Rights, Wrongs & Returns 2018 year-of choices & consequences

Please refer to page 51 for important disclosures and analyst certification, or on our website
www.macquarie.com/research/disclosures.
GLOBAL
Inside
Key Recommendations & Portfolios 2
Executive Summary – fork in the road 3
Risk 1: Central Bank’s ‘chicken run’ 8
Risk 2: What would China do? 17
Risk 3: Could inflation break out? 23
Risk 4: Financial markets are not ready 27
Equities – limited room for error 31
Portfolio allocation: less remains more 38
Appendices 45
G4 + Swiss – Central Bank Balance
Sheet Changes (US$ bn) (% YoY)
Source: Bloomberg; Macquarie Research, November 2017
Global non-financial sector incremental
debt – China share (US$ bn) (%)
Source: BIS; Macquarie Research, November 2017
Analyst(s)
Viktor Shvets
+852 3922 3883 viktor.shvets@macquarie.com
14 November 2017
Macquarie Capital Limited
Rights, Wrongs & Returns
2018 – Year of choices & consequences
In a world of meaningless noise, 2018 might be an exception; it might turn out to
be the year of critical choices and their consequences.
In our reviews, we have described 2017 as a Clash of the Titans. As in
Greek Titanomachy, the Olympians (disinflation due to technology, globalization
and over-financialization) are fighting the Titans (aggressive public/monetary
policies and reflation). While ultimately the Olympians (younger gods) are likely
to win over sluggish older gods (Titans), through ‘17, the Titans were winning.
What was the source of their strength? In our view, the global economy was
influenced by: (a) closer co-ordination among central banks (CBs), in the wake of
volatilities of late ‘15 and early ‘16; (b) continuing strong flow of central bank
liquidity; and (c) China’s stimulus, with domestic political considerations leading
to more elongated cycle and only a gradual slowdown through ‘17.
The key question for 2018 is whether CBs decade-long policies and
China’s stimulus, have finally restarted a self-sustaining recovery? If this is
the case, then CBs would have a space to gradually withdraw liquidity and raise
cost of capital, as revitalized private sector maintains momentum. This would
imply that after a decade of recuperation, animal spirits and productivity are
coming back and it is only appropriate that support structures are dismantled.
However, if investors are just witnessing a familiar cycle of liquidity, asset
inflation and China, then withdrawing liquidity and/or trying to raise cost of capital
could backfire. The ‘canary in the coalmine’ would be asset price volatilities. This
would be tolerable if there is a sustained private sector recovery, but it could be
devastating to over-financialized and productivity-starved economies reliant on
assets and leveraging for growth. We remain convinced that there is no
evidence of sustained private sector recoveries.
We see three risks. First, our key concern is the impact of liquidity withdrawal
and persistence by CBs in trying to raise cost of capital, irrespective of evidence
that neither supply nor demand can support higher rates. If we take CBs’ rhetoric
at face value, it is likely that liquidity injections could compress by more than
US$1 trillion in ‘18, turning negative in ‘19. While CBs promise to be careful, this
is a fundamental shift, akin to mixing combustible elements, with highly
unpredictable results. Neither FI, FX nor equities are ready. Second, we are
concerned that China might not fully realize the extent to which global recovery
is contingent on its ability to maintain commodity-intensive growth. This is
particularly critical, following recent power consolidation. Third, any sign of an
even mild stagflation (due to supply side and/or pockets of tightness) might
prompt CBs to overreact, trying to get ahead of ‘behind the curve’ narrative.
The above imply a potentially sharp fork in a road for every financial asset
class, with high risk of policy errors. Where do we stand? We maintain that the
world continues to critically rely on assets and financialization and unless there is
a robust private sector growth, any liquidity tightening could cause sharp value
reversals, undermining growth and financial stability. While policy errors cannot
be ruled out, we believe that at any sign of volatilities, CBs and China would
have no choice but to reverse. Not a permanent answer, but neither is there a
reason to believe that ’18 is when the dam finally breaks. Our base case is one
of ‘Kondratieff autumn’ persisting, and hence we remain constructive on
financial assets not because we believe in a sustained recovery, but because
we do not see alternatives to excess liquidity and declining cost of capital. US
equities remain vulnerable; we prefer Europe, Japan and EM. Portfolio-wise, we
are staying with non-mean reversionary Quality, Growth & Thematics.
-10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
(1,000)
(500)
-
500
1,000
1,500
2,000
2,500
3,000
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
QE Increment % Growth
Non-Financial sectors World China China Share (%)
2001-2005 27,316 1,587 5.8%
2006-2010 48,397 8,019 16.6%
2011-2017 (1Q) 28,315 17,265 61.0%
2014-2017 (1Q) 8,838 7,885 89.2%
Non-Financial Corporates
2008-2013 12,973 9,874 76.1%
2014-2017 (1Q) 4,878 4,529 92.8%

Macquarie Research Rights, Wrongs & Returns
14 November 2017 2
Key Recommendations & Portfolios
Fig 1 MQ ASXJ ‘QSG’ Portfolio (Nov-17) Fig 2 MQ Global ‘QSG’ Portfolio (Nov-17)
Source: Macquarie Research, November 2017 Source: Macquarie Research, November 2017
Fig 3 MQ ASXJ ‘Thematics’ Portfolio (Nov-17) Fig 4 MQ Global ‘Thematics’ Portfolio (Nov-17)
Source: Macquarie Research, November 2017 Source: Macquarie Research, November 2017
Fig 5 MQ – Asia ex ‘QSG’ Portfolio – up 8% YTD Fig 6 MQ Asia ex JP – Country Allocation (%)
Source: Bloomberg; Macquarie Research, November 2017 Source: Macquarie Research, November 2017
Ticker Name Reco. Country
BABA US Alibaba Group Holding OP CHINA
700 HK Tencent OP HK/China
005930 KS Samsung Electronics OP Korea
2330 TT Taiwan Semicon Mfg OP TAIWAN
2317 TT Hon Hai Precision Ind OP TAIWAN
002415 CH Hangzhou Hikvision A OP CHINA
HUVR IN Hindustan Unilever OP INDIA
002352 CH SF Holding A OP CHINA
MSIL IN Maruti Suzuki India OP INDIA
NTES US NetEase ADR OP CHINA
288 HK WH Group OP HK/China
EIM IN Eicher Motors OP INDIA
EDU US New Oriental Education ADR OP CHINA
HMCL IN Hero MotoCorp OP INDIA
669 HK Techtronic Industries OP HK/China
SRCM IN Shree Cement OP INDIA
300124 CH Shenzhen lnovance Tech OP CHINA
GCPL IN Godrej Consumer Products OP INDIA
UNTR IJ United Tractors N/R INDONESIA
1590 TT Airtac Grp OP TAIWAN
PGOLD PM Puregold Price Club OP PHILIPPINES
Ticker Name Reco. Country Ticker Name Reco. Country
GOOGL US Alphabet A OP US RMS FP Hermes N/R FRANCE
AMZN US Amazon.com OP US ADP US ADP N/R US
700 HK Tencent OP HK/China ADS GR adidas OP GERMANY
FB US Facebook A OP US 6594 JP NIDEC Neutral Japan
JNJ US Johnson & Johnson N/R US MSIL IN Maruti Suzuki India OP INDIA
005930 KS Samsung Electronics OP SOUTH KOREA EA US Electronic Arts OP US
V US Visa A N/R US MNST US Monster Beverage OP US
2330 TT Taiwan Semicon Mfg OP TAIWAN ILMN US Illumina N/R US
DIS US Disney Neutral US 8035 JP Tokyo Electron OP JAPAN
MC FP LVMH Moet Hennessy N/R FRANCE SWK US Stanley Black & Decker OP US
AMGN US Amgen N/R US HO FP Thales N/R FRANCE
SIE GR Siemens N/R GERMANY RACE IM Ferrari N/R ITALY
HON US Honeywell N/R US NOW US ServiceNow OP US
BAYN GR Bayer N/R GERMANY CAP FP Capgemini N/R FRANCE
AVGO US Broadcom OP UNITED STATES MHK US Mohawk Industries OP US
2317 TT Hon Hai Precision Ind OP TAIWAN ADEN SW Adecco Group N/R Swiss
FDX US FedEx N/R UNITED STATES HMCL IN Hero MotoCorp OP INDIA
SYK US Stryker N/R US
300124 CH Shenzhen lnovance Tech OP CHINA 002415 CH Hangzhou Hikvision A OP CHINA
1590 TT Airtac Grp OP TAIWAN 079550 KS LIG Nex1 OP SOUTH KOREA
2317 TT Hon Hai Precision Ind OP TAIWAN STE SP Singapore Techs Eng Neutral SINGAPORE
300024 CH SIASUN Robot & Automation AOP CHINA
002527 CH Shanghai Step Electric A OP CHINA Theme 5: "Education & Skilling"
Theme 2: Asia's High Technologyniches EDU US New Oriental Education ADR OP CHINA
TAL US TAL Education Group ADR Neutral CHINA
2330 TT Taiwan Semicon Mfg OP TAIWAN
981 HK SMIC OP HONG KONG
2382 HK Sunny Optical Tech Grp OP HONG KONG 300015 CH Aier Eye Hospital Group A N/R CHINA
INRI MK Inari Amertron OP MALAYSIA 1448 HK Fu Shou Yuan Intl Group N/R HONG KONG
000660 KS SK hynix OP SOUTH KOREA RFMD SP Raffles Medical Group N/R SINGAPORE
BDMS TB Bangkok Dusit Medical OP THAILAND
MIKA IJ Mitra Keluarga Karyasehat N/R INDONESIA
700 HK Tencent OP HONG KONG Theme 7: "Disruptors & Facilitators"
NTES US NetEase ADR OP CHINA BABA US Alibaba Group Holding OP CHINA
002241 CH GoerTek A Neutral CHINA BIDU US Baidu ADR OP CHINA
1128 HK Wynn Macau OP HONG KONG
Theme 1: "Replacing Humans": Robots, Industrial Automation & AI Theme 4: "Bullets and Prisons": Defense, Security,
Prisons/Correction Centres
Theme 6: "Demographics": Funeral Parlours, Hospitals and
Psychiatric Centres
Theme 3: "Opiumof the people": Games, Casinos/Virtual Reality
ABBN SW ABB N/R SWITZERLAND 002415 CH Hangzhou Hikvision A OP CHINA
6506 JP Yaskawa Electric UP JAPAN LMT US Lockheed Martin N/R US
6954 JP FANUC OP JAPAN RTN US Raytheon Co N/R US
ISRG US Intuitive Surgical N/R UNITED STATES NOC US Northrop Grumman N/R US
SYK US Stryker N/R UNITED STATES HO FP Thales N/R FRANCE
SIE GR Siemens N/R GERMANY ESLT IT Elbit Systems N/R ISRAEL
HON US Honeywell N/R UNITED STATES
6503 JP Mitsubishi Electric OP JAPAN
1590 TT Airtac Grp OP TAIWAN Theme 5: "Education & Skilling"
300124 CH Shenzhen lnovance Tech OP CHINA EDU US New Oriental Education ADR OP CHINA
NVDA US NVIDIA Neutral UNITED STATES TAL US TAL Education Group ADR Neutral CHINA
AMGN US Amgen N/R UNITED STATES 1448 HK Fu Shou Yuan Intl Group N/R HONG KONG
BIIB US Biogen Idec MA N/R UNITED STATES SCI US Service Corp Intl N/R UNITED STATES
ABBV US AbbVie N/R UNITED STATES UHS US Universal Health Services B N/R UNITED STATES
ILMN US Illumina N/R UNITED STATES
Theme 7: "Disruptors & Facilitators"
700 HK Tencent OP HONG KONG AMZN US Amazon.com OP UNITED STATES
ATVI US Activision Blizzard OP UNITED STATES FB US Facebook A OP UNITED STATES
EA US Electronic Arts OP UNITED STATES CRMUS Salesforce.com OP UNITED STATES
NTES US NetEase ADR OP CHINA GOOGL US Alphabet A OP UNITED STATES
7974 JP Nintendo OP JAPAN BABA US Alibaba Group Holding OP CHINA
MGMUS MGMResorts OP UNITED STATES
1128 HK Wynn Macau OP HONG KONG
Theme 1: "Replacing Humans": Robots, Industrial Automation & AI Theme 4: "Bullets and Prisons": Defense, Security, Prisons/Correction
Theme 2: "Augmenting Humans": Genome/Biotechnology/DNA
sequencing
Theme 6: "Demographics": Funeral Parlours, Psychiatric Centres
Theme 3: "Opium of the people": Games, Casinos/Virtual Reality
95
100
105
110
115
120
125
130
135
140
145
Mar-13
Jun-13
Sep-13
Dec-13
Mar-14
Jun-14
Sep-14
Dec-14
Mar-15
Jun-15
Sep-15
Dec-15
Mar-16
Jun-16
Sep-16
Dec-16
Mar-17
Jun-17
Sep-17
ASXJ "Quality Sustainable Growth" portfolio (rel to MSCI ASXJ, $ TR basis) -3 -2 -1 0 1 2 3
China
India
Korea
Philippines
Taiwan
Hong Kong
Singapore
Malaysia
Thailand
Indonesia

14 November 2017 3
Executive Summary – fork in the road
‘It has been said that something as small as the flutter of a butterfly’s wing can
ultimately cause a typhoon halfway around the world’ – Chaos Theory.
There is a good chance that 2018 might fully deserve shrill voices and predictions of
dislocations that have filled almost every annual preview since the GFC.
Whether it was fears of a deflationary bust, expectation of an inflationary break-outs,
disinflationary waves, central bank policy errors, US$ surges or liquidity crunches, we pretty
much had it all. However, for most investors, the last decade actually turned out to be
one of the most profitable and the most placid on record. Why then have most investors
underperformed and why are passive investment styles now at least one-third (or more likely
closer to two-third) of the market and why have value investors been consistently crushed
while traditional sector and style rotations failed to work? Our answer remains unchanged.
There was nothing conventional or normal over the last decade, and we believe that
neither would there be anything conventional over the next decade. We do not view
current synchronized global recovery as indicative of a return to traditional business and
capital market cycles that investors can ‘read’ and hence make rational judgements on asset
allocations and sector rotations, based on conventional mean reversion strategies. It remains
an article of faith for us that neither re-introduction of price discovery nor asset price
volatilities is any longer possible or even desirable.
However, would 2018, provide a break with the last decade? The answer to this question
depends on one key variable. Are we witnessing a broad-based private sector recovery, with
productivity and animal spirits coming back after a decade of hibernation, or is the latest
reflationary wave due to similar reasons as in other recent episodes, namely (a) excess
liquidity pumped by central banks (CBs); (b) improved co-ordination of global monetary
policies, aimed at containing exchange rate volatilities; and (c) China’s stimulus that reflated
commodity complex and trade?
The answer to this question would determine how 2018 and 2019 are likely to play out.
If the current reflation has strong private sector underpinnings, then not only would it be
appropriate for CBs to withdraw liquidity and raise cost of capital, but indeed these would
bolster confidence, and erode pricing anomalies without jeopardizing growth or causing
excessive asset price displacements. Essentially, the strength of private sector would
determine the extent to which incremental financialization and public sector supports
would be required. If on the other hand, one were to conclude that most of the improvement
has thus far been driven by CBs nailing cost of capital at zero (or below), liquidity injections
and China’s debt-fuelled growth, then any meaningful withdrawal of liquidity and attempts to
raise cost of capital would be met by potentially violent dislocations of asset prices and rising
volatility, in turn, causing contraction of aggregate demand and resurfacing of disinflationary
pressures. We remain very much in the latter camp. As the discussion below illustrates, we
do not see evidence to support private sector-led recovery concept. Rather, we see support
for excess liquidity, distorted rates and China spending driving most of the improvement.
We continue to believe that Japan (here) is at least a decade ahead of the rest of the
world, and it teaches us two lessons: (a) how to quietly and gradually re-distribute and then
eventually liquidate national debt; and (b) how demographics have become largely irrelevant
in the new Information Age, opposite to the key role that they played in the Industrial Age of
19th
-20th
centuries. However, these are lessons that most nations find unpalatable as they
involve a sharply slower growth trajectories. This is not acceptable for countries with unequal
income and wealth distribution and younger demographics (or the case of demographic
dividends turning into curses). Hence the political and social angst that is engulfing the world.
We have in the past extensively written on the core drivers of current anomalies. In a
‘nutshell’, we maintain that over the last three decades, investors have gradually moved
from a world of scarcity and scale limitations, to a world of relative abundance and an
almost unlimited scalability. The revolution started in early 1970s, but accelerated since
mid-1990s. If history is any guide, the crescendo would occur over the next decade. In the
meantime, returns on conventional human inputs and conventional capital will
continue eroding while return on social and digital capital will continue rising. This
promises to further increase disinflationary pressures (as marginal cost of almost everything
declines to zero), while keeping productivity rates constrained, and further raising inequalities.
Despite many alerts,
the past decade was
the most placid on
record but…
…there was nothing
conventional about
either economies or
investments
Would 2018 and
2019 be different?

14 November 2017 4
The new world is one of disintegrating pricing signals and where economists would
struggle even more than usual, in defining economic rules. As Paul Romer argued in his
recent shot at his own profession (The trouble with macroeconomics, Dec ’16), a significant
chunk of macro-economic theories that were developed since 1930s need to be discarded.
Included are concepts such as ‘macro economy as a system in equilibrium’, ‘efficient market
hypothesis’, ‘great moderation’ ‘irrelevance of monetary policies’, ‘there are no secular or
structural factors, it is all about aggregate demand’, ‘home ownership is good for the
economy’, ‘individuals are profit-maximizing rational economic agents’, ‘compensation
determines how hard people work’, ‘there are stable preferences for consumption vs saving’
etc. Indeed, the list of challenges is growing ever longer, as technology and Information Age
alters importance of relative inputs, and includes questions how to measure ‘commons’ and
proliferating non-monetary and non-pricing spheres, such as ‘gig or sharing’ economies and
whether the Philips curve has not just flattened by disappeared completely. The same implies
to several exogenous concepts beloved by economists (such as demographics).
The above deep secular drivers that were developing for more than three decades, but
which have become pronounced in the last 10-15 years, are made worse by the
activism of the public sector. It is ironic that CBs are working hard to erode the real value of
global and national debt mountains by encouraging higher inflation, when it was the public
sector and CBs themselves which since 1980s encouraged accelerated financialization. As
we asked in our recent review (CBs - can slaves become masters?), how can CBs exit this
‘doomsday highway’? Investors and CBs are facing a convergence of two hurricane systems
(technology and over-financialization), that are largely unstoppable. Unless there is a miracle
of robust private sector productivity recovery or unless public sector policies were to undergo
a drastic change (such as merger and fiscal and monetary arms, introduction of minimum
income guarantees, massive Marshall Plan-style investments in the least developed regions
etc), we can’t see how liquidity can be withdrawn; nor can we see how cost of capital
can ever increase. This means that CBs remain slaves of the system that they have built
(though it must be emphasized on our behalf and for our benefit).
If the above is the right answer, then investors and CBs have to be incredibly careful as
we enter 2018. There is no doubt that having rescued the world from a potentially
devastating deflationary bust, CBs would love to return to some form of normality, build up
ammunition for next dislocations and play a far less visible role in the local and global
economies. Although there are now a number of dissenting voices (such as Larry Summers
or Adair Turner) who are questioning the need for CB independence, it remains an article of
faith for an overwhelming majority of economists. However, the longer CBs stay in the game,
the less likely it is that the independence would survive. Indeed, it would become far more
likely that the world gravitates towards China and Japan, where CB independence is largely
notional.
Hence, the dilemma from hell facing CBs. If they pull away and remove liquidity and try to
raise cost of capital, neither demand for nor supply of capital would be able to endure lower
liquidity and flattening yield curves. On the other hand, the longer CBs persist with current
policies, the more disinflationary pressures are likely to strengthen and the less likely is
private sector to regain its primacy. We maintain that there are only two ‘tickets’ out of this jail.
First (and the best) is a sudden and sustainable surge in private sector productivity and
second, a significant shift in public sector policies. Given that neither answer is likely (at least
not for a while), a co-ordinated more hawkish CB stance is akin to mixing highly volatile
and combustible chemicals, with unpredictable outcomes.
Most economists do not pay much attention to liquidity or cost of capital, focusing almost
entirely on aggregate demand and inflation. Hence, the conventional arguments that the
overall stock of accommodation is more important than the flow, and thus so long as CBs are
very careful in managing liquidity withdrawals and cost of capital raised very slowly, then CBs
could achieve the desired objective of reducing more extreme asset anomalies, while buying
insurance against future dislocation and getting ahead of the curve. In our view, this is where
chaos theory comes in. Given that the global economy is leveraged at least three times GDP
and value of financial instruments equals 4x-5x GDP (and potentially as much as ten times),
even the smallest withdrawal of liquidity or misalignment of monetary policies could
become an equivalent of flapping butterfly wings. Indeed, in our view, this is what
flattening of the yield curves tells us; investors correctly interpret any contraction of liquidity or
rise in rates, as raising a possibility of more disinflationary outcomes further down the road.
It depends on
whether the private
sector recuperates
and productivity
rates improve
Our view is no; and
hence, CBs and
China need to be
exceptionally
careful, otherwise…
…volatilities would
jump, derailing
asset classes and
exposing fragilities
that were papered
over by liquidity and
stimulus

14 November 2017 5
Hence, we maintain that the key risks that investors are currently running are ones to
do with policy errors. Given that we believe that recent reflation was mostly caused by
central bank liquidity, compressed interest rates and China stimulus, clearly any policy errors
by central banks and China could easily cause a similar dislocation to what occurred in 2013
or late 2015/early 2016. When investors argue that both CBs and public authorities have
become far more experienced in managing liquidity and markets, and hence, chances of
policy errors have declined, we believe that it is the most dangerous form of hubris. One
could ask, what prompted China to attempt a proper de-leveraging from late 2014 to early
2016, which was the key contributor to both collapse of commodity prices and global
volatility? Similarly, one could ask what prompted the Fed to tighten into China’s de-
leveraging drive in Dec ’15. As discussed in our report, there is a serious question over
China’s priorities, following completion of the 19th
Congress, and whether China fully
understands how much of the global reflation was due to its policy reversal to end de-
leveraging.
What does it mean for investors? We believe that it implies a higher than average risk, as
some of the key underpinnings of the investment landscape could shift significantly, and even
if macroeconomic outcomes were to be less stressful than feared, it could cause significant
relative and absolute price re-adjustments. As highlighted in discussion below (and our other
pieces – World without risk), financial markets are completely unprepared for higher
volatility. For example, as discussed in this report, value has for a number of years
systematically underperformed both quality and growth. If indeed, CBs managed to withdraw
liquidity without dislocating economies and potentially strengthening perception of growth
momentum, investors might witness a very strong rotation into value. Although we do not
believe that it would be sustainable, expectations could run ahead of themselves. Similarly,
any spike in inflation gauges could lift the entire curve up, with massive losses for bond-
holders, and flowing into some of the more expensive and marginal growth stories.
While it is hard to predict some of these shorter-term moves, if volatilities jump, CBs would
need to reset the ‘background picture’. The challenge is that even with the best of
intentions, the process is far from automatic, and hence there could be months of extended
volatility (a la Dec’15-Feb’16). If one ignores shorter-term aberrations, we maintain that there
is no alternative to policies that have been pursued since 1980s of deliberately suppressing
and managing business and capital market cycles. As discussed in our recent note, this
implies that a relatively pleasant ‘Kondratieff autumn’ (characterized by inability to raise cost
of capital against a background of constrained but positive growth and inflation rates) is likely
to endure. Indeed, two generations of investors grew up knowing nothing else. They
have never experienced either scorching summers or freezing winters, as public sector
refused to allow debt repudiation, deleveraging or clearance of excesses. Although this
cannot last forever, there is no reason to believe that the end of the road would necessarily
occur in 2018 or 2019. It is true that policy risks are more heightened but so is policy
recognition of dangers.
Fig 7 US – Rolling Bubbles (PER x) – no alternative
to riding financial bubbles…
Fig 8 US – Real vs. Financial Assets (x) - …financial
assets would continue to dominate
Source: CEIC, Macquarie Research, July 2017 Source: CEIC, Macquarie Research, July 2017
0
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Real Estate Equities Bonds, rhs
Dot.com equity Bubble Real estate Bubble Bond bubble
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0.20
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1.00
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Real/Financial Assets
Risk of policy errors
is high
We are still in the
camp that excess
liquidity must be
provided and cost of
capital cannot rise
Hence ‘Kondratieff
autumn’ persisting
for a bit longer

14 November 2017 6
We therefore remain constructive on financial assets (as we have been for quite some
time), not because we believe in a sustainable and private sector-led recovery but
rather because we do not believe in one, and thus we do not see any viable alternatives to
an ongoing financialization, which needs to be facilitated through excess liquidity, and
avoiding proper price and risk discovery, and thus avoiding asset price volatilities.
In the above outlined climate, we maintain that:
1. Broadly defined cost of capital cannot go up; this implies flatter yield curves
and CBs avoiding price and volatility surges by continuing to manage liquidity.
Over the long term, we still believe that cost of capital ultimately will need to go
negative. In the shorter-term high yield market looks extremely vulnerable;
2. There is a danger of sudden US$ surges, as policy divergences grow (i.e. Fed
moving ahead of other central banks), but we believe these would need to be
negated through tighter communication and jawboning the market. It is not so
much the level of US$ but rather the intensity and duration of surges that counts.
The key ingredients that could underpin stronger US$ include its relatively low
supply, surge in demand (safety or geopolitical reasons) and widening spreads;
3. We continue to prefer equities to other asset classes, not because we think
equities are cheap (as pretty much nothing is anymore) but rather because
equities are positioned in a much better equilibrium state, one level below macro
and only one level above management and cash flows;
4. US equities are vulnerable to any disappointment either on taxation or the
regulatory front. There is simply not a single valuation or measurement criteria
that does not indicate significant overvaluation (from CAPE, Tobin Q, Equity
capitalization to GDP and all the way to a more primitive forward point in time
multiples). Having said that, the US has the best quality and the most
prospective corporate sector, and that’s why our Thematics and Quality
portfolios are dominated by the US names. There is also a much tighter
relationship between personal net worth and personal saving rates, with equities
in the US (vs other jurisdictions) being far more prominent as a symbol of
success and good policies. This implies much greater policy sensitivity.
5. European and Japanese equities continue to be better positioned on
valuation, growth and an improving ROE basis. The key risk for both regions
is the possibility of sharp currency appreciation. If the ECB and BoJ largely
abandon their programs to reflate their respective economies, then in that
scenario, surplus of domestic savings (reflected in current account surpluses)
would drive both currencies potentially much higher, causing a correction in
corporate ROEs. However, in the absence of this, both regions should report
higher returns, while valuation multiples are nowhere near as stretched. We
particularly like how Japan is managing to deliver steady multi-factor productivity
(higher than the US or Europe) and we like its interesting Thematic plays.
6. EM equities have significantly outperformed DMs (particularly in 1H’17),
with stronger momentum driven by an accelerating global reflation,
contained US$, ample liquidity and a growing impact of technology cycles.
What about the future? Our current base case scenario assumes that China’s
reflationary pulse would get weaker while liquidity could become more
compressed (although we do not envisage a dislocating jump in volatilities). On
the other hand, we remain strong believers that the technology cycle is only (at
best) mid-stream and neither growth prospects nor valuation measures makes
us currently nervous. Given that technology now accounts for ~32% of MSCI
Asia ex Japan (double the level of five years ago), we believe this is both the
greatest opportunity and risk for EM equities. It is no longer financials,
infrastructure, or consumption that determine index performance. Normally,
weakening reflation and tighter liquidity could lead to potential significant EM
underperformance. However, changes in the index drivers make us more
comfortable, expecting a neutral performance, with Asia ex outperforming the
rest of EMs.
We therefore remain
constructive on
financial assets
But there is a
danger of sudden
spikes in US$
We continue to
prefer equities
US markets are
vulnerable and…
…we continue to
prefer Europe and
Japan while…
…EMs should hug
DMs, but Asia ex is
better positioned

14 November 2017 7
7. In terms of Asia ex markets, we continue to double down on our winners.
We highlight countries that have stronger domestic liquidity, a low degree
of external vulnerability and higher exposure to technology cycle. We
remain overweight on China, Korea and India, with broadly neutral positions in
the Philippines, Taiwan and Singapore. We continue to underweight terms of
trade countries or countries that could be dislodged in any dislocation (such as
Indonesia, Thailand and Malaysia).
In terms of stock selections, we continue to emphasize non-mean reversion strategies
and that ‘less is more’.
As discussed in the past, we believe that over the next decade, marginal costs (and hence
marginal revenues) will continue to fall, and gradually more and more corporates will be
forced to consider extreme measures (such as mergers and acquisitions, disposals, self-
liquidation through capital returns, financial engineering). We also view activist fund
managers as performing a useful social function of making corporates recognize that building
another factory makes absolutely no sense, and hence the capital should be returned to
shareholders. Unfortunately having gotten cash, investors themselves have nowhere to place
it, and hence they compete for ever diminishing returns. We believe that the above describes
pretty much any conventional corporate (from Nestlé to Danone and GM to Renault). The
conventional capital and labour-intensive businesses are being squeezed by both
conventional and new players, and as long as cost of capital remains at zero, there will be
even more start-ups to threaten existing status quo. However, we believe the new
(technology-based) players are also facing their own disrupters, and over time, will look like
GM does today. Eventually, we believe that as marginal costs start to approach zero,
there will no longer be any need for corporates, and instead, new businesses will simply
resemble ‘flashes in the sky’, which shine bright for relatively short periods of time, and then
disappear, when their advantage goes.
However, this is decades in the future. In the meantime, our objective is to find
corporates that still have some ‘runway’ left (whether it is several years or decades). Over
the last five years, we have attempted to do it through two non-mean reversionary strategies.
First, ‘Quality Sustainable Growth’ (QSG) portfolios which are based on relatively strict criteria
of ROEs, derived mostly through margins and without excessive leveraging. In other words,
we are asking corporates to deliver moderate growth, without dropping margins or leveraging.
As discussed below, we are agnostic as to sectors and valuation is not our prime
consideration. Second, another portfolio that we have been running is based purely on
‘Thematics’ and has no quality overlays. We have identified seven themes, with most
focusing on the basic concept of ‘declining return on humans and conventional capital and
rising returns on social and digital capital’. In the report we discuss our criteria as well as our
latest stock selections. In other words, our portfolios consist of quality, growth and thematic
names but it virtually never has value names.
We believe that the coming two years will test whether our long-term view of inability
to return to a conventional business and capital market cycles is still valid or whether
it will need to be re-assessed. Our portfolios and country selections would clearly struggle if
mean-reversion and conventional sector and style rotations return. We think it is unlikely, but
time will tell.
In Asia ex we
continue to prefer
China, India and
Korea
Our stock selection
strategies continue
to be shaped by
Quality,
Sustainability,
Growth and
Thematics
The next year will
test our non-mean
reversion
assumption

14 November 2017 8
Risk 1: Central Bank’s ‘chicken run’
“We are both heading for the cliff, who jumps first, is the chicken”, movie ‘Rebel
without cause’, 1955
We believe the key question facing investors is whether Central Banks will be able to
withdraw liquidity and/or raise rates without causing an uncontrolled rise in asset price
volatilities. It is a highly delicate task.
While investors have been aware of the degree of their dependence on exceptionally loose
monetary levers, it is still quite startling to witness the sheer extension of central bank support
mechanisms, and how this support (when prematurely withdrawn, as in 2013-15) could cause
massive asset volatility spikes and significant deflationary pressures.
As can be seen below G4+Swiss central bank balance sheets expanded from a run rate of
around US$3trillion in 2005-06 to ~US$15.6 trillion. If we include PBOC, the G5+Swiss
central bank balance sheet now stands at over US$21 trillion, representing around 40% of
GDP. At different points in time, various Central Banks have taken the lead. Initially, most of
the running was done by the Fed and BoE, but in the last two years, the bulk of incremental
growth came from ECB, BoJ and SNB. Overall liquidity injections have over the last two years
grown at a ~13%-15% clip, slowing recently towards 10%-12%. On the current trajectory, the
above Central Banks are on course to inject in excess of US$2bn or 2.5% of global GDP.
Fig 9 G4+Swiss Central Bank Assets (US$ bn) Fig 10 G5+Swiss Central Bank Assets (US$ bn)
Source: Bloomberg, Macquarie Research, November 2017 Source: Bloomberg, Macquarie Research, November 2017
Fig 11 G4+Swiss Central Bank Assets (% YoY) Fig 12 G5+Swiss Central Bank Assets (% YoY)
-
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
Jan-99
Nov-99
Sep-00
Jul-01
May-02
Mar-03
Jan-04
Nov-04
Sep-05
Jul-06
May-07
Mar-08
Jan-09
Nov-09
Sep-10
Jul-11
May-12
Mar-13
Jan-14
Nov-14
Sep-15
Jul-16
May-17
Fed ECB BoJ BoE Swiss
-
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
18,000
20,000
22,000
Jan-99
Nov-99
Sep-00
Jul-01
May-02
Mar-03
Jan-04
Nov-04
Sep-05
Jul-06
May-07
Mar-08
Jan-09
Nov-09
Sep-10
Jul-11
May-12
Mar-13
Jan-14
Nov-14
Sep-15
Jul-16
May-17
Fed ECB BoJ BoE Swiss PBoC
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
Oct-09
Mar-10
Aug-10
Jan-11
Jun-11
Nov-11
Apr-12
Sep-12
Feb-13
Jul-13
Dec-13
May-14
Oct-14
Mar-15
Aug-15
Jan-16
Jun-16
Nov-16
Apr-17
Sep-17
G4+Swiss (YoY)
End of QE3
12%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
Oct-09
Mar-10
Aug-10
Jan-11
Jun-11
Nov-11
Apr-12
Sep-12
Feb-13
Jul-13
Dec-13
May-14
Oct-14
Mar-15
Aug-15
Jan-16
Jun-16
Nov-16
Apr-17
Sep-17
G5+Swiss Growth (YoY)
End of QE3
10%
Central Banks (CBs)
seem to be
determined to
withdraw liquidity
and raise rates

14 November 2017 9
If one assumes that ECB will reduce its purchases to ~€30bn per month from January 2018
while extending purchases all the way to December 2018 (rather than obeying a self-imposed
September 2018 deadline), its net purchases would fall by ~US$400bn when compared to
2017. Similarly, we would expect BoJ to buy around ¥20trillion (US$180bn) less while BoE
should curtail purchases by a further US$100bn. It then comes down to the Fed and on its
proposed trajectory, the balance sheet might shrink by ~US$300bn-500bn. Thus, in total, we
expect that the net purchases of G4+Swiss Central Banks could decline by more than
US$1 trillion when compared to 2017.
It implies that the pace of liquidity injections should drop from the current level of ~12%
towards 5%. If indeed we are witnessing a sustainable acceleration in private sector demand
and productivity, then this would be an appropriate reduction in liquidity supports. However, if
most of the reflationary pulse through ‘16-17 was due to excess liquidity and China stimulus,
then the fading of both through ‘18 could have highly unpredictable consequences. The
excess liquidity is already declining, and in the absence of higher velocity of money, it might
not satisfy nominal demand (as indeed happened in late ‘14 and through ‘15).
Fig 13 G4 – Nominal GDP vs. Broad Money supply
(%) – surplus liquidity is already shrinking, just as…
Fig 14 G4+Swiss – Central Bank Balance Sheet (US$
bn, %YoY) - …CBs are starting to reduce liquidity
The extent to which excess liquidity and associated leveraging/asset prices are required
clearly depends on whether the private sector is accelerating its momentum, without any
incremental support. In other words, excess liquidity and leveraging is not needed if
private sector productivity improves.
How would we know that this is occurring? There are several tests that one can perform,
some more backward looking than others, but essentially all are based on a mix of
productivity measures (such as multi-factor productivity and/or its simpler cousin of output per
hour worked or per employee), velocity of money and net sectoral balances.
Let’s start with velocity of money. As can be seen below, the over leveraging and
associated wastage of capital as well as continuing expansion of monetary accommodation
are continuing to depress velocity of money across almost all jurisdictions. In the case of the
US, velocity of money seems to be stabilizing at around 1.4x (down from 2.2x during the
dot.com bubble), but there is no evidence of any meaningful uptick. The same is true of
Eurozone, where velocity of money remains nailed at the historically low point of around 1x,
Japan (~0.56x), China (~0.5x) and Korea (~0.7x). Even in the UK, which has seen a fairly
strong recovery in 2013-16, velocity of money is starting to ease back again. We believe the
best that can be argued is that at least economic velocity of money is no longer
deteriorating but it will require a microscope to detect any meaningful improvement.
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
Dec-12
Mar-13
Jun-13
Sep-13
Dec-13
Mar-14
Jun-14
Sep-14
Dec-14
Mar-15
Jun-15
Sep-15
Dec-15
Mar-16
Jun-16
Sep-16
Dec-16
Mar-17
Jun-17
Sep-17
Surplus Liquidity Nominal GDP M3
-10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
(1,000)
(500)
-
500
1,000
1,500
2,000
2,500
3,000
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
QE Increment % Growth
Taking their rhetoric
for granted, liquidity
contraction could
exceed US$1 trillion
This is appropriate if
private sector
productivity
accelerates
However, whether
we look at velocity
of money…

14 November 2017 10
Fig 15 US – Velocity of Money (GDP/M2) (x) Fig 16 Eurozone – Velocity of Money (GDP/M2) (x)
Fig 17 Japan – velocity of Money (GDP/M2) Fig 18 Korea – Velocity of Money (GDP/M2) (x)
Fig 19 China – velocity of Money (GDP/M2) Fig 20 UK – Velocity of Money (GDP/M2) (x)
Next we can look at sectoral balances. As in the case of velocity of money, it is a backward
measure, with most estimates ending in 2Q2017. Nevertheless, we maintain that sectoral
balances provide what is arguably the best picture of what drives economies.
For example, these balances have been highlighting for some time that Eurozone, Korea,
Taiwan and Japan instead of injecting global demand were essentially surfing on the waves
of deficits generated by Anglo-Saxon economies (principally the US and UK). Although the
same applies to China, unlike those countries, China also happens to be the world’s largest
generator of incremental debt and its largest consumer of commodities. Hence, China’s role
is far more subtle. As highlighted in our prior notes, China is both the greatest threat to the
global economy and its Guardian Angel, as it can have a massive reflationary impact via
commodity complex, infrastructure and real estate.
1.30
1.40
1.50
1.60
1.70
1.80
1.90
2.00
2.10
2.20
Dec-59
Mar-62
Jun-64
Sep-66
Dec-68
Mar-71
Jun-73
Sep-75
Dec-77
Mar-80
Jun-82
Sep-84
Dec-86
Mar-89
Jun-91
Sep-93
Dec-95
Mar-98
Jun-00
Sep-02
Dec-04
Mar-07
Jun-09
Sep-11
Dec-13
Mar-16
Velocity Average (1990-2015)
Average (1960-1990)
1.42 = Historic Low
0.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
1.60
1.70
1.80
Mar-95
Jun-96
Sep-97
Dec-98
Mar-00
Jun-01
Sep-02
Dec-03
Mar-05
Jun-06
Sep-07
Dec-08
Mar-10
Jun-11
Sep-12
Dec-13
Mar-15
Jun-16
Velocity Average (1995-2015)
1.0x
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
2.25
Mar-57
Dec-59
Sep-62
Jun-65
Mar-68
Dec-70
Sep-73
Jun-76
Mar-79
Dec-81
Sep-84
Jun-87
Mar-90
Dec-92
Sep-95
Jun-98
Mar-01
Dec-03
Sep-06
Jun-09
Mar-12
Dec-14
Velocity Average (1957-1987) Average (1988-2015)
0.56x = Historic low
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
2.00
2.20
2.40
Mar-85
Sep-86
Mar-88
Sep-89
Mar-91
Sep-92
Mar-94
Sep-95
Mar-97
Sep-98
Mar-00
Sep-01
Mar-03
Sep-04
Mar-06
Sep-07
Mar-09
Sep-10
Mar-12
Sep-13
Mar-15
Sep-16
Korea Velocity Average (1985-2015)
Historic Low
0.7
0.40
0.50
0.60
0.70
0.80
0.90
1.00
1.10
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
China Velocity
Historic Low
0.48x
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
2.00
Mar-87
Jun-88
Sep-89
Dec-90
Mar-92
Jun-93
Sep-94
Dec-95
Mar-97
Jun-98
Sep-99
Dec-00
Mar-02
Jun-03
Sep-04
Dec-05
Mar-07
Jun-08
Sep-09
Dec-10
Mar-12
Jun-13
Sep-14
Dec-15
Mar-17
UK Average (1987-2015)
0.87x
…sectoral balances
or…

14 November 2017 11
The US arguably has had the best recovery in sectoral balances, with private sector savings
declining from the ‘dark days’ of 2009-10 (~9%-10%) of GDP to around 2.3%-2.4% currently.
However, as the US insists on perpetually faster growth rates, its public sector net sector
borrowings remain high (~4.8% of GDP), implying that the US continues to import capital to
support its growth. However, in the last 18 months there was no significant further decline in
private sector savings. In the UK, private sector savings have gone into step decline, beyond
even levels experienced during the dot.com. However, this opened massive current account
deficits. In the last two quarters, the UK private sector and the government (public sector) are
starting to pull back.
Fig 21 US – Sectoral Balances (% of GDP) Fig 22 UK – Sectoral Balances (% of GDP)
Source: Federal Reserve, Macquarie Research, November 2017 Source: CEIC, Macquarie Research, November 2017
The Eurozone (as a block), and more importantly some of its more vulnerable members (such
as Spain, Portugal, Greece and Italy) are also reporting declining private sector savings.
However, unlike the US or UK, Eurozone’s public sector is not willing to absorb private sector
savings, and hence the Eurozone continues to have surplus private sector capital that it
needs to export (principally to the US, UK and some emerging markets).
As can be seen below, private sector net savings dropped by 2Q2017 to around 4% (from
5.4% in 2Q2016 and the cyclical high of over 6% in ‘10). Having said that, private sector
savings remain high, loan growth (though no longer falling) remains weak and the more
fragile members continue to rely on Bundesbank to continue providing credit, with Target 2
balances of both Italy and Spain remaining at the highest levels ever while ECB continues to
suppress bond market volatilities, with Eurozone’s corporate and high yield bond spreads at
the lowest levels ever, as ECB backstops weaker corporates.
Fig 23 Eurozone – Sectoral Balances (% of GDP) Fig 24 Spain – Sectoral Balances (% of GDP)
Source: ECB, Macquarie Research, November 2017 Source: ECB, Macquarie Research, November 2017
-15.0%
-12.5%
-10.0%
-7.5%
-5.0%
-2.5%
0.0%
2.5%
5.0%
7.5%
10.0%
12.5%
1997Q1
1997Q4
1998Q3
1999Q2
2000Q1
2000Q4
2001Q3
2002Q2
2003Q1
2003Q4
2004Q3
2005Q2
2006Q1
2006Q4
2007Q3
2008Q2
2009Q1
2009Q4
2010Q3
2011Q2
2012Q1
2012Q4
2013Q3
2014Q2
2015Q1
2015Q4
2016Q3
2017Q2
Private sector Public Sector ROW
Saving
Spending
-10.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Dec-14
Dec-15
Dec-16
Private Sector Government ROW
CA Deficit
Saving
Spending
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
2017Q2
20163Q
2015Q4
2015Q1
2014Q2
2013Q3
2012Q4
2012Q1
2011Q2
2010Q3
2009Q4
2009Q1
2008Q2
2007Q3
2006Q4
2006Q1
2005Q2
2004Q3
2003Q4
2003Q1
Saving
Spending
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
Dec-00
Mar-02
Jun-03
Sep-04
Dec-05
Mar-07
Jun-08
Sep-09
Dec-10
Mar-12
Jun-13
Sep-14
Dec-15
Mar-17
Saving
Spending

14 November 2017 12
Fig 25 Italy – Sectoral Balances (% of GDP) Fig 26 Portugal – Sectoral Balances (% of GDP)
Fig 27 Eurozone Lending (% YoY) - ~1% growth Fig 28 Germany – Target 2 Balances (Euro bn)
Fig 29 Italy – Target 2 Balances (Euro bn) Fig 30 Spain – Target 2 Balances (Euro bn)
As far as Japan is concerned, the private sector savings are largely ‘stuck’ at around 6% of
GDP. As in the case of both the US and Eurozone, there are no signs of rapid escalation but
neither are there signs of any sustained recovery. As we have been highlighting in our prior
notes, China’s re-balancing continues at a relatively glacial pace. At the current momentum, it
would take China more than a decade (and possibly two plus) to rebalance.
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
Dec-00
Mar-02
Jun-03
Sep-04
Dec-05
Mar-07
Jun-08
Sep-09
Dec-10
Mar-12
Jun-13
Sep-14
Dec-15
Mar-17
Saving
Spending
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
Dec-00
Mar-02
Jun-03
Sep-04
Dec-05
Mar-07
Jun-08
Sep-09
Dec-10
Mar-12
Jun-13
Sep-14
Dec-15
Mar-17
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
Jan-04
Sep-04
May-05
Jan-06
Sep-06
May-07
Jan-08
Sep-08
May-09
Jan-10
Sep-10
May-11
Jan-12
Sep-12
May-13
Jan-14
Sep-14
May-15
Jan-16
Sep-16
May-17
Household Non-Financial Corporates Private Sector
0
100
200
300
400
500
600
700
800
900
2017Sep
2017Apr
2016Nov
2016Jun
2016Jan
2015Aug
2015Mar
2014Oct
2014May
2013Dec
2013Jul
2013Feb
2012Sep
2012Apr
2011Nov
2011Jun
2011Jan
2010Aug
2010Mar
2009Oct
2009May
2008Dec
2008Jul
2008Feb
2007Sep
2007Apr
(500)
(400)
(300)
(200)
(100)
-
100
2017Sep
2017Apr
2016Nov
2016Jun
2016Jan
2015Aug
2015Mar
2014Oct
2014May
2013Dec
2013Jul
2013Feb
2012Sep
2012Apr
2011Nov
2011Jun
2011Jan
2010Aug
2010Mar
2009Oct
2009May
2008Dec
2008Jul
Italy
'Do whatever it takes'
(500)
(450)
(400)
(350)
(300)
(250)
(200)
(150)
(100)
(50)
-
2017Sep
2017May
2017Jan
2016Sep
2016May
2016Jan
2015Sep
2015May
2015Jan
2014Sep
2014May
2014Jan
2013Sep
2013May
2013Jan
2012Sep
2012May
2012Jan
2011Sep
2011May
2011Jan
2010Sep
2010May
2010Jan
2009Sep
2009May
2009Jan
2008Sep
Spain

14 November 2017 13
Fig 31 Japan – Sectoral Balances (% of GDP) Fig 32 China – Sectoral Balances (% of GDP)
Source: CEIC, Macquarie Research, November 2017 Source: CEIC, Macquarie Research, November 2017
On balance, it is hard to say that there is any consistent evidence of private sector
vitality, and it certainly is hard (perhaps impossible) to disentangle signs of stability and
globally co-ordinated reflation from massive injection of central bank liquidity. This particularly
applies to Eurozone and Japan.
Finally, we can examine both contemporaneous and lagging indicators of labour
productivity. By far the best data base for multi-factor or Total Factor (TFP) productivity is
provided by the Conference Board (TED). While it is lagging by a year, it provides the best
indication of real productivity gains, separate from contribution of labour and capital. TED
data base supplies ICT adjusted estimates. SF Fed also provides timely (three-six months
lag) estimates of the US TFP. Various agencies supply a far more frequent but far more
simplistic measure of output per hour or per employee.
What do these estimates tell us?
First, if we examine the US, according to SF Fed, the 2Q2017 TFP growth rate was a
negative 0.3% and three year moving average was barely at zero. Indeed, TFP growth rates
have been on a fairly consistent declining curve since the mid-to-late 1970’s and over the last
decade, the average was not much better at zero. The TED data base yields a broadly similar
conclusion. A simpler version of output per hour (non-farm businesses) has been showing
some pick-up over the last two quarters, but again, over the longer term, it is still within a
declining channel.
Fig 33 US – TFP Growth rates (%)
Fig 34 US – TFP Growth rates (3YMA) (%) – hugging
zero bound
Source: SF Fed, Macquarie Research, November 2017 Source: SF Fed, Macquarie Research, November 2017
-10.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
Dec-98
Mar-00
Jun-01
Sep-02
Dec-03
Mar-05
Jun-06
Sep-07
Dec-08
Mar-10
Jun-11
Sep-12
Dec-13
Mar-15
Jun-16
ROW Private Sector Public Sector
Saving
Spending
-10
-8
-6
-4
-2
0
2
4
6
8
10
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Public Private ROW
Saving
Spending
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
1950-1955
1956-1960
1961-1965
1966-1970
1971-1975
1976-1980
1981-1985
1986-1990
1991-1995
1996-2000
2001-2005
2006-2010
2011-2016
TFP Growth Rates (%) Average 1950-1980
Average (1980-2016)
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
1950:Q1
1952:Q3
1955:Q1
1957:Q3
1960:Q1
1962:Q3
1965:Q1
1967:Q3
1970:Q1
1972:Q3
1975:Q1
1977:Q3
1980:Q1
1982:Q3
1985:Q1
1987:Q3
1990:Q1
1992:Q3
1995:Q1
1997:Q3
2000:Q1
2002:Q3
2005:Q1
2007:Q3
2010:Q1
2012:Q3
2015:Q1
3YMA TFP
…narrow or broad
measures of
productivity…

14 November 2017 14
Fig 35 US – Output per hour (non-farm) (%)
Fig 36 US – Output per hour (non-farm) (%) – recent
jump but within LT declining pattern
Source: BLS, Macquarie Research, November 2017 Source: BLS, Macquarie Research, November 2017
This is the same answer one derives when examining productivity rates in the UK and across
Eurozone as well as some of the key Eurozone economies. Generally, productivity growth
rates were on a declining curve for extended periods, in some cases for decades. The same
largely now applies to emerging markets, with the only exception of the least developed
countries (such as India or the Philippines). For example, countries like China, Malaysia,
South Africa and Brazil are now reporting negative TFP.
Fig 37 UK – Output per hour (%) – barely positive Fig 38 UK – TFP Growth (%) – remains negative
Source: CEIC, Macquarie Research, November 2017 Source: ONS, Macquarie Research, November 2017
Fig 39 Eurozone – Output per hour (%) – growth
rates contained to ~0.5%
Fig 40 Eurozone – TFP Growth (%) – hugging close to
zero
Source: CEIC, Macquarie Research, November 2017 Source: TED, Macquarie Research, November 2017
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
1901-10
1911-20
1921-30
1931-40
1941-49
1950-54
1955-59
1960-64
1965-69
1970-74
1975-79
1980-84
1985-89
1990-94
1995-99
2000-04
2005-09
2010-14
2015-17
Productivity Average (1970-2015) Average (1901-70)
Illusion?
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
Mar-96
Feb-97
Jan-98
Dec-98
Nov-99
Oct-00
Sep-01
Aug-02
Jul-03
Jun-04
May-05
Apr-06
Mar-07
Feb-08
Jan-09
Dec-09
Nov-10
Oct-11
Sep-12
Aug-13
Jul-14
Jun-15
May-16
Apr-17
Non-Farm Productivity (4QMMA)
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
Sep-72
Dec-74
Mar-77
Jun-79
Sep-81
Dec-83
Mar-86
Jun-88
Sep-90
Dec-92
Mar-95
Jun-97
Sep-99
Dec-01
Mar-04
Jun-06
Sep-08
Dec-10
Mar-13
Jun-15
Output per Hour (3QMA)
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
1971-1975
1976-1980
1981-1985
1986-1990
1991-1995
1996-2000
2001-2005
2006-2010
2011-2016
Average 1971-2016
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
Sep-96
Dec-97
Mar-99
Jun-00
Sep-01
Dec-02
Mar-04
Jun-05
Sep-06
Dec-07
Mar-09
Jun-10
Sep-11
Dec-12
Mar-14
Jun-15
Sep-16
Labour Productivity (3QMA)
0.5%
-2.5
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017

14 November 2017 15
Fig 41 Key EM economies – TFP growth rates (%)
Fig 42 Emerging & Developing economies –
Productivity growth (%) – hugging zero at TFP
Source: TED, Macquarie Research, November 2017 Source: TED, Macquarie Research, November 2017
A similar message of limited signs of productivity recovery is also evident if we
examine gross fixed capital formation.
Although improving, it remains firmly in the long-term decline channel. As discussed in our
prior notes, it makes sense to us, as we do not believe that (apart from the least developed
countries), there is need for any significant uplift in fixed asset investment. In most cases, the
private sector is already providing a sufficient amount for maintenance as well as incremental
improvement. The key is that what really matters in the contemporary world is not capital
intensive (such as code sequence, instructions, basic R&D etc). Indeed, we maintain that
activist fund managers are correct to demand a return of capital. It is doubtful that
another factory or improved road would enhance productivity or provide a sufficient return.
Having said that, we see that there is an urgent need for greater investment in the least
developed economies, as this is where bottlenecks are real and opportunities for productivity
gains are the greatest. However, as discussed (here), regions like Africa, Middle East, Central
Asia and South Asia require a ‘Marshall Plan’ rather than conventional private sector driven
investment.
Bond markets are not mispricing the long end
As discussed in our recent note (CBs vs. markets – Can CBs shift the entire yield curve? 27th
Oct 2017), we believe that the more the Fed tries to tighten, the more the market is likely to
flatten the yield curve. This in turn would severely limit the Fed’s ability to continue tightening.
In our view, investors are correctly assuming that the more the Fed withdraws liquidity and
tightens, the greater will be longer-term disinflationary pressures. Thus, instead, of endearing
greater confidence, the Fed actions could lead to lower liquidity and greater preference for
saving rather than consumption.
Unless, the entire yield curve moves up, it is doubtful that the Fed will be able to tighten or
withdraw liquidity. This in turn returns us to the subject of private sector productivity and
vibrancy or alternatively a significant shift in public sector policies. Given that we do not
believe that it is likely that private sector productivity rates will improve much, we have been
expecting a more robust public sector response. First, however, we believe that we do need a
‘jolt’ to the system or some form of significant dislocation before far more aggressive policies
are likely to become more palatable. Eventually we maintain our view that the merger of fiscal
and monetary policies (and hence elimination of the linkage between borrowing and
spending) is on the cards. We also expect the introduction of universal minimum income
guarantees, more aggressive infrastructure and spending program as well as a significant lift
in Marshall Plan-type investment in extensive areas of the least developed parts of the world.
However, all of this is for the future. In the meantime, it comes down to a balance between
productivity growth rates and attempts by CBs to return to some form of normality. If we do
not believe in the productivity renaissance, then an ongoing financialization is the only way to
maintain aggregate demand, through asset prices and leveraging. We maintain that neither
demand nor supply can justify a higher cost of capital, irrespective of what the Fed
would like to achieve. The alternative would be to bring forward the dislocation that
CBs are trying to avoid.
1990-1999 2000-2009 2010-2016 2013-2016
South Africa -1.1 0.7 -0.8 -1.4
China 1.0 1.9 0.1 -0.8
India 1.0 1.4 1.5 1.8
Indonesia -2.2 0.8 0.6 0.4
Malaysia -1.2 0.1 -0.4 -0.6
Philippines -1.3 0.8 1.5 1.2
Korea 0.5 0.7 0.4 0.1
Taiwan 0.9 0.6 1.2 0.2
Thailand 0.3 1.4 1.3 0.8
Turkey -0.3 -0.5 0.6 0.0
Brazil -0.3 0.1 -1.9 -3.3
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Output/Employee TFP
There is no
evidence of any
consistent rise in
productivity
We believe bond
markets are
correctly judging
that tightening and
withdrawal of
liquidity would lead
to more
disinflationary
outcomes later

14 November 2017 16
Hence, we believe one of the greatest risks facing investors is one of policy error by Central
Banks misjudging the balance between growth, inflation, liquidity, cost of capital and
productivity.
Fig 43 US 10Y Bond Yield – firmly in a channel Fig 44 US – 10/2 Yield curve – one of the flattest ever
Fig 45 US 30Y Bond Yield – firmly under 3%
Fig 46 US – 30/2 yield curve – gets flatter every time
Fed tightens – one of the flattest ever
Fig 47 US -10 Y term premium – negative and one of
the lowest ever (%) Fig 48 G4 – Real 10Y Bond yield – ‘hugging zero’
As in the James Dean classic, Central Banks have stepped on the accelerator, and the
question investors need to ask is whether they will be able to get out before plummeting off a
cliff. In the movie, James Dean’s character (Jim) survived by jumping out of the car before it
plummeted down the cliff; but it did not turn out so well for Buzz.
0
2
4
6
8
10
12
14
16
18
Mar-76
May-78
Jul-80
Sep-82
Nov-84
Jan-87
Mar-89
May-91
Jul-93
Sep-95
Nov-97
Jan-00
Mar-02
May-04
Jul-06
Sep-08
Nov-10
Jan-13
Mar-15
May-17
10Y
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Feb-08
Jul-08
Dec-08
May-09
Oct-09
Mar-10
Aug-10
Jan-11
Jun-11
Nov-11
Apr-12
Sep-12
Feb-13
Jul-13
Dec-13
May-14
Oct-14
Mar-15
Aug-15
Jan-16
Jun-16
Nov-16
Apr-17
Sep-17
Yield Curve (10/2)
0
2
4
6
8
10
12
14
16
Apr-77
Oct-79
Apr-82
Oct-84
Apr-87
Oct-89
Apr-92
Oct-94
Apr-97
Oct-99
Apr-02
Oct-04
Apr-07
Oct-09
Apr-12
Oct-14
Apr-17
30Y
1.0
1.2
1.4
1.6
1.8
2.0
2.2
2.4
2.6
2.8
Mar-15
May-15
Jul-15
Sep-15
Nov-15
Jan-16
Mar-16
May-16
Jul-16
Sep-16
Nov-16
Jan-17
Mar-17
May-17
Jul-17
Sep-17
Yield Curve (30/2)
First tightening
Second Tightening
Third Tightening
-2
-1
0
1
2
3
4
5
Dec-61
Dec-64
Dec-67
Dec-70
Dec-73
Dec-76
Dec-79
Dec-82
Dec-85
Dec-88
Dec-91
Dec-94
Dec-97
Dec-00
Dec-03
Dec-06
Dec-09
Dec-12
Dec-15
ACMTP10 Average (1961-2015)
Lowest Ever
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
Dec-92
Jan-94
Feb-95
Mar-96
Apr-97
May-98
Jun-99
Jul-00
Aug-01
Sep-02
Oct-03
Nov-04
Dec-05
Jan-07
Feb-08
Mar-09
Apr-10
May-11
Jun-12
Jul-13
Aug-14
Sep-15
Oct-16
US Germany Japan UK
Hugging close to zero

14 November 2017 17
Risk 2: What would China do?
‘Most dynasties collapsed under the twin blows of inside disorder and outside calamity
(nei-luan wai-huan)’, John Fairbank, Harvard scholar on China’s views of dynasties.
Apart from Central Banks’ chicken run, another question that investors would need to confront
is what role China is likely to play in ensuring global growth and stability.
As discussed in our note (Comrades-in-arms – Parallel but different lives 27 Oct 2017), the
latest Communist Party Congress was a watershed. It finally and formally buried remnants of
‘collective leadership’ that prevailed over the previous thirty years. In our view, Xi Jinping has
drawn four lessons from the collapse of the Soviet Union: (a) never allow the role of the party
to be questioned; (b) never ‘disarm’ the party’ (unlike Gorbachev who disbanded Military
Commission); (c) permit sufficient commercial space while tightly controlling capital flows; and
above all (d) maintain a perpetual growth machine. In our view, these four factors explain
recent strengthening of state controls (not just in deeds but also thoughts, such as 2017
Cybersecurity law or restrictions imposed on entertainment and news gathering agencies) as
well as regular anti-corruption drives. While rent-seeking behaviour is deeply imbedded in the
system and within current institutional settings cannot be extinguished (as long as asset
claims are not clearly delineated and there a dual legal system), we believe tighter controls
and regular ‘sweeps’ can allow the system to continue to function.
However, the key remains growth. We continue to find investors’ ongoing discussion of
‘quality vs. quality’ of growth mildly amusing. Secular and structural reforms are inherently
deflationary and while tighter control could allow the state to ride out shorter-term challenges,
the growth rates cannot be allowed to fall in any meaningful manner. Although re-balancing of
the economy is occurring, at the current pace, we expect it would take more than a decade to
achieve any meaningful re-balancing. As can be seen below, household consumption
currently constitutes ~39% of GDP and the Government consumption adds another 14%.
While the bottom of household share was recorded in 2010 (~36% of GDP), we estimate it
would take until around 2030 to reach the global household average of ~53%-54% of GDP.
Even that is optimistic, as it is not clear whether savings rates would come off fast enough,
considering that real disposable incomes are easing. It also remains the classic ‘Catch 22’ as
incomes and savings are powered by investment, and hence, erosion of investment could
easily reduce both incomes and savings. It certainly looks to us like a ‘squirrel in the wheel’.
Fig 49 China – Household & Government
Consumption (% of GDP) – HH=~39% of GDP
Fig 50 China – Retail Sales & FAI (% YoY, nominal) –
consumption is maintained by regular bursts of FAI
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
25.0%
35.0%
45.0%
55.0%
65.0%
75.0%
1952
1956
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
2012
2016
HH Consumption Government Consumption, rhs
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0
Mar-14
May-14
Jul-14
Sep-14
Nov-14
Jan-15
Mar-15
May-15
Jul-15
Sep-15
Nov-15
Jan-16
Mar-16
May-16
Jul-16
Sep-16
Nov-16
Jan-17
Mar-17
May-17
Jul-17
Sep-17
Retail Sales FAI
China is another key
factor, particularly
after the Congress
Re-balancing is too
slow and hence…

14 November 2017 18
Fig 51 China – Disposable Income per capita (% YoY)
– down to ~7% from 15+ in 2008-15
- d
nFig 52 China – HH saving rates remained high when
income growth rates were much faster
Indeed, we believe nothing better illustrates China’s dependence on stimulus and fixed asset
investment, accompanied by rapid growth in financialization, then the country’s response to a
sharp slowdown experienced in the course of 2015. Essentially, the new leadership
attempted a true de-leveraging (starting from late 2014). The level of social financing was
compressed and the public sector refused to accelerate public sector spending and real
estate prices were allowed to fall across the country throughout 2015. One can debate
whether economic forecasting agencies like Capital Economics or Conference Board were
correct, but there is no doubt that China’s growth rate in 2H’15 has fallen significantly below
the 6-6.5% reported trajectory.
As can be seen below, by the end of 2015, private sector FAI went negative, while the public
sector has not increased spending. Also real incomes suffered from a significant slowdown.
Commodities prices started to drop precipitously, and the Federal Reserve did not help by
tightening in December 2015. As a result, there was a massive jump in volatilities. At one
stage in late January/early February 2016, it almost felt to us like Bear Sterns’ moment (circa
2008). However, two things happened from March 2016 onwards. First, Central Banks
converged monetary policies (following G20 agreement in Feb’16), with the Fed abandoning
tightening while ECB, BoE and BoJ continued on their respective stimulus trajectory. Second,
China reversed its policy. As can be seen from the Figures below, public sector (and SOE)
investment was accelerated to a run rate of ~24% between March and July 2016 and was
maintained at a ~15%-16% pace through the balance of 2016. Since then, public sector FAI
moderated to a run rate of ~10%. Private sector investment in China almost invariably follows
the public sector lead. Having bottomed-out in May-July 2017 (around zero), it accelerated in
2H2017 towards a ~5%-6% clip. In 2017, moderation of public sector FAI also led to
moderation in private sector investment. A significant portion of investment went into real
estate, with the pace of investment accelerating from near zero in very late 2015/early 2016
to around an 8%-10% clip (depending on statistics used).
Fig 53 China – Public vs. Private FAI (% YoY) Fig 54 China – Real Estate Investment (% YoY)
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
Mar-03
Nov-03
Jul-04
Mar-05
Nov-05
Jul-06
Mar-07
Nov-07
Jul-08
Mar-09
Nov-09
Jul-10
Mar-11
Nov-11
Jul-12
Mar-13
Nov-13
Jul-14
Mar-15
Nov-15
Jul-16
Mar-17Disposable Income per Capita (% YoY)
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Saving Rate (% GDP), rhs Disposable Income (% YoY)
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
30.0
Sep-14
Nov-14
Jan-15
Mar-15
May-15
Jul-15
Sep-15
Nov-15
Jan-16
Mar-16
May-16
Jul-16
Sep-16
Nov-16
Jan-17
Mar-17
May-17
Jul-17
Sep-17
FAI- Public FAI-Private
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
Jan-14
Mar-14
May-14
Jul-14
Sep-14
Nov-14
Jan-15
Mar-15
May-15
Jul-15
Sep-15
Nov-15
Jan-16
Mar-16
May-16
Jul-16
Sep-16
Nov-16
Jan-17
Mar-17
May-17
Jul-17
Sep-17
China - Real Estate Inv YTD (y/y)
China - FAI Real Estate YTD (y/y)
…quantity
continues to
override quality

14 November 2017 19
A rise in social financing (particularly bank lending) and acceleration of public sector
investment (and projects) have the effect of reflating commodity prices (as both infrastructure
and real estate are highly commodity intensive). It reflated China’s corporate profitability
(particularly materials), reduced pressure on the banking sector, and re-started the global
reflationary cycle, which this time has been much more synchronized than during prior
stimuluses (2009-10, 2013). As can be seen below, China’s deflators and PPI exited their
long-term deflationary territory, and nominal GDP returned back to double-digit levels,
which China requires, if it were to justify an ongoing FAI investment.
At the same time, China has completely dominated global debt creation. If we just examine
non-financial sectors, China since December 2010 has been responsible for over 60% of
global credit and in the last three and a half years, this dependency increased even
further, with almost 90% of the global non-financial sector and corporate debt growth
attributable to China. When investors ask China to liberalize and alter its economic model,
we believe the question that they should address is what would have happened to global
reflation and credit cycle, if China had not engaged in massive debt fuelled reflation?
Fig 55 China – Nominal vs. Real GDP (%) Fig 56 China – GDP deflator (%)
Fig 57 China – Share of Incremental Debt ($ bn) (%) Fig 58 China – National Debt (% of GDP)
Source: BIS, Macquarie Research, November 2017 Source: BIS, CEIC, Macquarie Research, November 2017
However, every action has an opposite and equal reaction. Given that China only uses
two key levers (infrastructure and real estate), stimulus almost inevitably results in either/or
over building and speculation.
Indeed, real estate prices have quickly responded to the 2016 stimulus, with almost every city
category reporting rising property prices. At one stage in September 2016, the average of the
top seventy cities was increasing at a pace of almost 2% per month. Over the last six months,
the Government has been attempting to ‘cool down’ the real estate market through a variety
of micro prudential control measures. As in any ‘command and control’ economy, it has
succeeded in reducing the pace of appreciation to ~0.2% MoM.
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
22.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
13.0%
Mar-10
Sep-10
Mar-11
Sep-11
Mar-12
Sep-12
Mar-13
Sep-13
Mar-14
Sep-14
Mar-15
Sep-15
Mar-16
Sep-16
Mar-17
Sep-17
Real GDP Nominal GDP, rhs
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
Mar-10
Jul-10
Nov-10
Mar-11
Jul-11
Nov-11
Mar-12
Jul-12
Nov-12
Mar-13
Jul-13
Nov-13
Mar-14
Jul-14
Nov-14
Mar-15
Jul-15
Nov-15
Mar-16
Jul-16
Nov-16
Mar-17
Jul-17
GDP Deflator
Non-Financial sectors World China China Share (%)
2001-2005 27,316 1,587 5.8%
2006-2010 48,397 8,019 16.6%
2011-2017 (1Q) 28,315 17,265 61.0%
2014-2017 (1Q) 8,838 7,885 89.2%
Non-Financial Corporates
2008-2013 12,973 9,874 76.1%
2014-2017 (1Q) 4,878 4,529 92.8% 0%
50%
100%
150%
200%
250%
300%
350%
2000 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Public Sector Non-Financial Corporates Household Financial
China has been the
key driver of global
reflation but…

14 November 2017 20
The good news however was that acceleration of nominal GDP has also started to erode
requirements for incremental social financing towards 3:1 vs. previous highs of 3.5:1, while
stabilizing ICOR (incremental capital-output ratio) at ~6-7:1 (or around Rmb 6 of investment
for incremental Rmb 1 of growth).
Fig 59 China – Real Estate Prices (%) – rapid
acceleration in 2H’16 but moderation afterwards, with
current pace below 0.2% MoM
Fig 60 China – Social Financing (Rmb bn) – attempted
de-leveraging (’14-’15) replaced with ample liquidity at
~25% of national GDP
Fig 61 China – Incremental Social Financing to GDP
(x) – stabilizing at ~3x
Fig 62 China – ICOR Rates – stabilizing at a very high
rate of 6x-7x GDP
China is at a crossroads – which way will it turn?
We believe that China is currently at a crossroads. Having rescued itself (and the world)
in 2016-17, and following completion of the Party Congress, what will be China’s objectives?
We believe the key challenge facing China is that it has joined the rest of the world in
reporting sharply lower multi-factor (or TFP) growth rates. Given the high degree of over
capitalization, China’s productivity gains have plunged, on some measures (such as TED),
turning negative over the last three years. At the same time, as in the case of Japan in the
1970s-80s, misallocation of resources is starting to erode corporate ROEs. Although a
recovery in commodity prices has allowed China’s SOEs to record a slight pullback in ROEs,
returns are down from 15%-16% in 2010-11 to around 10% currently (and these were as low
as 7%-8% in 2015-16), while private sector ROE’s have dropped from 25%-26% in 2010-11
to around 17%-18% now. The same applies to asset turn, with the past trend of rising asset
turn ratios over the 1999-2011 period decisively broken. Finally, there is also evidence of
generally weaker demand for money. This was also reported by Japan in the lead-up to
1990/91.
In other words, China is no longer as productive (and on some measures, it is
destroying capital), and this is being reflected in lower corporate returns, rising
corporate debts and more temperate demand for money.
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
Jul-05
Mar-06
Nov-06
Jul-07
Mar-08
Nov-08
Jul-09
Mar-10
Nov-10
Jul-11
Mar-12
Nov-12
Jul-13
Mar-14
Nov-14
Jul-15
Mar-16
Nov-16
Jul-17
Avg Property prices YoY (70 cities) Avg prices (MoM) [RHS]
0%
5%
10%
15%
20%
25%
30%
35%
40%
-
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
18,000
20,000
22,000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
All-System Financing % of GDP
Attempted de-leveraging
-
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Financing needed for Rmb of GDP Growth
-
1.00
2.00
3.00
4.00
5.00
6.00
7.00
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017China - ICOR China Average 1991-2007
…bubbles and
anomalies are
building and
productivity is
falling

14 November 2017 21
Fig 63 China – TFP Growth Rates (%) Fig 64 China – Corporate Asset Turnover (x)
Source: TED, Macquarie Research, November 2017 Source: CEIC, Macquarie Research, November 2017
Fig 65 China – SOE ROE and Margin (%) Fig 66 China – Non SOE ROE & Margin (%)
Fig 67 China – PBoC – demand for loans Fig 68 China – PBoC survey of depositors
As we have highlighted in our notes (What caught my eye? v.80 - Japan Debt Mountain: does
it matter? 22 Sep 2017; What caught my eye? v.74 - China – Atlas holding up the sky 24
March 2017, What caught my eye? v.60 - Parallel lives: Japan vs. China 23 June 2016;
What caught my eye? v.65 - Is China ‘a shining city upon a hill’? 7 October 2016), we do not
believe that China is facing an imminent credit or liquidity event. While there are many
parallels between Japan in the ‘70s-80s and China today, there are also differences. Arguably
two key factors are acting in favour of China: (a) it has learned to never fully open capital
account; and (b) the relationship between the state and economy is far tighter in China. While
neither country has ever been truly Capitalist, China is closer to a statist model.
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
1990-1999 2000-2009 2010-2016 2013-2016
Official Alternative, rhs
0.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
1.60
0.40
0.45
0.50
0.55
0.60
0.65
0.70
0.75
0.80
0.85
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
SOE Non-SOE, rhs
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
ROE Net Margin, rhs
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
ROE Net Margin, rhs
40
45
50
55
60
65
70
75
80
85
90
Mar-09
Aug-09
Jan-10
Jun-10
Nov-10
Apr-11
Sep-11
Feb-12
Jul-12
Dec-12
May-13
Oct-13
Mar-14
Aug-14
Jan-15
Jun-15
Nov-15
Apr-16
Sep-16
Feb-17
Jul-17
Large Enterprises Medium Enterprises
Small Enterprises
25.0
30.0
35.0
40.0
45.0
50.0
Dec-09
May-10
Oct-10
Mar-11
Aug-11
Jan-12
Jun-12
Nov-12
Apr-13
Sep-13
Feb-14
Jul-14
Dec-14
May-15
Oct-15
Mar-16
Aug-16
Jan-17
Jun-17
Preference for more Saving Preference for more investing

14 November 2017 22
Essentially, as long as China continues to ‘hide’ behind capital controls and there is a direct
line of sight between PBoC, banks and what is supposed to be the private sectors (such as
materials, coal, cement, metals, property developers), we believe China can always stimulate
while controlling consequences, and it can reflate demand and the commodity complex. If we
also reclassify SOE and public vs private sectors differently (i.e. by assuming that most
systemic sectors are really disguised SOEs), then real private sector GDP in China is
probably less than 50% (rather than the headline number of ~320%-330%). As in the case of
Japan (which is currently quietly liquidating its public debt burden), a significant proportion of
China’s debt effectively resides with state entities.
However, every time China embarks on a stimulus and the longer it continues to rely
on investment and the external side, it effectively shortens its own life. Hence, the
dilemma. China is controlling almost 30% of global savings flow because it is investing and
trading. If it reduces investment and allows its global trading share to erode, savings would
decline, but the same would probably happen to employment and incomes.
…follow the money, employment and wages
Historically whenever Chinese empires collapsed, it was always under the twin pressures of
internal turbulence and external dislocation. It applies today, as much as it did to the Ming or
Qing dynasties. No emperor ever survived rising inflation and declining incomes.
While we think China badly needs structural reforms and indeed we were suggesting several
policies that could both accelerate the pace of a rebalancing while also reducing pressures of
overcapacity and over investment (see What caught my eye? v.56 - Capital – Time for a
vegetarian diet? 11 May 2016; One Belt One Road (OBOR) - Selfish yet enlightened
Marshall Plan 15 June 2017), we believe it cannot ignore the short to medium term, as
secular reforms tend to be highly deflationary. We therefore believe that in the balance
between quantity and quality of growth, quality might have an edge (post the Congress) but
not a decisive one. The quantity rather than quality would still likely to be the policy mainstay.
Only during periods of global economic and political tranquillity would quality assume a
greater role. However, as in the case of Central Banks, at any signs of renewed volatilities,
quantity is bound to once again trump any other consideration and more so in China, where a
system’s legitimacy is still largely a rooted ability to generate growth.
At some point in time, we expect China’s ‘internalized financing system’ will need to
change, ushering radically different policies. However, as discussed in our prior notes, we
do not view China as a unique case. Rather, we believe the entire global economy and
political system are undergoing massive change, and we also believe that most other
economies are just as distorted as China. However, the difference with China is clearly its
size as well as its impact on global flows of demand, capital, commodities and investments.
As in the case of the US (which represents the world’s deepest end-user consumer demand
and prices the world’s global currency), China is the key pillar of the global economy that
determines the world’s deflationary and reflationary cycles.
As we have outlined in our preview of 2H’17 (see Rights, Wrongs & Returns - CBs – can
slaves become masters? 18 July 2017), we believe that the impact of China’s 2016 stimulus
will gradually get weaker, although it has become somewhat more elongated through 2H’17,
due to China’s domestic political considerations. We tend to agree with Larry Hu (our China
economist – here) that China will allow the reflationary pulse to get weaker but so long as the
weakness does not translate into significant deflationary pressures. As long as PPI remains
positive (say 2%-4% vs over 6.9% currently) and there is no outright rout in the real estate
market or severe external volatility, China would be happy to maintain a relatively steady and
slightly more deflationary stance.
However, all bets would be off, if either Central Banks or China commit policy errors, leading
to the re-establishment of true pricing signals and volatilities. We still believe that China is
the ‘guardian angel’ of the global economy, and hence we are against too rapid
liberalization or re-balancing (as this would preclude China from performing this vital
role).
China is at a cross
roads
China stimulus
wave is weakening
but we believe it
remains the
guardian angel of
the global economy

14 November 2017 23
Risk 3: Could inflation break out?
We have maintained a consistently disinflationary mind set for at least the last seven
or eight years. Indeed, at heart we remain deflationists.
As discussed in our various reports (see What caught my eye? v.76 - The world of no wages
14 June 2017; CBs vs. markets – Can CBs shift the entire yield curve? 27th
Oct 2017;
Cambrian explosion - Birth of the new; extinction of the old 10 July 2017; What caught my
eye? v.59 - In praise of Thematics 7 June 2016), we reside in a ‘transitional’ world
between conventional industrial societies and the information age. We have been
progressing through significant structural shifts since 1971 (when the first Intel chip was
produced), but with passage of time pressures increasing; the crescendo is likely over the
next decade or so. We have described in the past as the age of ‘declining returns on human
and conventional capital’ and ‘rising returns on digital and social capital’.
To us this is the core explanation for a complete breakdown of the Philips curve, stagnant
productivity, and inability to ignite inflation and rising income and wealth inequalities. We also
maintain that our predicament is made even more complex than it should as a result of our
own societal decision to defray and blunt the impact by micromanaging economies via
aggressive monetary and public sector policies, thus precluding conventional business and
capital market cycles (see What caught my eye? v.78 - How long would tranquil autumn last?
24 July 2017). The global economy is thus not only struggling with a technological shift
but also with a cumulative weight of three decades of lack of past cyclical clearance.
We were therefore not surprised that there have been no inflationary pressures (particularly at
the core level) or that wages were not accelerating even in the markets that are exhibiting a
high degree of conventional tightness. As discussed by Acemoglu & Robinson, one does not
require an absolute extinction of professions and occupations for labour to lose a
considerable part of its bargaining power. According to their paper, automation or
streamlining of 20%-30% of a given function is sufficient to eradicate most of the pricing
power.
It is this combination of technology and globalization that is placing a lid on wages, and we
maintain that even at much lower levels of unemployment, we are unlikely to see any
significant wage break-out. Even in the best of times, the Philips curve never really worked
(hence a myriad of adjustments to try to fit it into evidence on the ground). However, by now,
the idea that secular and structural factors do not matter (view prevalent in conventional
macroeconomics) and that the only thing that matters is stimulation of aggregate demand,
has been well and truly discredited. However, Central Banks cannot just throw out the Philips
Curve (basis for their assessment of supply-demand tightness) as there is nothing right now
to replace it. BLS and other agencies do not seem to be able to grasp the nature of ‘gig’ or
‘fissured’ employment, relying instead on increasingly outdated industrial age classifications.
Another factor that is depressing inflationary expectations is the central bank policies.
By depressing rates and forcing investors to seek out alternative investment opportunities and
reach for yield, depresses the term premium, which in turn further depresses inflationary
expectations, causing Central Banks to pump even more liquidity, which in turn further
reduces term premiums and inflationary expectations. Thus aggressive monetary policies
have not only precluded the global economy from proper resetting (i.e. repudiation of debt,
de-leveraging and clearance of excesses), but they also directly impact financial instruments
and expectations imbedded in estimates of inflationary expectations.
It is this deadly embrace between technology, dissolving labour markets and monetary
policies that is distorting yield curves, eroding inflationary break-even rates and
leading to lower than expected inflationary outcomes. As can be seen below, there is
currently no evidence of any systemic break-out of inflationary or wage pressures across
most markets, even those with increasingly tight conditions. It is particularly evident in core
inflationary gauges.
Another key risk is
the possibility of
inflation suddenly
breaking out

14 November 2017 24
Fig 69 Eurozone – CPI (%) – despite volatility, CPI
remains at around 1.4%....
Fig 70 Eurozone – Core CPI (%) - …and core
(excluding energy & food) is back down below 1%
Fig 71 Eurozone – Compensation per employee –
while wage pressures remain contained…
Fig 72 US – Core CPI (%) - …the same applies to core
CPI in the US…stuck at around 1.6%-1.7%...
Fig 73 US – Core PCE (%) - …ditto core PCE,
remaining at around 1.3%... Fig 74 US – Trimmed PCE (%) - …and trimmed PCE
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
Jan-97
Nov-97
Sep-98
Jul-99
May-00
Mar-01
Jan-02
Nov-02
Sep-03
Jul-04
May-05
Mar-06
Jan-07
Nov-07
Sep-08
Jul-09
May-10
Mar-11
Jan-12
Nov-12
Sep-13
Jul-14
May-15
Mar-16
Jan-17
1.4%
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Jan-97
Nov-97
Sep-98
Jul-99
May-00
Mar-01
Jan-02
Nov-02
Sep-03
Jul-04
May-05
Mar-06
Jan-07
Nov-07
Sep-08
Jul-09
May-10
Mar-11
Jan-12
Nov-12
Sep-13
Jul-14
May-15
Mar-16
Jan-17
Core CPI
0.9%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
Mar-96
Jun-97
Sep-98
Dec-99
Mar-01
Jun-02
Sep-03
Dec-04
Mar-06
Jun-07
Sep-08
Dec-09
Mar-11
Jun-12
Sep-13
Dec-14
Mar-16
Jun-17
% YoY Average(1996-2015)
1.6%
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
Jan-00
Oct-00
Jul-01
Apr-02
Jan-03
Oct-03
Jul-04
Apr-05
Jan-06
Oct-06
Jul-07
Apr-08
Jan-09
Oct-09
Jul-10
Apr-11
Jan-12
Oct-12
Jul-13
Apr-14
Jan-15
Oct-15
Jul-16
Apr-17
Core CPI (YoY %) Average (1960-2015)
Average (1985-2015)
1.7%
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Jan-05
Aug-05
Mar-06
Oct-06
May-07
Dec-07
Jul-08
Feb-09
Sep-09
Apr-10
Nov-10
Jun-11
Jan-12
Aug-12
Mar-13
Oct-13
May-14
Dec-14
Jul-15
Feb-16
Sep-16
Apr-17
Core PCE Average (1985-2015)
2.3%
1.3%
0.5
1.0
1.5
2.0
2.5
3.0
Jan-00
Oct-00
Jul-01
Apr-02
Jan-03
Oct-03
Jul-04
Apr-05
Jan-06
Oct-06
Jul-07
Apr-08
Jan-09
Oct-09
Jul-10
Apr-11
Jan-12
Oct-12
Jul-13
Apr-14
Jan-15
Oct-15
Jul-16
Apr-17
Mean Trimmed PCE - 12 months Average (1985-2015)
1.6%

14 November 2017 25
Fig 75 US – Non-Supervisory Employees – Hourly
wages (%) – pace remains slow despite 4.1% U/Rate
Fig 76 US – Average Private sector Real Wages (%
YoY) - …the same message from real wages…
Fig 77 UK – Average Weekly earnings (% YoY) -
…and in the UK, despite equally tight markets Fig 78 Japan – Core CPI (%) – hugging zero while…
Fig 79 Japan – Nominal & Real wages (%) - …wages
remain constrained, despite even tighter markets
Fig 80 Inflation Surprise Indices - …mostly turning
negative, after rebound earlier in the year
Source: CEIC, Macquarie Research, November 2017 Source: Bloomberg, Macquarie Research, November 2017
However, there are concerns regarding reflation of the commodity complex, through a
combination of China stimulus and supply-side reforms. It appears that thus far the
degree of OPEC compliance was better than what we would have expected, while the shale
gas response was less pronounced. At the same time, there were a number of government
initiated curbs on production from China. As a result, better demand and more constrained
supply, when combined with contained US$, led to a significant uptick in the CRB index.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
Jan-00
Oct-00
Jul-01
Apr-02
Jan-03
Oct-03
Jul-04
Apr-05
Jan-06
Oct-06
Jul-07
Apr-08
Jan-09
Oct-09
Jul-10
Apr-11
Jan-12
Oct-12
Jul-13
Apr-14
Jan-15
Oct-15
Jul-16
Apr-17
2.3%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
Jan-09
Jun-09
Nov-09
Apr-10
Sep-10
Feb-11
Jul-11
Dec-11
May-12
Oct-12
Mar-13
Aug-13
Jan-14
Jun-14
Nov-14
Apr-15
Sep-15
Feb-16
Jul-16
Dec-16
May-17
Private Sector Real Average Wages 3MMA
0.5%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
Jan-01
Oct-01
Jul-02
Apr-03
Jan-04
Oct-04
Jul-05
Apr-06
Jan-07
Oct-07
Jul-08
Apr-09
Jan-10
Oct-10
Jul-11
Apr-12
Jan-13
Oct-13
Jul-14
Apr-15
Jan-16
Oct-16
Jul-17
Regular Wages
2.2%
-0.4
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
Jan-14
Mar-14
May-14
Jul-14
Sep-14
Nov-14
Jan-15
Mar-15
May-15
Jul-15
Sep-15
Nov-15
Jan-16
Mar-16
May-16
Jul-16
Sep-16
Nov-16
Jan-17
Mar-17
May-17
Jul-17
Sep-17
CPI - ex Food & Energy & Tax
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
Jan-05
Nov-05
Sep-06
Jul-07
May-08
Mar-09
Jan-10
Nov-10
Sep-11
Jul-12
May-13
Mar-14
Jan-15
Nov-15
Sep-16
Jul-17
3MMA Nominal Earnings 3MMA Real Earnings
-50
-40
-30
-20
-10
0
10
20
30
40
Nov-11
Feb-12
May-12
Aug-12
Nov-12
Feb-13
May-13
Aug-13
Nov-13
Feb-14
May-14
Aug-14
Nov-14
Feb-15
May-15
Aug-15
Nov-15
Feb-16
May-16
Aug-16
Nov-16
Feb-17
May-17
Aug-17
EM Global G4

14 November 2017 26
As discussed in our past reviews, we view commodities as essentially a tax on consumers
and businesses, and although collapsing commodity prices (as in 2015/early 2016) are clearly
highly deflationary (and unwelcome), rapid appreciation could easily erode real purchasing
power and lead to (at least) mild stagflation (or higher inflation and lower real outcomes). If
commodity prices are driven primarily by improving demand, then the chances of stagflation
is minimized. But if commodity prices are moving mostly on supply constraints and currencies
and funds flows, then the situation becomes far more problematic.
As a single largest consumer of most commodities (particularly industrial commodities, with
share anywhere from 30%-70% of the world’s total), China is the most important driver of
global reflation or disinflation. Essentially, China reflated the global commodities complex
and demand through ‘16-17. It has not only improved global PMIs but also accelerated PPI
indices, and as currencies stabilized, China also stopped exporting deflation to the world. As
can be seen below, the US import prices from China are now broadly neutral vs. drops of as
much as 6% in early ‘16. Whether one looks at import prices excluding or including
petroleum, the US is now importing a mild (1%-2%) inflation rather than deflation.
If our view is correct that China’s reflationary pulse (though more elongated than we were
expecting earlier this year) has already passed its peak and that as long as the global
volatilities do not get out of control, China would rather prefer to ‘ride the wave’ rather than
embark on further stimulus, and if we are also correct in our long-standing view that supply-
side reforms are unlikely to be either deep or consistent, then CRB index is likely to remain
confined to around the 180-190 range through 2018, and possibly might weaken. As
can be seen below, this should imply contained inflationary outcomes. In the case of China’s
PPI, it would imply erosion towards the 2%-4% range (from almost 7% currently) while CPI of
G3 (US, Eurozone & Japan) plus China should continue to average around 1.5%-2.0%.
Fig 81 US – Import prices from China & Rmb – China
is no longer exporting deflation and…
Fig 82 US – Import Prices from all destinations –
including or ex petroleum – …slightly inflationary
Source: CEIC, Macquarie Research, November 2017 Source: Bloomberg, Macquarie Research, November 2017
Fig 83 China – PPI vs. CRB Index Fig 84 G3+China – CPI vs. CRB index
Source: Thomson Reuters, Macquarie Research, November 2017 Source: Thomson Reuters, Macquarie Research, November 2017
At this stage, our base case scenario is that global deflationary pressures are sufficiently
strong to overpower any reflationary pulse emanating from the commodity complex,
leaving the global economy in a mildly reflationary mode.
-4%
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
-10%
-5%
0%
5%
10%
15%
Dec-04
Jul-05
Feb-06
Sep-06
Apr-07
Nov-07
Jun-08
Jan-09
Aug-09
Mar-10
Oct-10
May-11
Dec-11
Jul-12
Feb-13
Sep-13
Apr-14
Nov-14
Jun-15
Jan-16
Aug-16
Mar-17
RMB/$ y/y chg (lhs) US Import prices from China y/y ($)
-5
-4
-3
-2
-1
0
1
2
3
-15
-10
-5
0
5
10
Jan-12
Apr-12
Jul-12
Oct-12
Jan-13
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
Oct-14
Jan-15
Apr-15
Jul-15
Oct-15
Jan-16
Apr-16
Jul-16
Oct-16
Jan-17
Apr-17
Jul-17
Import Prices Import prices ex Petrolium, rhs
-60
-40
-20
0
20
40
60
-10.0
-5.0
0.0
5.0
10.0
15.0
Jan-07
Sep-07
May-08
Jan-09
Sep-09
May-10
Jan-11
Sep-11
May-12
Jan-13
Sep-13
May-14
Jan-15
Sep-15
May-16
Jan-17
Sep-17
China PPI y/y CRB y/y, RHS
Assumes commodity prices remain at
current levels for next six months
-60
-40
-20
0
20
40
60
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
Jan-07
Aug-07
Mar-08
Oct-08
May-09
Dec-09
Jul-10
Feb-11
Sep-11
Apr-12
Nov-12
Jun-13
Jan-14
Aug-14
Mar-15
Oct-15
May-16
Dec-16
Jul-17
Feb-18
G3+China inflation (y/y) CRB y/y, RHS
Assumes commodity prices remain at
current levels for next six months
We believe this to
be unlikely

Rights, Wrongs & Returns 2018 year-of choices & consequences

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Rights, Wrongs & Returns 2018 year-of choices & consequences