Investment Manager Report
Dear Valued Investors,
It has been a decidedly mixed year in Asia. Japan’s equity market held up relatively well, whereas Asia ex Japan fell about 15%. The sell-off has been even more aggressive peak to trough—with the FactSet Aggregate Asia ex Japan losing about 31% of its value, thus far, on September 25, 2015.
“So, where are we in this process?” I will share my thoughts, with the usual caveat about my inability to time markets and the fact that what we really do at Matthews Asia is long-term, bottom-up stock selection. Nevertheless, I think Asia’s markets are reasonably valued right now. Although the current economic environment remains unclear, I admit that I am more inclined to be optimistic.
First, if one looks at valuations, some markets (Hong Kong Stock Exchange at 9.6X forward price-to-earnings ) look very cheap; others (the S&P Bombay Stock Exchange 100 Index at 18.8X) look more expensive. Overall, though, the region is priced fairly on a forward price-to-earnings basis (14.2X versus an historic average of 13.5X), and cheaply on a price-to-book (P/B) basis (1.5X versus an historic average of 2.0X). These valuations give me comfort that we have a bit of a tailwind for long-term investors. Those bargain hunters looking for signs of distress are more likely to take heart from the price-to-book measure than the price-to-earnings measure. I ascribe the difference to the fact that the price-to-earnings valuation is achieved at a time when earnings forecasts have been revised down quite dramatically and margins in the region have been thin for a few years now, dragging down returns on equity.
The main cause for panic in the markets recently has been China. Its small devaluation sparked a further round of weakness across Asian currencies that had already been struggling against the strong dollar and weak commodity demand. My view on China is that it did this partly as a technical requirement for the International Monetary Fund’s Special Drawing Rights (SDR), and partly because it wanted to stimulate domestic growth whilst opening up the capital account. This view would logically suggest a further drift down in the renminbi as China’s central bank stimulates demand. Now the accuracy of this view hinges on the capital account being open or at least being opened
—if it is relatively closed, then China can stimulate without unduly affecting the exchange rate. The evidence in favour of my view has been weaker recently—despite more openness, Chinese officials now seem inclined to enforce rules that they had benignly ignored in the recent past. China may even decide to risk a few negative headlines on its reform process in the short term in order to pump up domestic demand without as much devaluation pressure as my view may lead me to expect. In addition, we are probably going to hear more weak economic data coming out of China, such as exports and industrial production. This is partly because it is weak; but partly because the year-over-year comparisons are made more difficult by quite a strong second half in 2014. Sequentially, that is month-on-month, the data continues to show reasonable growth in China, particularly in services and retail.
Throughout the rest of Asia, Japan’s Abenomics seems to be having its desired effect on nominal growth. Real growth may remain somewhat more pedestrian, but Japan’s total wage bill has had some success in raising nominal wages in the past three years and should support demand. In the Association of Southeast Asian Nations, Malaysia and Indonesia have taken the lion’s share of the negative sentiment—justifiably so because of their dependence on commodities. In Thailand, there is still no sign of a robust uptick in growth. Indeed, throughout Asia, I have the overall feeling that in general, we are still trudging through the downswing of an economic cycle. But this has been going on for some time—real growth across the region peaked in 2007 and then again in 2010. We have spoken about the ability of Asia’s markets to withstand pressure—current account surpluses, low inflation and lower levels of U.S. dollar debt. Therefore, there is a much lower likelihood that the region’s economies will see severe drops in real GDP or rises in unemployment due to the deflationary global environment, compared to what we witnessed in 1997. Indeed, it is largely because of the region’s ability to depreciate its currencies and retain sensible monetary policy that we have not seen the kind of dislocations in the economies that we saw nearly 20 years ago.
This leaves us with markets that have adjusted quite aggressively, and can be seen as reasonably valued—in some cases quite cheap—even though we are perhaps most of the way through an economic cycle. U.S. monetary policy remains the biggest unknown. I reiterate my view that monetary policy has been tightening since May 2013 and has further tightened in the last few weeks. A further tightening of monetary policy by hiking rates would add to deflationary pressure—it seems bizarre that we are considering this scenario while 10-year inflation expectations in the U.S. have fallen to 1.5%—well below the U.S. Federal Reserve’s own target.
Reactions to this uncertain economic backdrop have been quite fearful. For Asia, however, the forces driving real growth—savings, reform and productivity—are still intact. And if monetary policy is our greatest fear, then we should remember that many of its effects are ultimately transient. Whilst monetary mistakes can distress the markets, long-term growth in Asia should ultimately be decided by the drive for self-improvement and the business savvy of its citizens.
Robert Horrocks, PhD
Chief Investment Officer
Please see glossary page
for definitions and disclosures.
P/E and P/B figures are as of August 31, 2015