By HENRY MCVEY May 10, 2016

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

When my colleague Frances Lim and I arrived in Beijing in late April, it just felt different than recent visits to China. Sentiment was generally upbeat, corporate executives talked constructively about their business outlooks, and even the smog overhang had subsided.

Without question, this positive backdrop stood in stark contrast to the downbeat and somewhat overwhelming experience I had with some of my KKR colleagues in the country’s capital at year-end 2015. During that visit both investors and CEOs talked begrudgingly about their business prospects, and one needed a heavy duty environmental mask to even walk out of the hotel to fight the dense smog and winds afflicting China’s capital city before the holidays.

Overall, our most recent time in both Beijing and Hong Kong was well spent, and we walked away with what we believe are important short-term and long-term investment conclusions. They are as follows:

  1. As it relates to the short term, we are lifting our 2016 GDP forecast for China to 6.5% from 6.3%. This change represents our first uptick in forecasted Chinese GDP growth since we arrived at KKR in 2011. The primary catalyst for the increase is the government’s renewed commitment to achieving its 6.5% growth target for 2016 via robust liquidity injections into the economy. As one might sense, the recent decision to substantially boost more credit creation appears to run counter to the government’s original reform agenda of targeting a less levered, more market-based economy. Meanwhile, our inflation forecast for 2016 in China moves to 2.0% from 1.7%. The primary driver of the change is the aforementioned slightly higher growth, which results in slightly higher core inflation.
  2. Longer-term, however, we do not think that the recent stimulus can help the Chinese economy to re-establish a higher sustained growth rate. In fact, growth in residential property and infrastructure – both areas that are already suffering from excess capacity in many parts of the country – were the two primary stimulants of growth during 1Q16 (Exhibit 1). Including liquidity added to these two areas, a total of RMB 7.5 trillion (U.S.$1.2 trillion) of stimulus was injected into the economy during the first quarter, which fully equates to 47% of total GDP on an annualized basis, according to work done by Goldman Sachs in April of this year. Not surprisingly, we view these types of stimulus initiatives as unsustainable for an economy that already has a total debt to GDP ratio of 245%.
  3. Corporate credit growth remains outsized relative to GDP, which has implications for – among others – the country’s banks, insurers, and brokers. Investors hoping for a “big bang” write-off in the banking sector, however, are likely to be disappointed in the near-term. From what we can tell, it’s not coming. Rather, during our visit there was a lot of discussion amongst bank executives, investors, and CEOs around more measured approaches. For example, there was quite a “buzz” about the proposed introduction of debt to equity swaps for corporations with large loans outstanding, which should theoretically provide some form of equity capital relief for banks. Another big initiative to improve the situation in the banking sector is a program that allows debt from local government funding vehicles (LGFVs) held by banks to be refinanced through the municipal bond market at lower rates and capital charges as well as for longer durations. Unfortunately, we view both the debt for equity swap strategy and the replacement of LGFV debt with municipal debt somewhat more cautiously than the consensus because neither actually represents a true injection of external equity. Moreover, we still wrestle with the fact that credit is growing more than 13% year-over-year, which is nearly twice the pace of nominal GDP (Exhibit 24). If current trends persist, my colleague Frances Lim forecasts that debt to GDP will reach 300% or greater by 2020.
  4. There is no “One China” anymore, as the country’s economy is undergoing a massive transition. Importantly, though, we are not talking purely about the transition from manufacturing towards services. In our view, this economic “hand-off” has been somewhat overhyped. The reality is that fixed investment as a percentage of GDP is now higher than any period in recent memory – largely the compliment of outsized government stimulus in recent years. Rather, we are talking about the significant transition that China’s millennials, many of whom are quite Internet savvy, are driving across the economy, particularly in the country’s retail, travel and leisure, consumer finance, sports, and healthcare/wellness sectors.
  5. To offset the slowdown in global trade and flows, China is also repositioning its export economy to take market share in higher value-added services. Some of this transition is linked to internally building a “fast follower” strategy in certain sectors, but the lion’s share of executives with whom we spoke indicated that the number one priority was to acquire overseas firms with customer knowledge, global supply chains, distribution networks, and superior intellectual property. If we are right, then we should expect more outbound global M&A by China in the near-term as well as more global pricing cuts in the long-term.
  6. China Inc.: Coming to a theater near you. Without question, this trip’s dominant view centered on the desire by many Chinese business leaders to acquire companies, properties, and experiences outside of China. Getting assets outside of China is clearly a major focus after the August devaluation. There is also some sound industrial logic too. For example, there is clearly a growing desire to shift excess capacity from the country’s domestic economy to new markets, the U.S. in particular. In addition, some CEOs with whom we spoke wanted to acquire high-end expertise across technology and healthcare. Finally, some Chinese businesses want to learn more about consumer behavior in developed markets, so that they can bring that expertise back home or be more prepared when the local Chinese market becomes more mature.

Over time, we see really only one path forward for China’s long-term prospects: It must shift some of its credit creation away from the local government and corporations towards consumers and the central government. This process has started, but – as with any process – there are lots of vested interests and roadblocks along the way. However, if this strategy is not pursued more vigorously, then we believe it will be nearly impossible for China to achieve 6.0-6.5% growth over the next five years due to ongoing misallocation of resources. Simply stated, investing more in loss-making businesses creates a notable drag on productivity, and as labor force growth slows further in China, productivity improvement will quickly become the only catalyst for boosting longer-term growth.

Exhibit 1

Recent Monetary Stimulus Has Certainly Worked to Bolster Animal Spirits…

Data as at March 31, 2016. Source: China National Bureau of Statistics, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

Exhibit 2

…But There is Now a Bigger Issue in China: As Credit as a Percentage of GDP Rises, Real GDP Growth Falls

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

Exhibit 3

China’s GDP Growth Will Rise and Fall With Stimulus, but the Trend Is Downward Sloping

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

Exhibit 4

China Has Already Had a Hard Landing In Nominal Terms, We Believe

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

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

Exhibit 5

Credit Has Increased by More Than 100 Percentage Points of GDP Since 2000

Data as at 3Q2015. Source: BIS, PBoC, China Bureau of National Statistics, Haver Analytics, KKR Global Macro & Asset Allocation analysis.

Exhibit 6

Diminishing Returns: Credit per Unit of GDP Growth in China Remains on an Upward Trajectory

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

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

Exhibit 7

China’s Overall Manufacturing and Export Machine Has Slowed…

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

Exhibit 8

…But Within Its Export/Industrial Sector, Profitability Is Surging in Its Higher Value Industries

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

In terms of investment opportunities, we left with similar takeaways as from our prior trips. Specifically, we continue to eschew the Chinese public equity markets, which are heavily skewed towards large banks (Exhibit 9). By comparison, in the private markets we still continue to see more interesting opportunities, albeit we believe one has to be more valuation disciplined than in the past. In particular, we continue to favor the high value-added segments of the market that are direct plays on rising GDP-per-capita, not just rising GDP (which is what we think the public markets in aggregate represent). This opportunity set includes healthcare, consumer finance, food safety, and mobile/Internet penetration. We also continue to see growing opportunities in sports and wellness. On the other hand, while environmental investment “plays” appear theoretically attractive, the space now feels overcrowded, including increased government participation.

Exhibit 9

Financials Continue to Represent a Large Percentage of the MSCI China Index; By Comparison, Consumer Is Quite Small

Data as at April 28, 2016. Source: JPM Research “Emerging Markets Strategy Dashboards” dated April 28, 2016.

Exhibit 10

Revisions In China Continue to Be on a Downward Trajectory

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

Separately, we spent a lot of time on the non-performing loan (NPL) opportunity this trip. On the surface, the opportunity appears significant, as NPLs have increased for 17 consecutive quarters, and in the last year total non-performing assets on bank balance sheets in China increased to 1.3 trillion RMB, a full 51% increase year-over-year (Exhibits 27 and 28). We are by no means experts in this area, but our base conclusion is that this opportunity could take more time to ramp up than the current consensus now thinks. True, the government is cracking down on off-balance sheet lending structures that shield NPLs, as well as increasingly pushing banks to dispose of problem assets. However, we did not sense that we are on the cusp of a crisis moment, nor did we leave Beijing under the impression that there would be a policy change that dramatically favored foreign capital players in terms of loan workouts. Also (and somewhat ironically), the government’s recent decision to boost liquidity has actually helped many weak corporations and property players to stay the course, not restructure the way they potentially should. Finally, returns across many deals we discussed were not as high as one might think, particularly relative to what we are now seeing in regions like Europe.

Looking at the bigger picture, we still think that the global capital markets remain in “Adult Swim Only” mode. As we saw with the Bank of Japan’s recent decision to refrain from more stimulus, there is a lot of confusion and anxiety around negative interest rates. Meanwhile, aggregate global EPS growth continues to disappoint, as nominal revenues are falling amidst higher debt expenses. This combination is somewhat worrisome, though we are sticking to our team’s base view that the next global recession likely occurs in late 2017/early 2018.

Against this backdrop, our major macro and asset allocation themes remain largely unchanged. Specifically, we continue to favor an overweight positon in private credit, including direct lending, mezzanine, and asset-based lending. Year-to-date, these markets have represented some of the best risk-adjusted returns, we believe. Importantly, our work shows that private equity tends to outperform public equities at this point in the cycle. Within private equity, we favor consumer facing businesses more than industrial/export related franchises. Key to our thinking is that 1) globally, we just shifted $2.7 trillion in value from commodity producing nations to consumer-oriented ones and 2) global trade and global flows continue to disappoint, which we view as a secular, not cyclical, phenomenon. Finally, within real assets, we remain bullish on our Yield and Growth thesis, which leads us to infrastructure, broken energy stories with upside optionality, and dislocated real estate credit.

DETAILS

GDP Update/Putting China in Perspective

As we indicated above, we have boosted our 2016 GDP forecast for China to 6.5% from 6.3%. This increase is important for all global investors because, as we show in Exhibit 11, China accounts for about one-third of total incremental global growth in nominal USD terms. If we are using purchasing power parity as a measuring stick, then China’s contribution is even larger. That said, as Exhibit 12 shows, strong absolute growth in China has not led to strong growth in profits and/or returns on shareholder equity. We link this “disconnect” between strong GDP growth but weak profits to the reality that nominal GDP as well as nominal revenues in China have fallen sharply at the same time that corporate debt service burdens have increased dramatically. In addition, some of this GDP growth has come from loss making industries with excess capacity.

Exhibit 11

In 2016, the U.S. and China Will Be the Major Contributors to Global Growth in U.S.$ Terms

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

Exhibit 12

Despite Strong GDP Growth, Corporate Returns Remain Lackluster in China

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

Despite our increasing concern about the trajectory of debt levels in China as well as the ability of this economy to translate GDP growth into profits, we see three important, positive economic trends from our trip that we think are worth highlighting. First, China has been using its growing strength in high-end exports to drive increased market share, despite an overall slowing export environment. In fact, China has actually been gaining share in total net exports in recent years (Exhibit 13) at the time it has been ceding the low-end of the market to players like Vietnam, Africa, and Mexico (Exhibit 15). All told, China’s proportion of global exports rose to 13.8 percent last year from 12.3 percent in 2014, the highest share any country has enjoyed since the United States in 1968.

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

Exhibit 13

As China Rebalances Towards Higher Value-Added Exports, It Continues to Grow Its Share of Global Exports at the Expense of Japan, Germany, and the U.S.

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

Exhibit 14

China Is Maintaining Share by Exporting More High-End Goods. However, It Is Also Importing Less as It Builds Local Competitive Advantages

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

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

Exhibit 15

The Traditional “Made in China” Export Economy Is in Secular Decline…

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

Exhibit 16

…But Services Are Now Growing Nicely

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

Exhibit 17

Private Consumption Is Growing Rapidly in China, a Trend We Expect to Continue

Data as at April 12, 2016. Using 2014 ratio of Consumption % GDP against IMF estimate of nominal GDP. Source: IMF, Haver Analytics.

Exhibit 18

China’s Tech Sector Is Now Bigger Than Europe’s

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

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

Exhibit 19

China Has More Researchers Than the U.S….

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

Exhibit 20

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

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

Exhibit 21

The 25-34 Year Old Age Bracket Is Driving Online Spending Growth in China

Data as at June 30, 2015. Source: China Internet Network Information Center (CNNIC), Credit Suisse Live and Breathe the Internet 2015 Investment Guide.

Exhibit 22

World Internet Penetration: China Stands at a 49% Penetration Rate, Suggesting More Running Room

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

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

…But Still More Balance Is Needed

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

While we applaud Premier Li’s recent “call to arms,” we think that there are at least three other strategies the government should consider to promote more stable long-term growth. For starters, we would argue that the aforementioned SOE reform can’t achieve its desired effect unless weakened competitors across industries with excess capacity are allowed to fail. To do so, however, credit creation growth must trend down below nominal GDP growth. To date, however, the exact opposite has been true, as nominal lending growth is now running more than six hundred basis points above nominal GDP, one of the widest gaps ever (Exhibit 24). As such, while China is “ruthlessly bring(ing) down capacity” in some areas, excess credit is allowing “absolute overcapacity” in other areas of the economy.

Exhibit 23

Loss-Makers Form an Increasing Share of SOEs

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

Exhibit 24

Nominal Credit Growth Is Still Running Way Above Nominal GDP; Reform Can’t Happen Unless This Relationship Changes, We Believe

Data as at March 31, 2016. Source: People’s Bank of China, China National Bureau of Statistics, Bloomberg, Haver Analytics.

Another option for the government to consider is to facilitate more credit creation from the consumer segment of the market versus the existing strategy of re-stimulating an already over-leveraged corporate sector. If done properly, we believe this strategy would help to make China less reliant on its old economy sectors, manufacturing in particular. In addition, by providing access to a segment of the market that has traditionally had an extremely high savings rate, it would further drive consumption at the expense of fixed investment, which is what is really required to rebalance the economy. If there is good news, many of the banking executives and officials with whom we spoke seem supportive of this game plan. The bad news is that this rebalancing is moving slowly; in fact, consumer credit still now only accounts for about 25% of total loan growth4.

Exhibit 25

China Has Too Much Corporate Debt

Data as at 3Q15. Source: Bank for International Settlements, Statistical Office of the European Communities, Cabinet Office of Japan, Bureau of Economic Analysis, China National Bureau of Statistics, Haver Analytics.

Exhibit 26

China Needs to Encourage More Consumer Borrowing, Not Savings, at This Point In Its Economic Cycle

Data as at December 31, 2015. Source: IMF, OECD Net Household Savings Rate, Bureau of Economic Analysis, China National Bureau of Statistics, Haver Analytics.

The final potential change that we think warrants consideration is an increasing focus on building out a credible bond market, one that is transparent enough to attract foreign capital on a sustained basis. We see several positives to this strategy. First, in a world of zero interest rates, we think that China’s bond market – if run properly – could act as an attractive destination for foreign capital seeking returns. Just consider that only 17% of the $48 trillion Barclays Multiverse Aggregate Index currently yields north of three percent5. By comparison, there are hundreds of quality companies in China with corporate debt yielding five percent or more6. Second, in terms of balancing the capital account, we think a credible local bond market in China would potentially help to offset the ongoing desire by locals to remove capital from the mainland. Given our view that capital flight is likely one of the biggest risks to the China story, we think ensuring a greater source of alternative inflows into the country warrants attention at this point in China’s capital markets liberalization strategy. Finally, we believe the development of a credible bond market, so early in China’s capital market development, could ultimately become a competitive advantage versus other markets like Japan and Europe, both of which still rely heavily on a concentrated bank market for credit creation.

China: The Ultimate Macro Paradox?

After enjoying its Golden Era of growth during the 2000-2010 period, the China macro narrative has become much more complicated, one today that is filled with a series of ongoing policy trade-offs that often end up being more intertwined – and sometimes conflicting – than one could ever imagine. Indeed, too many times on this trip it felt like we heard the refrain that “on the one hand…but on the other…” Just consider the following points:

  • On the one hand, we heard continuously that the Chinese government has pledged more serious SOE reform, including more competitive and profitable global industries. On the other hand, the government is again boosting domestic credit growth to more than 13% year-over-year. At such a high level above nominal GDP, the recent pace of credit growth all but ensures that many of the country’s weakest corporate entities sidestep bankruptcy and/or avoid default, which is ultimately at odds with improving competitiveness and productivity.
  • Amidst low inflation and bumpy growth, China has continued to lower rates further to ease financial conditions. Importantly, more easing is likely needed, as the country’s GDP deflator hovers near zero. On the one hand, if the People’s Bank of China does ease further, then it will certainly give a much needed boost to the corporate sector, which appears to be lumbering under the weight of excess debt service burdens. On the other hand, if the central bank does lower rates, it could have a negative impact on the currency, which could create significant capital markets volatility inside and outside of China.
  • Meanwhile, a weaker currency could be good for exports, but it would undermine some of the credibility achieved by China gaining admission to the Special Drawing Right (SDR). A weaker currency would also make it more expensive for consumers to import things and for companies to acquire abroad, both of which appear to be strategic priorities for the country. On the other hand, if the currency were to re-adjust downward towards what we view as fair value, then the recent bout of capital flight might finally subside if locals felt that there was less downside risk to the local currency.

Why does it feel like there is a surge in Chinese macro-related inconsistencies? We see at least three reasons, all of which are inter-related. First, the current Chinese government is being forced to make some unnatural concessions as it attempts to fulfill the party’s original mandate to double GDP between 2010 and 2020. Given more challenging demographics and the recent slowing of global trade, the government now needs to run the economy even hotter than normal to achieve the annual growth it requires to fulfill its long-term GDP mandate. This mandate in turn leads to a need to boost credit growth towards double-digit levels to overcome the offsets linked to structurally slower growth. And because credit growth is so strong, the country is obliged to clamp down on its capital account to prevent this growth in capital from fleeing the system.

Second, while the government wants to boost productivity to drive growth, rapid credit growth to aid the old economy actually hurts long-term efficiency. The third challenge is that there appears to be somewhat of a conundrum between the government’s desire to support growth and to consolidate power via anti-corruption initiatives. In fact, a number of local people we met thought that recent reform initiatives were only hurting, not helping, growth. While we agree that reform often requires painful adjustments, it also represents the most credible path forward to longer-term sustainable growth in China, in our view.

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

Banking: the Slow Burn

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

Exhibit 27

The NPL Ratio Has Risen as GDP Growth Has Fallen…

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

Exhibit 28

…But NPLs Have Not Kept Pace With Loan Growth

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

Exhibit 29

And If China Keeps On Growing Credit At 13%, Then Credit to GDP Will Reach 300% By 2020

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

We can’t vouch for the loan books of the Chinese banking sector, but we do have some insights into why the capital ratios still appear robust, despite rising NPLs. First, our research shows that many LGFVs recently paid back their bank loans, then immediately began swapping their liabilities into local municipal debt securities. This corporate finance “baton hand-off” is significant because municipal debt tends to be longer in duration and has a capital charge of 20% versus 100% for LGFV loans/bonds. As such, banks enjoyed essentially an overnight re-equitization, though no actual capital has been injected into the banking system in some instances. Second, many banks are now on track to swap corporate debt obligations into equity positions, which improves the capital structure of the business and prevents – in the near-term – what could have been a significant impairment that a bank would have had to otherwise taken. Third, because loan growth remains so robust in China, it is actually hard for reported non-performing loans as a percentage of total bank assets to actually “catch-up.”

Even with these accounting tailwinds, certain banks, particularly the smaller ones, are seeing notable deterioration in their loan books. Moreover, a real NPL market is beginning to form. Indeed, using publicly available data, we believe that commercial banks in China have around RMB 1.3 trillion of official NPLs, while loans that “warrant special attention” now total RMB 2.9 trillion. Collectively, this RMB 4.2 trillion of souring assets (Exhibit 30) is now sufficiently larger than the RMB 1.6 trillion of asset management equity (note that RMB 200 billion has been raised, but it can be levered 8:1 for RMB 1.6 trillion).

Moreover, these reference points do not tell the entire picture, as the aggregate loan market is actually about RMB 111 trillion (Exhibit 31). If we assume loss ratios of eight or nine percent (which many analysts believe is more realistic) versus the current reported number of one to two percent for normal commercial bank loans, then the total capacity needed to digest NPLs across multiple asset classes is closer to RMB 10 trillion, or 15% of GDP in China.

Exhibit 30

Total NPLs in China Are Running at RMB 4.2 Trillion or an NPL Ratio of 5.5% After Including Special Mention Loans

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

Exhibit 31

Including Non-Commercial Bank Financing, the Total Loans Outstanding Is Roughly RMB 111 Trillion

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

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

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

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

China Inc. Is Headed Overseas

When we go to China and do a series of meetings over a few days, there is always a lot of debate around key issues/topics. Will the government stimulate more, what is the direction of the currency, are the NPLs understated? Then there is a consensus that forms around one or two big ideas. Without question, this trip’s consensus view centered on the desire by many Chinese business leaders to acquire companies, properties, and experiences outside of China. Getting assets outside of China is clearly a major focus after the August devaluation. There is also some sound industrial logic too. For example, there is clearly a growing desire to shift excess capacity from the country’s domestic economy to new markets, the U.S. in particular. In addition, some CEOs with whom we spoke wanted to acquire high-end expertise across technology and healthcare. Finally, some Chinese businesses want to learn more about consumer behavior in developed markets, so that they can bring that expertise back home or be more prepared when the local Chinese market becomes more mature.

Regardless of the reason, the demand side of the aforementioned equation is surging. One can see this in Exhibits 32 and 33. What does this mean for investors? It likely means that Chinese companies will now compete more aggressively against strategic and private equity investors on the acquiring side of deals, but could provide a logical buyer of choice on exits. Second, once a company has been acquired, investors should be wary if Chinese management competes aggressively on price. Beyond the impact at the company and the industry levels, increased price competition could likely add a deflationary backdrop to what is already a disinflationary global macro environment and add further downward pressure on interest rates. Finally, China will need to manage its currency base firmly in other areas (i.e., prevent further outflows) if M&A volumes do — in fact — tick up from current levels.

Exhibit 32

China’s Influence Has Risen to 25% of Global M&A, Exceeding That of the U.S.

* Greater China = China + Hong Kong + Taiwan. Data as at December 31, 2014. Source: United Nations Conference on Trade and Development.

Exhibit 33

China Is on a Mega Buyout Spree

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

China’s Role in the Recent Commodity Spike

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

Exhibit 34

Commodities Have Experienced, on Average, a 66% Price Correction in Recent Years…

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

Exhibit 35

… Which Has Lasted Between Four and Ten Years

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

We see several forces at work. First, as we show in Exhibits 36 and 37, respectively, research done by my colleague Frances Lim shows that major initial declines are subsequently followed by counter trend rallies that can produce returns of 41-110%. Second, we do think that Fed policy has changed in recent months towards being more accommodative, which is dollar bearish and commodity bullish. Importantly, though, we think that the current dollar “pause” lasts only 12-18 months, which is consistent with our view that commodities are enjoying a cyclical bounce, not a fundamental, long-term resurgence in prices across the complex.

Exhibit 36

Real Prices Tend to Hit an Initial Trough After Five Years, But The Full Cycle Might Be As Long As 40+ Years

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

Exhibit 37

An Initial Rebound In Commodities Can Be Sizeable, Running Up 41-110% in Real Terms, Before Falling to New Lows Again

Data as at March 22, 2016. Source: USGS, BP Statistical Review, Yale/Robert Shiller data, Statistical Abstract of the United States, History of the Great Lakes, Federal Reserve Bank of Minneapolis: Handbook of Labor Statistics, NBER, BLS, IMF, World Bank.

Third, our time in China leads us to conclude that many local Chinese investors, particularly those who have gained an appreciation for how much stimulus entered the system during 1Q16, have shifted significant investment profits out of stocks and real estate and into commodities. For example, as we show in Exhibits 38 and 39, respectively, iron ore trading volumes are up 106% in three months ending April 2016 and over 360% in the twelve months, while steel rebar futures trading volumes are up 142% and 197%, respectively, during the same periods.

To put this surge in trading volume in context, the current 30-day average daily trading volume in iron ore futures of 600 million tons per day is equal to 63% of China’s total iron ore imports of 950 million tons for all of calendar 20158. Taken together, the nascent iron ore and steel rebar markets have recent daily trading volume that on some days is equal to the notional U.S. dollar volume of the S&P 500 futures, the largest and most liquid global equity index future contract. Not surprisingly, the Dalian exchange just recently announced that it would be increasing margin requirements and transaction costs on iron ore futures.

Exhibit 38

Of Late, There Has Been a Surge in Both Prices and Trading Volumes of Iron Ore…

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

Exhibit 39

…While Steel Rebar Futures Are Up 56% Over the Same Three Months

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

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

Exhibit 40

The Path Down Takes Much Longer Than the Path Upwards

Data as at March 22, 2016. Source: USGS, BP Statistical Review, Yale/Robert Shiller data, Statistical Abstract of the United States, History of the Great Lakes, Federal Reserve Bank of Minneapolis: Handbook of Labor Statistics, NBER, BLS, IMF, World Bank.

Exhibit 41

A Final Peak-to-Trough Real Price Correction Is Roughly 70-85%. However, the First Trough Normally Occurs After Five Years and a 60-75% Correction

Data as at March 22, 2016. Source: USGS, BP Statistical Review, Yale/Robert Shiller data, Statistical Abstract of the United States, History of the Great Lakes, Federal Reserve Bank of Minneapolis: Handbook of Labor Statistics, NBER, BLS, IMF, World Bank.

Exhibit 42

We Do Not Believe That Copper Inventories Have Yet Peaked…

COMEX = Commodity Exchange, LME = London Metals Exchange, SFE = Shanghai Futures Exchange. Data as at April 30, 2016. Source: Bloomberg.

Exhibit 43

… And Hard to Call a Peak in Oil Inventories When Global Production Is Currently Running at a 1.9% Surplus to Demand

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

Conclusion

Our belief has never been higher that – to have conviction on the overall global macro landscape – one has to spend more time understanding the big trends occurring in China. Importantly, it is not just the massive growth contribution that China makes to the global economy. The direction of China’s currency too has huge implications for global capital markets stability; in addition, its M&A and export strategies can also materially influence the pace and absolute rate of global trade and inflation.

The good news is that our most recent visit gives us assurance that there is a base rate of growth – likely around 6.5% in our view – that this government will work hard to achieve in 2016. As such, we believe investors should take comfort that some of the fundamental weaknesses that we saw in the Chinese economy during the last quarter of 2015 has stabilized – and potentially even reversed. We are also encouraged that it appears the government is reflecting more deeply about how it handled its involvement in the stock market and currency events that occurred in recent quarters.

The bad news is that near-term gains in growth come at the expense of long-term sustainability. At some point, a country, particularly an emerging one, can’t continue to run with nominal lending growth rates so far above nominal GDP for so long. Also, while the government has done a good job of plugging its capital account, this is not a long-term solution for a country that wants to move towards more of a markets-based environment.

Against this backdrop, we continue to expect more volatility, and amidst that volatility, we believe that equity investors should consider migrating their investment dollars towards high-value services, including healthcare, consumer services, travel, and leisure. The push towards the Internet, particularly by a dynamic millennial cohort, is also another important theme on which to focus for both offensive and defensive reasons.

On the debt side, we think now is the time to start to position oneself to take advantage of the significant transfer of credit assets that will ultimately occur from banks to private investors. However, this opportunity is likely a walk, not run, one in the near-term unless there is a more blatant directive from the government that foreign capital has emerged as the most efficient solutions provider to the growing NPL issue (not our base view).

Overall, though, we believe that the higher risk premiums now required to invest in China are likely to persist. Key to our thinking is that nominal credit growth continues to grow too rapidly relative to nominal GDP, and much of this credit growth is still occurring in sectors of the economy where debt levels need to be reduced, not increased. Besides rising debt loads in many parts of the economy, investors now must also face a more challenging exit environment for their capital, particularly given the recent downdraft in reserves as well as the recent uptick in expansionary M&A. Finally, given that many other economies have stalled in the developed world, it feels like China has been asked to take on too much responsibility for driving global growth amidst its own internal economic repositioning. In our view, this “burden” unfortunately is leading to excesses in several sectors of the Chinese economy, particularly if the mandate to double GDP between 2010 and 2020 is maintained. As such, then our base view remains that it is “Adult Swim Only” across the global capital markets, China in particular.

1 Data as at June 30, 2015. Source: China Internet Network Information Center (CNNIC), Credit Suisse Live and Breathe the Internet 2015 Investment Guide.

2 Data as at January 15, 2016. Source: Credit Suisse, iResearch.

3 Data as at February 29, 2016. Source: FT, China’s State-Owned Zombie Economy.

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

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

6 Data as at April 21, 2016. Source: Citigroup.

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

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