Investment Manager Report
Dear Valued Investors,
China and Asia are once again at the forefront of many investors' minds. Investors have taken notice of a potential resolution to the trade dispute with the U.S., the pause in Federal Reserve tightening and the curtailing of the U.S. dollar's rally, along with headlines suggesting China is looking to stimulate growth. In meetings with clients across Europe, Latin America and the U.S., I sense a renewed interest in the region as sentiment and momentum in the markets start to improve.
This makes me both happy and, on the other hand, wary. I have never really profited from thinking of Asia and China in terms of near-term cycles. Nor does it sit very well with the way my colleagues on the investment team run their portfolios. We aim to take a longer-term view of the region's growth prospects. So, let me try to analyze the recent market moves in a longer-term context.
To understand last year, we have to go back to 2017. In mid-2017, we had extreme differences in valuations between fast-growing and slow-growing companies. China had loosened policy and earnings were accelerating for the first time in six or seven years. There was momentum and bullish sentiment in the markets and often prices seemed to be pushed higher on news flow rather than fundamentals. Last year, this came to a screeching halt. Many reasons have been offered, but often those garnering the most headlines were the least important. First, the trade dispute: the actual effect of tariffs was largely to raise prices for U.S. consumers on some goods. There may have been a marginal change in sourcing some goods, which may have had an infinitesimal impact on China's GDP. Otherwise, effects are likely to include an accelerating of investment in Southeast Asia and a reorganization of supply chains—all of which can be used to benefit corporate China as well as its Southeast Asian neighbors. Wild swings in sentiment as markets priced in risks of extreme events certainly dominated the headlines and influenced short-term markets moves but were always likely to be transient.
A bigger issue was tight money in the U.S. We argued it was overly tight. That seems to have been the case. Yield curve inversion tells us that the bond market is worried about growth. Economies across Asia, though not forced to be tight, felt they had to be. This tightness led much of the region to a disinflationary savings surplus, with consumers living well within their means. And while this may have underpinned currencies, it was harmful to equity markets and credit spreads. On top of this, tight Chinese money was the real driver of weak markets. In some respects, this was not a deliberate policy. I don't think the Chinese were overly concerned with core inflation at 2.5% but they did take acute action to clean up bad debts and to restructure the financing of local government investment vehicles. Their policies soaked up reserves and this tighter liquidity environment of tighter money hit profits, demand and sentiment—and core inflation fell to 1.7%.
Within this environment, earnings per share growth slowed across the region. Sentiment weakened. Asia started to fall before the rest of the world. By midyear, we believed Asia was cheap in absolute terms and cheap relative to the U.S., Europe and Latin America. Local Asian currencies stabilized and countries such as Indonesia saw much stronger performance in the latter half of the year. That performance seemed to come at the expense of places like Japan, which saw a very weak fourth quarter. This felt to me like the proverbial “last shoe to drop.” The acute falls we saw in the last quarter of the year impacted small- and mid-caps particularly, and we did see margin calls in places like Japan and China. But given the overall weak sentiment, low valuations, resilient macroeconomic backdrop and stable currencies, the downturn seemed destined to be reversed.
And so it has been. Or at least thus far, such has been the story of 2019. Low valuations, a more helpful monetary environment, better headlines coming out of the trade talks—all of these are reasons to be more cheerful. And yet, this is where I get a bit wary. It is not because I don't believe that the rally can be sustained (more on that later). Rather, it is because the reasons being cited for being more positive are inherently cyclical, tactical and short term in nature. They are hardly signs of a shift toward a more strategic, long-term view of the region.
And yet there is reason to be positive about the long term. If we look out a decade or more, all of the elements needed to sustain long-term growth are there: savings, productivity growth, strong manufacturing bases. Politicians are embracing the idea of free markets and global collaboration. There is even the opportunity that Chinese investment will help raise the subpar productivity performance (subpar in an Asian context but good in a global context) of much of Southeast Asia. Thereby, the economic growth we have seen in North Asia and the Indian subcontinent might broaden across the entire region. We have seen, too, efforts by governments across Asia to pay greater attention to social coherence and the gap between rich and poor in their countries. In so doing, through minimum wage programs, they may have significantly decelerated regional profit growth for many years, but they might also have put their economies and societies on a much more balanced footing than we have in the West. The last year of tight money has indeed left Asia with current account surpluses and low rates of inflation—surely not optimal conditions for the region. They have not had a strong credit cycle. Much of the region seems to be underperforming on a cyclical basis, with so much promise for sustained growth in the economies and, yes, profits.
I am, however, concerned that some investors are seeking to take advantage of this by overemphasizing the cyclical elements of the situation. In so doing, they align themselves with the speculator and the trader, who may be overpaying for near-term excitement and underappreciating economies and companies with longer-term sustainable growth. We are heartened by the improving sentiment but we seek to keep our eyes on the distant horizon and to hold those companies that will get us there, through thick and thin, and that we feel will reward strategic long-term minority investors.
As always, it is a privilege to be your investment advisor.
Robert Horrocks, PhD
Chief Investment Officer
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