Investment Manager Report


October 2013

Dear Valued Investor,

This has been a topsy-turvy year in some respects, with financial markets performing against expectations and central bank activity continuing to give macroeconomists plenty to debate. There have been some reasonably strong results from the world’s economies in the face of controversially tight fiscal policy leading economists to debate whether monetary policy is really all that impotent, even with interest rates close to zero. Developed markets have rallied in the face of austerity and outperformed seemingly healthier emerging economies. China has muddled through while Japan has become the new great hope for growth. Who would have thought it? The resurgence of profits in the U.S. has driven its markets to new highs, whilst those in the emerging market classification have sometimes struggled to push higher. Indeed, it is puzzling that profits were so strong in the U.S., whilst job growth remained so feeble. The answer, of course, is that margins have expanded and profits as a percentage of GDP are now at 12%, similar to the peaks achieved in the booms of the 1950s and 1960s. Investors seem to have taken this short-term performance and extrapolated it into the far future. While it is perfectly possible that the U.S. could enjoy some years of fast non-inflationary growth if it can repair unemployment, nevertheless to accord U.S. corporate earnings a valuation multiple roughly 35% higher than that of Asian corporates seems to place a great deal of confidence in the long-term performance of the U.S. economy relative to those in Asia.

Coupled with this has been the surprising resilience of the U.S. economy in the face of fiscal tightening. For U.S. government spending has contracted by between 2.5% and 3.0% of GDP since the end of the recession with much of that happening quite recently. Given expected multipliers, this ought to have led to a much slower economy. The reason it has not, seems to be that the U.S. Federal Reserve has continued with its loose monetary policy. With short-term interest rates at nearly zero, monetary policy was supposed to be ineffective. But it seems to have been particularly good at offsetting the effects of fiscal contraction. And if unconventional monetary policy truly does work, then there is a good chance that Japan, too, can break out of its deflationary trap and stimulate profit growth in its domestic businesses. Of course, this will depend not only on the desire of policymakers to continue the experiment but also the market's assessment of their resolve.

We believe Japan has for some time been a useful place to invest because of the cheapness of the market and the seasoned nature of some of its businesses. It has also been considered a “safe harbour” during the financial crisis, and has now become the region’s short-term growth market. In some cases, it has the valuations to match. It has certainly added a lot more volatility into portfolios, where it used to be a “dampener”. And I would expect the volatility to continue as people watch short-run data for any signs of whether “Abenomics” (the policies of Prime Minister Shinzo Abe) is working or failing. In the meantime, Japan’s government appears to be on an unprecedented public relations push for its policies, including an address by its Prime Minister at the New York Stock Exchange. Japan has become a daring experimenter in macroeconomic policy on a grand scale and is doing so with fanfare on the international stage.


Like I say, it’s a world in which conventional wisdom is being tested. And it has led some to conclude that it’s time to ditch the emerging markets in favour of developed markets. As far as I can see, this is great news for investors in Asia! Asia is comparatively cheap. In price-to-earnings ratio terms, Asia ex Japan trades at 11.1x next 12 months’ earnings*, versus 13.7x in the Eurozone, 14x in Latin America and 15.4x in the U.S. Only Malaysia and the Philippines have a comparable valuation ratio with the U.S. So the markets, not for the first time since the global financial crisis began, seem to be paying far greater attention to cyclical pressures than they do to secular trends. I reckon it’s not hard to see who the culprit is: the Fed and its tapering shenanigans. For the flip side of effective unconventional monetary policy is that it matters even more what they say rather than what they do. This makes the job of Fed-watching unusually thrilling. When the Fed first began talking about stepping on the brakes, the markets immediately put pressure on emerging currency and debt markets. Bond yields have risen, partly due to the Fed tapering, but mostly, I suspect due to expectations of U.S. growth. And this has made long-term debt and higher yielding equities less attractive investments; growth equities and more cyclical businesses more attractive. There has recently been a switch from financially sound, higher-yielding Asian equities to more risky or cyclical businesses, which have created headwinds for some of our portfolios. But this is not altogether unexpected nor is it something that, whilst it can persist for some time, will cause wholesale changes to what we do. However, we do see more value in stocks that have higher growth profiles than those that seem “safer” in the immediate future.

This market myopia may have offered up some opportunities in instances, for example, in which individual companies might have been sold down aggressively because they had businesses in Indonesia or India. And there is no doubt that Asia’s markets are now less expensive. Yet, on another level, the markets were also quite discriminating. This discrimination was also good news. Apart from India and Indonesia, and some (welcome) pressure on the Australian dollar, Asian currencies were fairly resilient. For it is really only the subcontinent plus Indonesia where current account deficits and inflation appear to be in need of being brought under control. The rest of Asia, for the most part, has moderate inflation and a current account surplus. In a world that seems to be dealing with the aftermath of various excesses of borrowing, that may mean that Asia for the most part still lives within its means and on some level, investors are recognising that fact.

At the risk of sounding like a Pollyanna, I believe the problems Asia is now dealing with—shallow and less liquid capital markets; over-reliance on bank credit; underdeveloped infrastructure (sometimes physical, sometimes virtual); the social strains of income inequality and a growing middle class and entrepreneurial class—are all issues that Asia has been successfully grappling with for decades. Productivity growth across Asia continues to outpace the rest of the world and it remains the only region that has consistently outgrown the U.S. on a GDP per capita basis over the last 30 years. So, whatever challenges Asia faces in the future, I submit that these are lesser obstacles to sustained growth than those which Asia has already overcome. This puts me at odds with those who would cast out Asia, and the emerging markets as a whole, in favour of the developed world. That is fine. I take a contrary view and believe I have valuations and history on my side.

Despite the somewhat lacklustre performance of the region's markets, support for investing in Asia has remained strong. As always, we feel privileged to be your investment advisor, and thank you for your support.

Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC


*Forward earnings are calculated by dividing market price per share by expected earnings per share.