Perspectives on China Economy and Markets

Dr. HUANG Haizhou

With input from CICC Macro and Strategy Team January 2014 SFC CE Ref: AMU474 SAC License No. S0080613050003

Major markets have bottomed out after significant changes

270 250 230 210 190 170 150 130 110 90 70 Mar-09 US Europe Japan China?

Sep-13 Sep-09 Mar-10 Sep-10 Nikkei 225 Mar-11 S&P 500 Source: Bloomberg, CICC Research Sep-11 Mar-12 SHCOMP Sep-12 DAX Index Mar-13 1

Global environment is becoming more supportive: global synchronized recovery in 2014?

1,800 5,950 1,600 4,950 1,400 3,950 2,950 1,200 ？ 1,000 1,950 800 950 Oct-01 Oct-02 Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 SHCOMP Index Oct-08 Oct-09 S&P 500 Oct-10 Oct-11 Oct-12 Source: Wind, CICC Research 600 2

Investors have downgraded expectations for the Chinese economy

SHCOMP Index and consensus GDP growth

8.0

7.5

7.0

9.5

9.0

8.5

11.0

(Consensus GDP growth ， %) 10.5

10.0

2008 2009 2010 2011 2012 2013 2014

4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 2008 2009 2010 2011 Source: Wind, Bloomberg, CICC Research 2012 2013 2014 SHCOMP Index (RHS) 3

We see upside risks to Chinese economy

SHCOMP Index and China's GDP growth

3,500 3,300 3,100 2,900 2,700 2,500 2,300 2,100 1,900 1,700 13 12 11 10 9 8 7 6 1,500 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 2008: -65.4% 2009: 80.0% 2010: -14.3% 2011: -21.7% SHCOMP Index (LHS) GDP:QoQ 3 Q 4Q 1Q 2Q 3Q 2012:3.17% YTD:-4.9% 5 Source: Wind, CICC Research 4

China: GDP growth

GDP QoQ

8.1

7.6

7.4

7.8

7.7

7.5

GDP YoY

% 10 7.8

7.4

© CICC Macro

8.0

7.8

7.5

9 7.3

8 7 6 6.7

6.9

7.8

9.4

6.7

6.3

8.9

8.0

7.7

7.5

7.0

7.0

1Q 2Q 3Q 2012: 7.7% 4Q 1Q 2Q 3Q 2013E: 7.6% 4Q 1Q 2Q 3Q 2014E: 7.6% 4Q 5 Source: CEIC, CICC Research 5

China economy: Supply is not the main bottleneck

GDP YoY PPI YoY

2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: CEIC, CICC Research % 20 15 10 5 0 -5 -10

Real interest rates diverge for different sectors

Real interest rate

Consumers Corporations Property investors % 10 8 6 4 2 0 -2 -4 -6 Source: CEIC, CICC Research * as of Nov 2013

RMB appreciation amplifies negative effects of structural problems on the economy

40 %

YoY

2010=100 120

REER (RHS)

30 115 110 20 10 105 100 0 -10 -20 2005 2006 2007 2008 2009 2010 2011 2012 2013 95 90 85 80 Source: CEIC, CICC Research

Stabilization in growth



Factors supporting aggregate demand

–

Fiscal expansion

–

Targeted credit policy

–

Property market warms up



Economic growth to stabilize at around 7.5%

–

7.6% for 2013, 7.6% for 2014

–

Upside risks



Inflation to remain mild

–

CPI

：

2.7% for 2013, 3.1% for 2014

Priorities in structural reforms



Opening up: China (Shanghai) Free Trade Zone



Reduce monopoly and promote competition



Tax and fiscal reforms



Interest rate liberalization and opening of the capital account



New urbanization and land reform



Relax family planning policy

A-share Strategy: key points

    

A-share market likely to deliver 20% annual return in 2014.

Macro:

2014 will be different from previous years as: – – – Investors have downgraded expectations for the Chinese economy; A new round of reforms is likely to improve economic potential, balance and quality; and The synchronized recovery of major global economies is likely to last into 2014, boding well for the Chinese economy.

Earnings:

we expect A-share earnings to grow 15.2% 2014 ( top-down);

Valuation & Liquidity:

CSI300 valuation at historical low in terms of PE/PB, Small mid caps’ valuation at historical high; growth recovery has supported some moderate valuation expansion in large cap index. Real reforms will arouse revaluation of China.

Sectors:

We suggested buying three types of sectors towards the end of 2013: 1) Real estate, building materials and steel; 2) Mass consumer goods such as home appliances, foods and beverages; 3) Securities firms and insurance companies; Investors should also keep a close eye on the rail, shipping, airline, healthcare and media sectors. Meanwhile, we remain bearish on base materials (e.g. coal and non-ferrous metals) and sectors with stretched valuations and a gloomy outlook (e.g. electronic components). 11

2014E top-down earnings should grow by 15.2% Earnings forecast:

2012 1~3Q13 2013E 2014E

Top-down: Non-financials Revenue growth Net margin Earning growth Financials Overall Bottom-up for CSI300 Index Non-financials Financials Overall

7.9

4.16

-11.8

13.7

0.8

Consensus

9.6

4.39

13.3

16.5

15.1

10.7

4.36

12.0

15.0

13.7

CICC

12.8

4.50

18.0

13.0

15.2

2013E

12.9

14.7

14.0

Source: Wind, CICC Research

2014E

16.4

11.8

13.6

2013E

13.0

15.4

14.5

2014E

13.5

13.1

13.2

12

CSI300 valuation at historical low

50 45 40 35 10 5 0 30 25 20 15 CSI 300 Source: Wind, CICC Research CSI 500 SME GEM 13

Sector allocation: We suggested buying three types of sectors

Macro Sector Earnings Valuation Sector Weighting Sector Score Technical

Real Estate Securities Insurance Home Appliances Food & Beverages Construction materials Steel Environmental services Auto & Parts Apparel & Textiles Railway & Toll roads Ports & Shipping Health Care Airports & Airlines Retail Agriculture Banks Power Media & Internet Tech Equipments Construction & Engineering Travel & Hotel & Restaurant Information Services Oil & Gas Electrical equipments Machinery Chemicals Light Manufacturing Electronic Components Coal Non-ferrous metals Neutral Neutral Neutral Neutral Neutral Neutral UW UW UW UW OW OW OW OW OW OW OW Neutral Neutral Neutral Neutral Neutral Neutral Neutral Neutral Neutral Neutral Neutral Neutral Neutral Neutral

2 2 2 2 2 1 1 1 1 1 3 3 3 3 3 3 2 5 5 4 5 5 4 4 5 4 4 4 4 3 2

3 3 3 3 3 4 4 4 4 4 3 3 4 4 4 3 3 4 3 4 3 4 3 3 3 3 3 4 3 4 3 4 3 4 4 4 3 4 4 4 3 3 3 5 1 3 3 2 2 4 1 1 2 3 3 1 2 5 3 3 4 3 3 4 1 1 4 3 4 3 2 5 2 2 2 5 1 3 4 1 1 1 2 5 1 5 1 3 2 4 5 5 3 5 4 4 2 3 4 3 4 4 3 3 3 4 1 2 3 2 1 2 1 1 3 3 4 1 1 4 5 5 5 3 4 4 3 2 5 3 3 4 4 5 2 3 3 1 3 3 1 1 2 1 1 2 4 3 4 1 2 4 4 5 3 3 2 5 5 5 2 2 4 5 4 3 2 2 2 2 1 1 4 1 1 1 2 3 2 5 5 5 1 4 5 5 5 4 3 3 4 3 4 3 3 3 4 2 4 1 4 1 4 5 5 1 1 1 2 4 2 5 5 2 4 3 4 5 3 2 3 2 3 3 1 5 3 3 5 3 1 5 1 1 4 4 2 2 4 1 4 2 4 5 3 1 3 2 4 5 3 2 5 3 5 3 1 3 2 2 2 4 1 1 1 2 1 2 1 5 4 1 5 5 4 2 3 5 5 4 3 4 3 2 3 3 4 5 3 3 2 2 5 1 2 1 2 1 2 1 1 5 3 5 3 2 3 5 3 4 5 4 3 4 4 4 3 4 1 3 5 3 2 4 2 2 1 1 2 3 1 4 3 3 5 5 1 1 4 2 3 4 5 4 5 2 4 5 3 3 1 5 2 1 4 3 2 3 1 3 4 2 4 2 2 5 5 1 1 4 2 5 3 5 4 5 1 3 4 3 3 1 5 2 3 4 1 1 1 1 2 3 1 4 4 3 5 4 1 3 3 2 2 5 4 2 5 3 5 5 4 3 2 5 5 4 4 3 3 1 5 2 2 1 3 2 2 3 4 1 1 3 2 1 5 4 5 4 2 4 5 3 3 1 5 5 3 3 2 3 3 2 1 3 4 3 5 5 3 1 1 1 5 3 3 3 5 4 4 1 4 5 2 2 5 3 5 3 3 3 3 3 3 1 3 3 3 5 5 3 1 1 1 5 3 3 5 5 4 4 1 5 5 3 3 5 3 3 4 3 3 3 3 3 3 3 3 3 4 3 3 3 4 3 3 3 3 2 4 3 3 3 3 3 3 3 3 3 14

Key themes: #1 The potential reversal of the deep cyclical sectors

Industries Steel Construction materials

Tightened capacity control improves demand-supply balance in southern and eastern China. Steady bottom line growth and reduced downside risks help raise long-term valuation.

Non-ferrous metals Machinery Airlines & airports Possibility and reason of turnaround

Baoshan Iron and Steel sold loss-making assets in 2012. Its full-year net profit (excluding nonrecurring items) is likely to grow YoY. Steel industry valuation is cheap and stockholding by mutual funds is low.

To solve the serious overcapacity problem in aluminum industry, the government will strictly control new projects, shut down technologically obsolete plants and encourage M&As and restructuring.

The high speed rail sector has turned around. Shipping and marine engineering will likely rebound from the bottom. Having declined for two consecutive years, global shipbuilding orders tend to rebounded significantly in 2013. The new shipbuilding orders over January September rose 98.8% YoY. Given the strong purchase intention in shipbuilding, we expect the recovery in order volume to continue over the next 6-12 months at least.

1) Supply growth in 2014 is likely to be slower than that in 2013. The industry does not face additional challenge from high speed railway. 2) Continued QE relieves the downward pressure on renminbi and oil price is unlikely to rise in the future. 3) Valuation is at historical low and gloomy outlook has been priced in.

Stocks

Baoshan Iron & Steel Co.,Ltd.

Angang Steel Company Limited Tangshan Jidong Cement Co.,Ltd.

Anhui Conch Cement Company Limited Aluminum Corporation of China Limited Guangzhou Shipyard International Company Limited China CSSC Holdings Limited China Eastern Airlines Corporation Limited Air China Limited China Southern Airlines Company Limited

Shipping

1) Coastal coal and international oil freight rates increased recently; 2) Capacity utilization rates in dry bulk and tanker markets will reach inflection points in 2014, and BDI has found effective support at 1500 points. Most shipping companies will likely turn profitable in 2014.

3) Sector valuation is at historical low; 4) Whether capacity utilization rate in the container market will reach an inflection point in 2014 depends on whether demand exceeds supply.

China Shipping Development Company Limited China Shipping Container Lines Company Limited

Railway

Freight rates reform is imminent. An increase of Rmb0.015~0.025 in freight rate in 2014 implies EPS of Rmb1.13~1.37 for Daqin Railway.

Source: Wind, CICC Research * As of Nov. 8 th Daqin Railway Co., Ltd.

Valuation PE (2013) PB (2013E)

10.27

0.61

20.90

41.52

9.45

0.46

0.93

1.53

n.a.

n.a.

263.89

12.56

11.92

14.47

n.a.

n.a.

8.59

1.30

1.15

1.49

1.84

1.34

1.13

0.94

0.78

0.64

15

Key themes: #2 SOE Reforms Six major issues mentioned in Xi’s Wuhan speech in July

6) Improve the party's leadership and governance capabilities; play overview coordinating role 1) Accelerate the formation of a unified, open, competitive and orderly market system 2) Enhance the public sector's economic development: encourage, support and guide the private sector's economic development

The four key aspects of SOE reforms

•Refocus resources to key areas and refrain from others

Business focus Incentive and discipline

• Change targets, enhance efficiency, dispose of non-core assets, establish incentive schemes & diversify ownership structure Comprehensive reforms require in-depth investigation of six issues 5) Achieve social fairness and justice; safeguard people's rights 4) Enhance social development; promote social harmony and stability 3) Improve macroeconomic regulation; improve the efficiency and effectiveness of government •Make full use of domestic and international markets to utilize excessive capacity and to build world-class brands

Global vision More competition

• Administrative monopoly to be reduced, and SOEs to face more competition from private businesses Source: Wind, CICC Research 16

Key themes: #3 M&As

China USA Deal value/GDP 12% 10% 8% 6% 4% 2% 0% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 USD bn 180 160 140 120 100 80 Traditional industries Emerging industries Financials 60 40 20 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Wind, CICC Research 17

Million 700 600 500 400 300 200 100 0

Key themes: #4 Wireless Internet Applications

China Internet Users Mobile Internet Users Rmb bn 1,400 1,200 1,000 800 600 400 200 0 Market size: Online shopping Network utilization rate:online shopping (RHS) 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% Source: Wind, CICC Research 18

H-share Strategy: key points

     

~20% H-share upside in 2014

The H-share market has lost 2% YTD, lagging behind global peers. We expect the HSCEI to rise ~20% to 12,500 by end-2014, with a ~13% contribution from earnings revisions and a ~7% boost from valuation expanding to 9.5x 12-month forward P/E

Macro: Reforms to improve growth quality

We believe domestic growth will stabilize and downside risk is relatively limited. Our economists expect GDP growth is 7.6% in 2014, with a higher contribution from consumption . The expediting of reforms would enhance growth quality and raise medium- to longer-term growth potential

Earnings: Growth recovery to extend

We forecast H-share earnings to grow 14% in 2013 and accelerate to 15% in 2014. Non-financial earnings could grow 16% in 2014 thanks to higher top-line and a small expansion in profit margin; and financials are to deliver ~13% growth.

Valuation: ERP normalization to re-rate market

Current valuations of appear subdued relative to the historical range and global peers. We expect stabilizing domestic growth, mounting reform dividends and potential global tailwinds to help reduce H-share equity risk premium and prompt a moderate valuation expansion.

Implementation: Sector preference and top-picks

Focus on growth visibility and reform beneficiaries, and overweight select financials (real estate and brokers), select infrastructure (construction and city utilities), and select consumption (internet/software, healthcare, auto and home appliance); underweight telecom, coal, retail, apparel/textile and power. Continue to recommend our thematic baskets of new urbanization and environmental protection.

Risks

For China, we watch financial system risks, cyclical growth momentum, reform execution etc.; from overseas, key issues include US fiscal impasse and Fed’s policy.

19

  

2014 earnings to grow 15% on higher sales and profit margin

Non-financial and financials earnings would growth 16% and 13% in 2014 respectively Non-financial top-line sales growth to expand thanks to higher 2014 nominal GDP growth estimated by our economists Two drivers to potentially nudge-up non-financials profit margins in 2014: 1) subdued domestic commodity prices and a more valuable Rmb; and 2) better operating efficiency We are looking for 15% earnings growth in 2014, thanks to ~16% growth in non-financials and ~13% growth for financial companies

CICC Top-down Forecast vs. Consensus Sales Growth Net Margin Net Income Growth Net Income Consensus Revision from Now

2011A Non-finan.

Financials

H-share

2012A Non-finan.

Financials

H-share

2013E Non-finan.

Financials

H-share

2014E Non-finan.

Financials

H-share

27% 11% 10% 11% 7.2% 5.9% 6.1% 6.4% Source: Bloomberg, FactSet, MSCI, CICC Strategy Research 8% 28%

16%

-9% 15%

1%

13% 15% 14% 16% 13% 15% 15% 16% 14% 15% 9% 11% -1% -1% -0% 1% 4% 3%

  

ERP reduction to unlock value and induce valuation normalization

Improving cyclical momentum and mounting reform dividends, as well as a potential global ERP reduction, to somewhat alleviate concerns about medium-/long-term growth We expect ERP to narrow 0.5ppt from the current 7% to 6.5% by end-2014 Based on our 3 stage DDM and assuming China’s 10-year government bond yield is 4.3% at end-2014, the corresponding end-2014 target 12-month forward P/E is ~9.5x, implying a 7% expansion MSCI China has returned 20.5% since June 25, with a forward P/E expansion of 16.8% and forward EPS upgrade of 3.3% We estimate 9~12x as the fair range for H-shares based on our 3-stage DDM (Rebased) 140 130 120 12m forward EPS (RHS)

2013/1/4 2012/9/5 Change MSCI China 65.4

51.6

26.8% 12m fwd P/E 10.4x

8.5x

23.2% 12m fwd EPS (HK$) 6.28

6.10

3.0%

12m forward P/E

2013/11/6 MSCI China 61.8

MSCI China

12m fwd P/E 8.9x

12m fwd EPS (HK$) 6.95

(HK$) 7.5

2013/6/25 Change 51.3

20.5% 7.6x

16.8% 6.73

3.3%

7.2

6.9

110 6.6

100

2013/6/25 2013/1/4 Change MSCI China 51.3

65.4

-21.6% 12m fwd P/E 7.6x

10.4x

-26.8% 12m fwd EPS (HK$) 6.73

6.28

7.2%

6.3

90 Apr-12 Jun-12 Aug-12 Sep-12 Nov-12 Jan-13 Feb-13 Apr-13 Jun-13 Jul-13 Sep-13 Nov-13 6.0

Source: Bloomberg, FactSet, MSCI, CICC Strategy Research Cost of equity sensitivity based on our MSCI China 3-stage DDM 18 16 14 12 10 9~12x the fair forward P/E range 8 6 8.0% 8.5% 9.0% 9.5% 10.0% 10.5% 11.0% 11.5% 12.0% 12.5% 13.0% Cost of equity Source: Bloomberg, FactSet, MSCI, CICC Strategy Research

Focus growth visibility & reform beneficiaries

 We continue to focus on growth visibility and reform beneficiaries in our sector picks. We suggest overweighting real estate and brokers, construction and city utilities and internet/software, healthcare, autos, home appliances, and underweighting telecoms, coal, retail, apparel/textiles, chemicals and power

Sector CICC strategy 2014 preference Previous preference Why we OW/UW Sector weights (%) 12m forward P/E (X) 12m trailing P/B (X) Growth visibility Reform impact 5 year rolling Valuation Z-Score

Software & Services Real Estate Capital Goods Auto & Parts City Utilities Health Care Diversified Financials Home Appliance Banks Oil & Gas Insurance Consumer Staples Transportation Hardware Cement Metals & Mining Paper Telecoms Coal Power Retail Apparel & Textile Chemicals OW OW OW OW OW OW OW OW Neutral Neutral Neutral Neutral Neutral Neutral Neutral Neutral Neutral UW UW UW UW UW UW OW OW OW OW Neutral Neutral OW OW Neutral Neutral Neutral Neutral Neutral Neutral Neutral UW Neutral UW UW Neutral UW UW UW 7.5

6.3

3.9

3.2

1.6

1.3

0.9

0.2

24.6

12.4

7.5

6.0

2.1

1.8

1.4

1.2

0.4

10.9

2.3

1.8

1.7

0.6

0.4

1.5

1.1

1.5

2.1

2.4

1.4

13.0

1.3

1.2

2.5

3.0

2.4

1.2

5.4

1.1

2.0

2.0

4.0

1.2

2.1

1.3

0.9

1.3

29.6

5.4

10.1

11.3

16.1

16.6

13.3

14.2

5.2

8.6

12.8

24.2

15.9

14.7

7.6

18.2

11.5

11.0

8.9

9.6

13.7

12.8

10.8

↑ ↑ ↑ (construction) ↑ (mid-/low tier) ↑ ↑ ↑ (clean energy) ↑ ↓ ↓ ↓ ↓ ↓ ↑ ↓ (luxury) ↑ ↑ ↑ ↑ ↓ ↓ (oil majors) ↑ ↑ ↑ ↓ ↓ ↓ ↓ (coal-fired) -0.5

-0.6

-1.0

-0.8

1.2

-0.2

0.9

-0.7

-0.1

0.4

0.5

-0.4

-0.4

1.2

-1.2

-0.4

-1.0

0.6

0.1

-0.0

-0.7

-0.0

0.1

Source: Bloomberg, Datastream, I/B/E/S, MSCI, CICC Strategy Research. Note: Based on MSCI China index constituents and GICS sector classifications; valuations are consensus estimates.

22

The long-term potential output will be driven by reform and opening-up

23 Source: CEIC, CICC Research

© CICC Macro

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