiesrealizeinordertoachievelong-termstabilityandprosperitytheeconomymustfindanewequilibriumlevel, and thisnecessarilymeans removingdistortionsand letting the chips fallwheretheymay.Inthiscontext,thetradewarisbothagiftandacurse.

We refresh one of our favorite charts that illustrates why this strategy of focusedsupportshouldprovetobefruitfulinbufferingthedecelerationgoingforward.

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DM Optimism Divergence Current Situation vs Outlook

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*Average of Zew economic sentiment survey scores for eurozone & Germany, Japan Economy Wathcers survey, and U.S. NFIB


Consumption expenditure growth from rural households has eclipsed that of urbanhouseholdsinrecentyears,andmostnotablyhasacceleratedatamuchfasterratethanthenationalaveragesincethestartoftheyear.

Inourview,vitaltothishasbeentheshantytownredevelopmentprogram5inthirdandfourthtiercities.Authoritiesunderstandthatmegacities,suchasShanghaiandBeijing,have become, well…mega, thus the opportunity set continues to diminish for ruralmigrantsasthesecitiesmoveupthevaluechain.

WhileBeijing,Shanghai,Tianjin,Chongqing,Hangzhou,andGuangzhouare the largestcities economically and in population density in the country, the majority of thepopulationisstillspreadacrossthirdandfourthtiercities,eventhoughtheyaccountforless in GDP-terms. This leaves ample room for improvement, and thus compels thebullishcaseforservicesandconsumptionasthesesegmentsofthepopulationenhancetheirearningpotential.

Thedevelopmentofopportunityandadvancementofregionaleconomiesisneededforamoreequaldistributionofprosperityandtoensuresocialstability.Thedescent intobitterpoliticalpolarization intheWestdueto inequality isnot lostonpolicyplanners.Wealsobelieveauthoritiesunderstandandappreciate thenatureofwealtheffects inChina,and that theyare intimately tied topropertyownership. It isnowonder, then,thataspropertypricesinthirdandfourthtiercitiesremainedmoreresilientthanthoseoffirsttiercitiesthisyear(byadministrativedecree),ruralhouseholdexpendituresrosein tandemwith disposable income attributed to property income. This is positive forconsumption, the penetration of goods into rural markets, and the proliferation ofservicesinthirdandfourcities.

5 “China has invested more than $170 billion for urban developed this year.” Reuters https://www.reuters.com/article/us-china-economy-property/china-puts-173-billion-into-shanty-town-redevelopment-in-jan-aug-ministry-idUSKCN1LX0TI

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Thesearealltrendsestablishedearlierintheyearandcontinuetoholdtrue,alongwithfurther monetary support for private sector enterprises via targeted reserverequirementratiocuts,officialcollateralsupportforunderwritingdebtofprivatesectorcompanies,andpreferentialwindowratesforbankslendingtoprivatecompanies.

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China Property Prices Δ 6-month

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But what wasmost illuminating and positive in October was finally receiving the fullweightofsupportfromtheverytop—PresidentXiJinping.6,7

Whydowethinkthisisimportant?

Up until this point, it was government reformers—Li Keqiang—that had beenattempting topush formoreprivate sector supportwhile PresidentXimaintainedhissupport for China’s old industrialmodel, touringnorthernChinese cities and factorieslargely avoiding the bastions of private enterprise in southern China. Fast-forward toOctober, after months of private sector stagnation and constraint due to the lack ofcreditavailabilityandplaguedbyuncertainty,

PresidentXiisnowspeakinginsupportofprivateenterprises.Hallelujah!Itwouldthenbeareasonableexpectationthattherestoftheapparatusshouldfollow.Andsofar ithas.

TheStateAdministrationofMarketRegulation8andtheSupremePeople’sCourt9issuedtheirdecreesinsupportofPresidentXi’s initiativetosupportprivateenterprises.EvenYiGang,governorofthePeople’sBankofChina,recentlystatedthateffortstodirectlystimulatetheprivatesectorhavebeenlessthanefficient,butthatadjustmentsareonthe way. This is confidence-inspiring for a brighter future, even though we humblyacknowledgethattherewillbepain intheshort-term.Thismuchwehaveseen inourperformance inOctober,amonthwheredomesticand international factorsconspiredagainstus.Butwearestarting toseeevidence thatdomestic investorsarestarting toseethelightattheendofthetunnel,whichiscriticalfortheexpansionofalphacaptureintheonshoremarket.10

The Market’s Tea Leaves Octoberwas a toughmonth for equity investors theworld over. The largest peak totroughdrawdown(-11.4%)inU.S.equityhistoryafterthecollapseinLehmanBrothers(-15%)affectedequitymarketsglobally.TheeffectsweremagnifiedinChina(-11.7%peakto trough) as the headwinds of earnings misses from key players, ongoing domesticslowdown, risingdefaults, tightening financial conditions, and deteriorating sentimentallconsumedlocalinvestorsthroughoutthemonth.

Much to the chagrin of local brokers and investors, the national government did notstep-inastheydidin2015.Instead,nationalauthoritiesattemptedtojawbonemarketsby trying to reinforce confidence and focus on the long-term value proposition thatChineseequitiesofferatcurrentlevels.Notably,authoritieshaveusedtheopportunityto consider removing restriction instead of enhancing them, as they did in previousmarket routs. This is another long-term bullish signal, albeit with short-term pain. Assystematiclong-onlyinvestors,thesearedetailswecarefullywatch.

Somesupportdidspringforthfromlocalauthoritiesandbrokerswhoidentifiedacausefor the sustained momentum behind selling pressures throughout the month—share

6 http://www.xinhuanet.com/english/2018-11/02/c_137577380.htm 7 https://www.caixinglobal.com/2018-11-02/president-xi-again-voices-support-for-private-sector-101341782.html8 http://paper.people.com.cn/rmrb/html/2018-11/06/nw.D110000renmrb_20181106_7-04.htm?mc_cid=dfedbca7eb&mc_eid=94579128cd 9 https://www.caixinglobal.com/2018-11-06/top-court-vows-to-better-safeguard-private-enterprises-101343158.html 10Jasper Capital will soon be releasing our empirical study on the onshore microstructure and critical factors to alpha generation.

“The purpose of today’s meeting is to pool our collective wisdom, buttress our confidence, and work together for a common purpose in order to maintain and strengthen our country’s private sector.”

– President Xi Jinping 6, 7


pledges. For context, share pledges are loans collateralized by equity holdings,whicharebynomeansanovelfeatoffinancialengineering.Itisjustthat,likeeverythingelseinChina,thevelocityofproliferationandultimatemagnitudewereimmense.

AccordingtoBloomberg,sharepledgesreachedmorethan$600billionandconstitutedtheequivalentof11%ofthetotalmarketcapitalizationoftheChineseequitymarketattheirpeakearlier thisyear.Further,Bloomberg reports that144companieshadmorethanhalfofsharespledgedascollateral.11Assumingatraditional50%haircutforusingequitiesascollateralinsecurities-basedlending,thismeansoutstandingloanshoveredaround$300billion.Localgovernmentsprovidedcollateralsupportforcompanieswithshares pledged as banks sold this collateral tominimize losses on loan books, whichcontinuetomountanywaysduetorisingdefaults.HaidianinBeijingpledged$1.4billionanda consortiumof11brokers contributed$3billion,12which is1.0%of thenotionaland,hence,tantamounttoasymbolicgesture.

Thedeclineinonshoreequitymarketsthisyearhadmanynervousduetothesizeofthesharepledgemarket, fearing theonsetofaviciouscycleofmarketdeclines (linked tobroaderfundamentalandtechnicalfactors)beingcompoundedbyliquidationsofsharepledge collateral. As with any collateralized lending, when the value of the collateraldeclines by a pre-defined amount, either more collateral has to be pledged or loanshave to be repaid. If neither of these occurs, then the lendermust liquidate existingcollateral. Thisdynamic is the reasonwhy Jasper implementeda signal that filters forcompanieswithsharespledged.

Themonthalsohadmore fundamentaldrivers in thedispersionof returns,aswell asthe performance of our funds,with the impulse originating in earnings surprises. ThetopsurpriseformanywastheunderperformanceofKweichowMoutai,China’s largestbeveragecompanyandtheworld’slargestliquorcompany.Theinitialshockofameager3.2%growth inrevenues inthethirdquarterhadmanytrigger-happycolumnists(whoalso tend to be the most uninformed) saying that this was a critical sign of slowingChinese consumer demand. However, their main competitors—Wuliangye andLuzhou—maintained revenue growth of 20% or more, suggesting that the slowdownwasanisolatedevent,andnotindicativeofthehealthoftheconsumer.

Ultimately, itwas attributed to central government pressures to reduce liquor prices.Hence,thestateoftheconsumerisfine,butMaotai,asastate-ownedenterprise,willsufferfromexogenous(read:Administrative)forces.Thestateoftheconsumerwasalsoproven by the likes ofHermes andAdidas showing still strong revenue growth in theChinesemarket,whichpointstohealthymiddle-andhigh-endluxury-markets.

Still,asthe largestof thebunch,Maotai’s fatedictatedthatof itspeers.Sotheentiresubsectorunderperformedoverthemonth(chartbelow).Itisalsocrucialtounderstandthat these companies are components to consumer-facing super sectors, whichwerethelargestprincipalcomponentsofourperformancelastmonth.

Separately, financial services did extraordinarily well—despite all the fundamentalheadwindsintheeconomy,morestringentregulation,andincreasesinnon-performingloans. As with Maotai, the fact that state-owned enterprises—ICBC, Bank of China,

11 NSN PGTNAK6JIJUP <GO> 12 NSN PH1RXL6KLVRL <GO>

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The Jasper Capital Newsletter – Published: November 2018

China Construction Bank, and Agricultural Bank of China—handily beat expectationsmeans that the groups outperformed as well. Both of these fundamentals were alsoreflectedinthedispersionofreturnsacrossequityfactors(bottomchart),mostnotablyearningsyieldandbeta,whichareclassicsignsthatearningsplayedasignificantroleindefiningreturnsforthemonth.

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As we have stated since the summer, we expect the slowdown to continue and forauthorities tomaintain their stanceof controlling thedecent.And thisobfuscates thepowerful forces at work that are generating the next leg of economic growth andmarket return, which we maintain is the story of the Chinese consumer and theevolutionofservices.Almosteveryeconomicpolicythathasbeenannouncedthisyearhasbeendonetoadvancetheconsumer-facingsectorsandservices,whichnecessitatesfunneling capital to private enterprises. These fundamentals are becoming moredivorcedfromprices.Webelievethesesteepdeclinesintheonshoremarketrelativetolong-term potential have not been lost on institutional investors, as they have beenincreasingexposuretoA-sharesthroughoutthelastseveralweeks.

Domestic investors, not captured in the above EPFR flows, were also seen turning acornerintheirsentimenttowardsequities,startingaroundthemiddleofthemonthandaccelerating into November. We proxy domestic retail investor flows by theperformance of small-cap indices, such as the CSI 1000, as retail investors tend togravitatetowardsvolatilestockswithagreaterpotentialofhavingwildswings—totheupsideistheirhope.Weparticularlyfocusontheperformanceofsmallcapsrelativetolargecaps,wheredomesticinstitutionalinvestorstendtofocustheircapital.ThisdroveJasperCapital’sαShares500strategytodeliver205basispointsinalphalastmonthandouronshorelong-onlysmallcapportfolioalsooutperformed,providinguswithanothersignalthatdomesticsentimentmaybestartingtoshift.

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Contact Information:

Carlo Passeri Director of Research and Macro Studies Email: [email protected]

Tel: +86 185-8840-2440

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Documents

THE JASPER CAPITAL NEWSLETTER...6.00 6.50 Jan Feb Mar Apr May Jun Jul Aug Sep Oct 10-Year Treasury Volatility vs S&P 500 ... 4According to the IMF, the world economy underwent a contraction