Investment Manager Report
Dear Valued Investors,
In many respects, the environment for investment has not really improved markedly since the start of the year. Trade tensions linger. Global indicators have weakened. Political tensions have intensified. Only the U.S. remains a bright spot—that perfect mix of good economic growth numbers, low inflation and (hurrah!) potential interest rate cuts to boot.
All of this just drains the appetite of investors for Asia's equity and bond markets. Everywhere I go, at every conference around the world it seems, Asia remains a top “intended” destination for new funds. And yet for the most part, industry flows suggest that few people are actually acting on their plans.
That is hardly surprising—Asia's reputation for volatility, the conventional wisdom that it is an export economy, the reticence of Asia's policymakers to stimulate in a strong dollar environment, and the supercharged (by tax breaks and low wage growth) earnings growth in the U.S. all inveigh against asset allocators making the courageous decision to move funds across the Pacific. After all, who wants to be courageous in this atmosphere? As one client with a flair for humorous exposition told me recently: “It never feels good to buy China.”
I think he was right. What we are up against is primarily sentiment. I don't want to downplay the trade war, the earnings issue, or the growth environment. However, market reactions to tweets on trade are out of proportion to the actual effect on GDP and earnings. Valuations suggest that the current pro-capitalist/anti-labor policies can persist in the U.S. without an economic or political backlash, and a belief that Asia's policymakers will remain tight-fisted on fiscal and monetary policy assumes a strong dollar regime will continue, which is at odds with the stated intention of the administration to reduce the trade deficit. It seems to me to just be a case of the market justifying “more of the same” and to follow the momentum trade.
That is fine. However, perhaps because of our focus on Asia, we see things slightly differently. We see the steady creep of China's economic influence through ASEAN and Central Europe, even now, bringing in Italy and Greece into the fold. We see the adjustments being made at the corporate level to circumvent the tariffs imposed by the U.S., and we see the acceleration of the buildout of the manufacturing base in the region. We see a region, in short, adapting to circumstance: fluid, and dynamic. We see a region where borders are being broken down by closer economic cooperation, not built up by economic protectionism.
It's hard to argue with momentum in the markets—the S&P 500 Index is making new highs as I write this. But it does increasingly feel to me as if pressures are building up to force an inflection in world markets. I doubt a severe recession is in the offing (though I worry about a long stagnation in Europe), but I do think that markets are going to be shaken out of their complacency. It has been a long expansion, after all, and there is little room for policy error. I guess I am not the only one to feel this way and hence, the reticence of people to buy.
For us, the trade issues have offered up opportunities. This is not because we believe there will be a rapid and total resolution—tension will rumble on between the U.S. and China for many a year—but because of the lack of proportion in market movements relative to actual effects of policy. These opportunities are predominantly in China and mostly, though not exclusively, in domestic-demand stocks that were somewhat inexplicably caught up in the weak market sentiment. Indeed, despite the breathless headlines at times and the gladiatorial nature of some of the language, we retain a cool posture.
One thing is clear in the data. The effects of tariffs so far have been: 1) to reduce the trade deficit between the U.S. and China; 2) to increase the trade deficit between the U.S. and the rest of Asia (plus Mexico); and to raise the prices of tariffed goods versus non-tariffed goods in the U.S. My interpretation of this is that Chinese manufacturers with factories in ASEAN and Mexico have been running their factories there on extra shifts and the corresponding increase in costs and inefficiencies has been largely borne by the U.S. consumer. The longer-term effects are likely to be simply to accelerate Chinese investment in these areas. And thus, trade wars, far from being easy to win, are complex and unpredictable events with winners and losers that are very different from what the protagonists might expect.
We remain, therefore, wedded to our cause. We are aware of the global macroeconomic risks but we are not paralyzed by them. Indeed, for such complex issues as this, there is perhaps more insight to be gained by talking to the companies who are “at the coal face” rather than trying to divine big trends from newspaper headlines. We will continue to follow where the pursuit of profit opportunity leads us, to be guided by the decisions of entrepreneurs, not by the pronouncements of politicians, and to respect the price signals of the market.
There remains ample scope for corporates to grow profitably by meeting the needs of the domestic consumer. There is plenty of opportunity in economic and political cooperation with neighbors to drive down costs and ramp up efficiency in production and to improve the region's living standards together. A few years ago, it might have seemed crazy that the U.S. would turn its back on globalization and that China would eagerly take up the role of champion of cross-border economic cooperation. But that is where we now are—the leadership of the global economy may already have passed from one superpower to the other.
With this strategic focus, the future of Asia looks bright beyond the headlines of the day—we continue to target investments in the domestic companies that are driving and profiting from the region's creation of wealth.
Robert Horrocks, PhD
Chief Investment Officer