October 1, 2009
Dear Fellow Shareholders,
How the market mood has fluctuated this year! Early in 2009, investors were facing the fall of capitalism and a second Great Depression. Equities were selling at “bargain” prices that few were willing to pay. Fiscal and monetary stimulus was seen as the last throw of the dice—a much needed “rescue package.” Now, investors worry that China’s stimulus packages were “fictitious growth” that ignited a bubble. They also fear that valuations, which with hindsight everyone can now agree were cheap, are “stretched.” Investors’ eternal search to get “something for nothing” continues, but markets are never so generous that they will offer up cheap prices in times of great optimism.
A Changing Reality
If a cynic is someone who knows the price of everything and the value of nothing, then by this yardstick, there are very few Asia cynics left. For as much as the knee-jerk reaction was to run to U.S. dollar assets when the crisis hit (somewhat confusingly, since it was the center of the crisis), as fears have calmed, Asia has been increasingly recognized as better placed economically than the West. One could make good arguments that:
- Asia’s growth will continue to surpass the Western world by a substantial margin for the medium to long term.
- Capital market developments may gradually reduce the overall cost of business.
- And even that Asia’s companies have on average become better managed.
This is a changing reality that we at Matthews have discussed and written about for some time. And for a long time it seemed as if the investing world was cynical of such claims. Well, now Asia is trading at a premium to global markets—a small premium relative to the U.S., perhaps, but a substantial one compared to Europe. The implications seem to me to be that Asian stock market valuations are no longer at odds with the prospects for their economies. To be sure, we have more evidence of Asian economies’ resilience and of Asian governments’ abilities to stabilize their economies by means of monetary and fiscal policy in a way considered impossible during the Asian financial crisis of 1997 – 1998. Nevertheless, much more of this is now realized and accepted by investors.
However, if a sentimentalist is someone who sees an absurd value in everything, and doesn't know the market price of any single thing, then by this measure too, the markets can hardly be said to be sentimental toward Asia. For valuations are becoming a major concern for market commentators at the moment. In terms of Asia’s long-term averages, valuations are no longer cheap. In general, valuations with a more cyclical component (i.e., price-to-earnings) are expensive partly because the earnings are depressed; valuations with a less cyclical component (i.e., price-to-book or sales) are far closer to average. And yet several commentators are already pronouncing India and China as “bubbles ready to pop.” There are reasons to be cautious—inflation is stirring once more in India. Loan growth in China has been extremely fast during the first half of the year and China is already putting on the brakes. Australia recently started what appears to be a cycle of interest rate increases. And yet, in a deflationary world environment, these are also signs of strength. If they are problems, then they are problems that the U.S. and Europe hope to share.
The Role of Government
With so much expected of their economies, Asia’s governments will have to continue to step in and promote the types of policies that support a shift in favor of domestic consumption away from the export sectors. This will mean the growth of the welfare state—to free up precautionary saving. It will mean greater capital market development—to facilitate the investment of capital domestically. And it will mean good management of fiscal and monetary policy—to support long-run growth and prevent imbalances.
Focus will probably shift to these key macro risks. Are governments able to follow through? These reforms are eagerly anticipated and policy makers are pursuing them. However, it is too much to hope that such reforms can proceed seamlessly—there is many a slip twixt cup and lip. I do not think that markets have entirely ignored these risks either.
Asia’s Contribution to Global Growth
Perhaps we are not sentimentalists yet. However, there has certainly been an increased belief and confidence in the Asia region. This confidence has been backed with strong investment flows and increased talk of holding Asia as a strategic component of one’s portfolio, rather than a tactical play on short-term global growth. But these are not necessarily signs of euphoria, in my opinion. Rather, they are a reassessment of the economic relationships between East and West of the last 20 years, and a realization that these relationships must change. Asia will contribute over half of global growth in the next five years, based on purchasing power parity, according to International Monetary Fund data. China alone will account for nearly one third. And despite Asia’s role in the global economy today, most portfolios in the U.S. likely carry a small weighting to Asian equities. It seems likely that if Asia continues to perform well, people will continue to re-allocate resources to these markets, but they would be well advised to do so in a prudent manner.
The capital gains in Asia to be won from a reassessment of global risks have now most likely disappeared. Anyone investing today expecting returns on par with the recent past is likely to be disappointed. Performance will be driven by long-term earnings growth. What part does valuation play in our process at Matthews? Generally speaking, we look first and foremost for companies that benefit from the secular growth trends we see in Asia. Second, we seek to identify that management is trustworthy and competent. Finally, we use valuation as a check to ensure that we don’t overpay. We do not expect to always see bargain prices before we invest and we like to see cheap prices for good businesses, but we are cognizant of the fact that the market seldom offers up such opportunities, and getting a good business for a fair price is the most one can hope for most of the time.
As always, we are honored to be your Asia investment specialists, and thank you for your investment in the Matthews Asia Funds.
Robert J. Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC