Investment Manager Report

April 2014

Dear Valued Shareholder,

Last year, events from the world’s three largest economies dominated market news: first, there was tighter money in the U.S., or “tapering;” second, looser money in Japan, or “Abenomics;” and third was China’s attempt to reign in credit growth, which was really more about capital market reform than tight money. So far this year, these trends have continued.

Nevertheless, analysts and investors would probably be well-served to look beyond the headlines. Whereas it is true that tapering in the U.S. represents tighter money, it is also a signal that the U.S. Federal Reserve expects nominal GDP growth to improve. That should mean more demand, sales, exports, jobs and higher wages, and should be good news both for the U.S. and the world. Tapering impacted portfolios in two major ways. The first was a drag on yield-related strategies. However, to the extent that yield and growth were mixed together in a strategy, it held up better. It was really a headwind for high yield, and the investment styles that seemed to do better were more focused on sustainable growth of quality franchises. By now, however, some of the overvaluation of the higher-yielding equities seems to have corrected so tapering is likely to pose somewhat less impact on investment styles.

However, tapering is likely to continue as there appears to be increased optimism for nominal GDP growth, judging by U.S. Federal Reserve Chair Janet Yellen’s recent comments as well as the movements in U.S. and European stock markets. For the most part, investor sentiment seems to be treating this as a reason to buy developed markets and shun emerging. However, if U.S. and Europe continue to recover, it is likely to boost Asia’s exports and relieve some external funding pressure in places like India and Indonesia. Indeed, the current account deficits in these two countries have narrowed significantly and they have rallied strongly as a result. Broadly speaking, the less-developed Asian economies have been leading performance thus far in 2014.

For Japan, we continue to question the importance of demographics versus economic slack. Japan’s market is among the weakest performers in the region this year. Concerns remain over whether wage hikes can sustain growth. Some fret over tax hikes and fiscal contraction. Others wonder how much of Japan’s economic funk has been due to deflation and how much to an aging workforce. At current valuations, a significant amount of optimism over Abenomics may already be built into stock prices. Ultimately, it comes down to the businesses that you own and whether or not they are being profitably run. Macroeconomists who are convinced of the efficacy of monetary policy to cure Japan’s deflationary woes will blanch at the suggestion that supply-side reforms, in the form of corporate governance/restructuring, are the most crucial adjustment necessary. They are unlikely to do any harm if the monetary policy is right and they are likely to unlock the most value for equity investors.

We have addressed much of the cyclical and secular issues in China in our recent white paper: “China—Separating Fact from Fiction.” Whilst these issues are unresolved in the minds of investors, two discrete data points have emerged to further depress sentiment toward China. First, there is the default of a corporate bond for a solar power company; second, the bankruptcy of a small property developer. These have been taken by some as a sign of China’s teetering economy. But, in reality, does it not just suggest that China has a problem, as does the U.S., with certain parts of the solar industry? Property developers facing bankruptcy also should not be seen as uncommon. It may actually be quite useful for authorities to allow some to go bankrupt to prevent excessive risk-taking.

“Buy on the rumor; sell on the news,” thus the age-old adage on trading goes. However, does it work in reverse? “Sell on the rumor; buy on the news”? For some time now, the markets have been under a steady drumbeat of negativity over China that has driven down valuations. But rather than reverse course on the news of a bond default or a developer bankruptcy, selling has arguably intensified. Perhaps this is partly due to the level of hyperbole involved.


And there certainly is hyperbole: rather than having non-bank financial institutions, China has “shadow financing.” Rather than urban redevelopment, eminent domain and overbuilding, China has “ghost cities.” At best, it makes China sound like a Peter Jackson movie; at worst like a Stephen King novel.

Concerns have even stretched to the renminbi (RMB), which shows the extreme nature of the bearishness. The RMB is backed by vast currency reserves—US$ 4 trillion. Recent short but sharp depreciations have been a deliberate tool used by authorities to try to deter offshore borrowing. So, even when the Chinese take prudent measures at an early stage (offshore borrowing is a tiny part of the Chinese economy), they get no credit for it; such is the conviction that China’s economy is a house of cards. Recently, noted China analyst Andy Rothman joined Matthews Asia to share his views on China’s politics and economy, and to help cut through the hyperbole and offer a more balanced view of China.

Finally, it all comes down to valuation, and there are many ways you can look at valuation discrepancies between the U.S. and Asia—While they were fairly close even three years ago, the U.S. is starting to look distinctly more expensive now; with the U.S. at 16.2X forward earnings(1), Asia Pacific at 11.7X and Asia ex Japan at 10.9X (for the Asia Pacific and Asia ex Japan universes as defined by FactSet). Asia Pacific and ex Japan both yield about 2.5% versus nearly 1.8% for the U.S.(2) So, what may explain this? It is the recent run-up in corporate profits in the U.S., and the fact that Asia’s earnings per share have grown but slightly. Yet, over a longer time horizon, Asia has clearly outperformed in earnings growth.

So, given that the key themes from last year have carried over to the first quarter of this year, one might be tempted to expect “more of the same.” But at some point, I suspect, those valuation differentials are going to count for something.

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

(1)Forward earnings are calculated by dividing current market price per share by expected earnings per share over the next 12 months.
(2)Yields for FactSet aggregates do not represent or predict the yield for any Fund. It is not possible to invest in an index or aggregate of indices.