Investment Manager Report

October 2017

Dear Valued Investors,
As we head into the final quarter of 2017, we reflect on markets that have rallied strongly, valuations that have remained reasonable and earnings that were robust. Many investors, however, remain skeptical. The most common question we still get is: “Have we missed the rally?”

It is worthwhile just rehashing a few points before we discuss fundamentals. Markets may have rallied strongly this year, but people have already forgotten the extent to which they sold down amid fears investors had over the new U.S. administration’s plans to impose import tariffs and possibly start a trade war with China. There were also concerns that tax cuts and infrastructure spending would cause the U.S. dollar to strengthen and interest rates to rise. Furthermore, despite strong economic growth and a rebound in earnings, Asia ex Japan earnings are only a meager 1% above where they were in July 2011. So I think it’s too soon to be talking about having missed the rally.

I have argued that Asia’s earnings growth is likely to outpace that of the U.S. in the near and medium terms, and that of Europe in the medium term. My view has been predicated on the idea that wages have lagged productivity growth in the West, leading to expanding corporate margins. As a consequence of deliberate policy, however, wages have increased faster than productivity in much of Asia, leading to thinner corporate margins. Further, these policy changes are petering out and governments will be looking to put in place moderately inflationary policies that may restore more of a balance between the worker and the capitalist; improve corporate margins; and lead to better returns in equity markets. How does the environment look now? Are things progressing as we expected? What will the likely future impact on markets be?

So far this year, we have seen minimum wage policies in China and elsewhere in Asia ease to the point that wages are no longer outstripping productivity. South Korea remains an outlier here with a potential for further wage hikes, but by and large, Asia’s wages have not gobbled up more than their fair share of the economic pie. We have seen central banks reflating. The earliest among them to do so was the Bank of Japan, starting around 2013. It reiterated its stance just recently: to continue reflating “to achieve a virtuous economic cycle” and will “continue easing persistently for the 2% goal.” China has joined the Japanese. While it will from time to time take administrative measures against overheating in the property market (and potentially equities, too, should they “bubble up”), China has managed to drive core inflation from 1.5% at the beginning of 2016 to 2.2% now. In both countries, corporate margins, cash flows and earnings have improved. Subsequently, equity markets have rallied. Further evidence of the spread of reflationary policies has come from a surprise cut in interest rates by Indonesia’s central bank. Despite this cut, the currency has remained stable.

This is the final element that people worry about—if Asia stimulates as the U.S. tightens and economic growth in Europe causes the European Central Bank to muse about “tapering,” won’t that hurt Asia’s currencies? But people are forgetting that this already took place! That is what the devaluations in 2013 were about. Currencies took a further hit after the election of President Trump. But this year, they have steadied and rallied. With current account surpluses growing and deficits shrinking across the region, and many Asian nations with inflation rates below the 2% level that the U.S. Federal Reserve targets, the fundamental backdrop for Asia’s currencies looks much less risky. Indonesia’s central bank noted this fact. And if Indonesia can ease monetary policy, other Asian countries which have much stronger current accounts and lower structural inflation can certainly do so, too.

So that is where we are in the economic sense. As for how markets have reacted? Well, I would say that they have paid more attention to the reflationary policy than to earnings improvement. As such, it has been the companies that are growing the fastest—sometimes irrespective of valuations—that have performed the best. In some cases, companies have embellished their fundamental businesses with “new economy” jargon that reminds me of previous occasions when the markets have become overexcited. But this time, the extent to which buzzwords are now being used to dress up otherwise unexciting businesses is nowhere as prevalent as this was during, for example, the years—and there are some great Asian internet companies to own. But I believe that if Asia’s earnings continue to grow as I expect, the market will not just chase blindly some of these large-capitalization growth companies but will start to see the opportunities in value names and in small- and mid-cap companies. There may be an element here that as people chase benchmarks and ETFs, there has been forced buying of some equities regardless of fundamentals, as some investors have warned.
This has certainly created some headwinds for relative performance for our Funds, even as absolute returns are strong. Asia’s highly valued counterparts of so-called FANG companies—Facebook, Amazon, Netflix and Google—account for a good chunk of the information technology’s weights in the MSCI All Country Asia ex Japan Index, now at almost one-third. However, I still believe markets as a whole to be quite reasonably valued, given that earnings have been weak for years and have a good chance of growing strongly over the medium term. This leads me to suspect that investment styles that either have an element of value or focus on the mid- and small-cap sectors of the market (or potentially both) are likely to have some tailwinds for relative returns in future years.

There are, of course, some political risks—whether it be future U.S. policy or the tensions with North Korea. We will continue to monitor and communicate with you on these issues. The likelihood of significant bills passing Congress for tax cuts and infrastructure spending look no greater than they were at mid-year; chances are far higher that Asia’s economies will use fiscal and monetary stimulus. Tensions on the Korean peninsula are more acute than I would have expected but I still think there are no good military options available to anyone and that therefore some kind of diplomatic resolution is the most likely. Perhaps it is these political tensions that have sidelined investors “waiting for the dip?” And perhaps that dip will come! Sentiment? I have no way of knowing if or when it will turn any time soon – it seems to me that there are still a lot of people who think they have already “missed out” on the rally. Nevertheless, I remain quite optimistic for the future economic growth of Asia and even more so for corporate earnings growth.
Robert Horrocks, PhD
Chief Investment Officer
Matthews Asia

As of 27 September 2017, accounts managed by Matthews Asia did not hold positions in Facebook, Inc., Inc., Netflix, Inc. and Alphabet Inc. (parent company of Google).
The MSCI All Country Asia ex Japan Index is a free float-adjusted market capitalization-weighted index of the stock markets of China, Hong Kong, India, Indonesia, Malaysia, Philippines, Singapore, South Korea, Taiwan and Thailand.
Indexes are unmanaged. It is not possible to invest directly in an index.

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