April 1, 2009
Dear Fellow Shareholders,
Odd as it may seem, the first quarter of 2009 was relatively calm in Asia. To be sure, share markets in the region were turbulent; riots in Thailand and Malaysia demonstrated how the current global downturn has exacerbated long-standing political tensions within the region. However, these events were overshadowed by the greater drama in Washington, D.C. As the various arms of the U.S. government exercised newfound authorities, markets everywhere gyrated on the ensuing deliberations—congressional debates over the national stimulus package; the administration’s attempts to define industrial policy; and the general furor over executive compensation and corporate performance. Some industries received favored government financing; others were deemed too big to fail.
As this very public wrangling played out amid a fragile domestic economy, it had the surprising effect of highlighting the relative stability of the Asian region. Asian financial markets slumped during the first two months of the year but finished March on a much stronger note. Shares that previously had been among the most depressed were those that rebounded most; industries such as energy and commodities performed well. Markets in China and Hong Kong lead the way, while Japan lagged. Amid this environment, some of the Funds fell behind their respective indices during the quarter. However, over longer investment horizons, most of the Funds outperformed their benchmarks with the exception of some of the individual country funds.
In our view, the events of the first quarter have been instructive for those contemplating the future of asset allocation. Regardless of one’s political or philosophical tendencies, the recent surge in direct government intervention in the economy has been startling. We assume such intervention will be short-lived and targeted to alleviate the worst aspects of the current downturn. However, we believe there will be at least one lasting implication: the distinction between “developed” and “emerging” markets has grown impossibly blurred.
Shades of Grey, Rather than Black or White
The terminology for “emerging markets” arose from investment models that attempted to categorize a variety of assets into different “classes.” Ideally, each asset class would add incremental benefit to an investor’s portfolio when included in the proper proportion. As these models incorporated more overseas investment, many labeled geographies as either “developed” or “emerging”—so as to clearly delineate those countries which could serve as relatively safe havens for investment, versus those that were more speculative in nature. At the time, countries seemed to divide neatly between those that had rule of law, property rights, stable and convertible currencies, relative fiscal prudence and reasonably transparent regulatory systems and those that did not. The “emerging” versus “developed” nomenclature rose to prominence; today, it has become a rule of thumb that frames allocation decisions for billions of dollars.
Given our focus, we have a natural inclination to see the “emerging” versus “developed” distinction as somewhat artificial—especially the binary aspect of it. Our work in Asia shows that countries are at different stages of economic, political and social development. However, in our view such distinctions are better made on a spectrum, rather than a pass or fail grade. Present events cloud the distinction further: the prevailing fiscal and regulatory instability in many wealthier countries would ostensibly undermine their “developed” status. Meanwhile, some of the larger “emerging” markets have handled their economic and political affairs with an unexpected degree of discipline. The important lesson to draw from all of this is that investors should be wary of using a well-intentioned, but ultimately arbitrary, classification scheme as a substantial basis for investment decisions. Instead, consider differentiating markets on their own individual merits. Not all “emerging” markets enjoy the same stability or hold the same long-term promise; nor are all “developed” markets equally resilient. Whatever approach you adopt, make sure to “look under the hood” of your chosen investment model. To do so is the only way to ensure that you achieve the exposures you really want, rather than ending up with a portfolio with the right nomenclature but based on the wrong premises.
Blurring the Distinction
China is the country in Asia that is most likely to defy easy categorization as either “emerging” or “developed.” As we mentioned in the 2008 annual report, China’s progress as a nation is emblematic of the region as a whole; despite the current downturn, its economic leadership has continued through the first quarter. The economy has been somewhat soft—export-oriented industries have suffered with the collapse of demand in Western markets. However, domestic consumption, along with domestic investment and property markets, have all been surprisingly firm—and each of these are much larger contributors than exports to the country’s growth. Thus, China has enjoyed a degree of relative economic stability compared with most of the rest of the world, where activity is contracting.
Perhaps of greater note regarding China’s long-term development was its continued effort to reform its domestic marketplace. The first three months of this year saw China engage in a flurry of activity that would suggest that the country’s leadership remains committed to market-based reforms and a stable social order. For instance, China announced further steps to implement a social safety net scheme, and to spend over US$120 billion on health care reform. Furthermore, in order to promote broader economic stability in the region, China extended tens of billions in currency swap arrangements with its trade partners in Asia. China is using its own currency, the yuan, to fill some of the vacuum left behind by the collapse of dollar-based capital markets—especially those that impacted short-term trade financing in the region. Perhaps most intriguingly, China demonstrated that it is still interested in the growth of its own capital markets, despite the seeming failure of such markets elsewhere around the world. At the end of March, the local securities regulator announced plans to create a new “Growth Enterprise Market” where younger companies would find it easier to list their shares. In our view this was a relatively small but meaningful undertaking, as it demonstrates the country’s commitment to a market-based economy.
Since the outset of the credit crisis, Asia’s currencies have weakened. Consequently, investors are once again asking a longstanding question: why don’t the Funds hedge more of their currency positions via derivatives?
While the Funds’ portfolio managers each have the authority to hedge currency positions at their discretion, they have historically made use of this authority only very rarely. However, the Funds will occasionally take up very short-dated currency hedges when settling certain transactions to moderate short-term fluctuations in the settlement process—in our view, this does not constitute a “structural” approach towards currency risk management.
We avoid using derivatives to hedge currencies in the portfolios for four main reasons. First, and foremost: in our experience, sustained currency hedging via derivatives is one of the most certain ways to destroy wealth. Even if properly executed, a hedge will tend to induce additional portfolio churn and related transaction costs. Meanwhile, if the wrong tactics are applied to the hedging process, the results can be far more disastrous. Certainly, there are instances where we believe it appropriate to manage currency risk. However, rather than introduce the risk and cost of currency derivatives, we prefer to use portfolio diversification—we attempt to pair offsetting positions against each other. We believe this approach is more cost efficient and less prone to error over the long run.
The second reason we tend not to hedge currencies with derivatives is because of the practical difficulty of doing so. Outside of a handful of the most developed markets in Asia (i.e., Japan and Australia), long-dated currency contracts are rare or non-existent, and invariably expensive. Third, we operate under the assumption that most clients allocate only a small portion of their assets to the Matthews Asia Funds. This being the case, we presume that the bulk of our clients would actually benefit from a bit of diversification in currencies outside the U.S. dollar, which the Funds can provide.
Lastly, on philosophical grounds we find it artificial to separate a company’s stock from the currency that it uses to denominate its financial statements. Modern financial theory suggests that investors can and should “unbundle” their currency decisions from security selection. However, it was this same sort of thinking that underpinned much of the derivatives that have collapsed as of late. We would acknowledge that such theory has some raw merit, but ultimately it is alien to our investment process. When we invest in stocks, our goal is to do so over an indefinite horizon. We do extensive research on the underlying company because we intend to invest in it for the long-term, not just make a trade in its stock. When you are buying a stock with the intent to hold it indefinitely, the notion that you could permanently separate a company’s fortunes from its underlying currency starts to look absurd. If the currency collapses, it is likely that the business conditions for the company have collapsed, too. Our research aims to develop an integrated view of a company, its stock, and the currency, and make a long-term decision that is based on the merits of each. For us to manage the currency risk separately would be a bit like buying a dream house—one you plan to live in for thirty years—but selling short the lot on which it is built. The value of the house, as well as the land, is ultimately intertwined with the future of the neighborhood. Our view of Asia is that it remains an attractive region in which to build wealth over the long term—this will likely be reflected in corporate profits and exchange rates.
As always, we are honored to serve as your Asia investment specialists and we thank you for your investment in the Matthews Asia Funds.
Andrew T. Foster
Acting Chief Investment Officer
Matthews International Capital Management, LLC
Robert J. Horrocks, PhD
Director of Research
Matthews International Capital Management, LLC
The views and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investments vehicles.