Semi-Annual 2010 Letter to Shareholders

June 19, 2010

Dear Fellow Shareholders,

In recent months, there has been a sharp divergence of performance among Asian markets. In the first half of this year, the Asia Pacific stock markets fell on average by about 7% in U.S. dollar terms. Most of this decline was accounted for by China (–16.5%), Taiwan (-10.5%), Australia (–16.8%) and New Zealand (–14.1%). That the regional index as a whole was not down by more is due largely to India (+2.1%) and ASEAN: Indonesia (+28.1%), Philippines (+14.0%), Thailand (+11.4%) and Malaysia (+9.8%). Much of this discrepancy is accounted for by concerns over excessive fixed asset investment in China in an environment of strong domestic demand in Asia overall.

Challenges for China

Caution was certainly warranted at the beginning of the year when the Asian growth story was perhaps being accepted too uncritically by the markets. That attitude appears to have given way to more skepticism. For example, one of Australia’s commodity producers, in comments that appear to be more widely accepted than in the past, argued that China's economy is more likely to grow at an average rate closer to 6% rather than 9% annually, and that 9% is no longer a sustainable target. Similarly, many investors seem to have accepted the concerns voiced by economic commentators that China’s slowing property market may potentially damage its banking system. All in all, the mood of investors toward Asia has mellowed markedly. What has been surprising to me is the extent to which India has been able to “take up the slack” in terms of the performance of its stock market. The region faces great changes in the years ahead and it is, after all, comforting to think that the region may be flying on more than just one engine.

This skepticism, or perhaps realism, is welcome. While we don’t subscribe to the view that China’s past decade of growth was a debt-fueled bubble, China certainly faces challenges in the near term. Its demographic profile starts to age in a few years’ time. The country is facing a slowdown in demand in its important external markets at the same time that domestic wage pressures are on the rise. The answer seems simple—change economic policy to favor domestic demand. But the implications of this are far from simple. Higher consumption spending means lower savings and investment—that change alone should lower the overall growth rate of GDP. Raising consumption’s share of GDP probably means higher government spending, too. I believe this to be the case for two reasons: first, higher consumption shares of GDP in wealthier countries have also been achieved by means of higher government spending; second, instituting welfare reform, such as unemployment benefits and a national health plan would liberate some precautionary savings (i.e., savings for a rainy day like job loss or illness). All of these changes are being managed in an international atmosphere that is demanding a swifter response—allow appreciation of the currency or suffer possible protectionist retaliation. And these changes are encompassed in the phrase “rebalancing of the global economy” as if the answer was as simple as watching a child’s see-saw move back to equilibrium. However, the reality entails a multitude of frictions that are likely to impede a smooth transition. Not least is trying to bring greater market discipline to China’s property markets without causing all the benefits to accrue to a wealthy minority of the population amid a speculative fervor. China’s desire to dampen speculation was partly responsible for the recent decision to allow the renminbi to appreciate and to implement strict controls on buying investment properties.

India's Resilience

Into the vacuum created by the increased nervousness over China has stepped India. For many years, India was treated as an afterthought in Asia investment. Since the reforms of the 1990s, the country has gained prominence and there are reasons to be optimistic. India does not face some of China’s demographic challenges—it has one of the youngest profiles of any Asian nation. India’s underdevelopment in infrastructure—to support both agriculture and manufacturing—is one of the issues its government, which for so long seemed to procrastinate, has more recently tackled with renewed vigor. The low growth rates of the 1980s (approximately 5%) have been replaced by growth in excess of 7%; this growth has been based on higher savings rates than in the past, probably making it more sustainable. In addition, the government remains committed to further reform. These advantages are, however, as always, not missed by the markets which accord a higher valuation to profits, cash flow and book value in India than they do in China.

Does this mean that the rose-tinted view of China has simply been replaced by over-optimism about India? Perhaps not. India certainly faces its own problems—its politics seem less stable than China’s and its economy more prone to bursts of inflation, possibly due to an agricultural sector that is both a large share of the economy and which has arguably not received the investment that would make its output less vulnerable to seasonal monsoons. The private sector remains starved of capital by a government that siphons off bank deposits to support its debt issuance. The private sector, thus deprived, has perhaps been too ready to embrace foreign capital without proper evaluation of the risks. On the other hand, maybe I shouldn’t have been surprised by India’s resilience. Given the laundry list of requirements for the next round of Asia’s growth story identified by institutions like the International Monetary Fund—stronger social safety nets, better infrastructure, financial sector deepening and more flexibility in exchange rates—India, where domestic demand accounts for a larger share of GDP than in China, seems as well-placed as any to take advantage of the new opportunities for growth.

What must never be too far from investors’ minds, however, is that although some of these changes may happen “naturally,” as the Western world has set a precedent for the evolution of market economies, these changes will also be supported, encouraged or challenged by government policy. One key risk is that as market optimism grows over the evolution of the region, economies like India may be pushed to change faster than their policymakers feel is prudent—a risk akin to undeveloped capital markets trying to deal with a surge in portfolio investment. India has always been more reliant on external financing than China. ASEAN, in particular, with its smaller, more open economies, may react to the optimistic demands of speculative foreign capital with tighter controls on that capital.

All of this—the transformation from one economic model to another—will take time and require new government policies. Waiting for new policies creates uncertainty, which in turn is generally bad for valuations. Markets have fallen back from the start of this year, from what were somewhat expensive levels in terms of the price of both earnings and book value, to what appear to be much more reasonable, if not marginally cheap. But some kinds of uncertainty should also be good for profits in the sense that profits are the reward to the entrepreneur for creating new markets. The degree to which a country has to reshape itself or its businesses to refocus should give rise to unexploited profitable opportunities. So we are mindful of the uncertainty surrounding Asia’s future growth but also aware that uncertainty and profit are just two sides of the same coin. The key, as always, will be to try to keep looking at the long term and to invest as prudently as we can. 

As always, it is a privilege to serve as your investment advisor for Asia.
Robert J. Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC