Investment Manager Report
Dear Fellow Shareholders,
The first quarter of 2011 certainly gave investors in Asia’s markets much to talk about. Rising inflation challenged policymakers and central bankers. Political unrest in North Africa and the Middle East brought comparisons between political systems in that region and in Asia. The earthquake and tsunami in Japan, and subsequent nuclear disaster roiled markets. Whilst this may appear like a litany of troubles for the region, the actual impact of these events will probably turn out either to be much less severe than at first feared or, in some cases, may even be positive. Despite the volatility, regional indices ended the quarter slightly higher than at the end of 2010, although this return masked some reasonably large disparities in performance between sectors.
The “Jasmine Revolution” in the Middle East and North Africa spurred numerous questions during the quarter about the possibility of similar revolutions in Asia. The natural logic seems to be that if people are oppressed, they will revolt against that oppression. And yet there are many steps in such a revolution. For example, was it really a spontaneous eruption of people or were there political parties backing and organising the movement?
Do similar conditions exist in Asia? China is often put forward as a nation that lives under a communist dictatorship. Yet, as someone who has lived there, I can say that, aside from obvious controls on media, the state is actually not very obtrusive on people’s daily lives. In addition, incomes have been rising rapidly since the regime opened the country to the outside world and to capitalistic production and distribution methods. Nor are there obvious fissures in the political elites—gone are the deep generational differences between octogenarian revolutionaries and middle-aged technocrats.
While nations such as Indonesia and India have had to adjust to living with terrorism (much as the U.K. did for much of the past century), they have recently exhibited much more stable political regimes. Two areas of more immediate concern in Asia remain—the unstable and unpredictable regime of North Korea and the divided politics of Thailand. Tensions in both these countries seem to have died down substantially, however, they are apt to recur at any time with little or no warning.
Focus on Inflation
Most of the attention focused on inflation during the quarter centered on headline rates of inflation (including food and energy) rather than core rates of inflation. And for the most part, people focused on policy risks in terms of rising interest rates in light of higher inflation. There are a few technical issues that are worth mentioning here. First, food and energy prices are quite volatile. When central banks think about inflation, they think about sustained rates of inflation over time and will not necessarily raise rates to deal with food and energy prices alone. Second, if the prices of goods and wages are rising together, this can mean that while costs for companies are rising, many companies will also see demand for their products and services go up too. Higher wages mean higher purchasing power. Indeed, the costs to an economy of a somewhat higher rate of inflation—if inflation affects all prices simultaneously—are quite hard to pin down in theory. Third, even if interest rates rise in such an environment, the real rate of interest that a company faces may be unchanged. So, why should I care if I am paying 1% more on my borrowings if the prices of my goods are rising by 1% too?
For some countries, inflation may have a positive effect—particularly if demand is sluggish, the workforce underemployed and the banking sector caught in a liquidity trap. (Japan may be such an economy.) Here, sustained higher rates of inflation may lead to lower real interest rates and that could spur both consumption and investment.
Indeed, there are some prices that seem likely to be high and sustained—among these, wages in the region, specifically China, appear to be headed higher as a deliberate policy on the part of the government to achieve a rebalancing of global demand. This would otherwise be realised through appreciating exchange rates against the U.S. dollar. Wage increases seem destined to exert a potentially larger and longer-term impact on investment opportunities than more cyclical food and energy prices. They would seem to call for an acceleration of automating manufacturing processes to replace (more expensive) people with (relatively less expensive) machines. They also would create a profitable opportunity for consumer businesses that are able to pass through increased costs to the end consumer.
Implications Related to Japan
Rather than dwell upon the details of recent events in Japan, I would like to make one general comment. While big, terrifying events may have long-lasting effects on markets, their effects may not be as long-lasting and impactful as the size of the event might suggest. On the other hand, events that may slip by almost unnoticed (one new policy here or a change to a tax law there) in any country may actually leave very large effects. Meanwhile, an earthquake and tsunami of the scale seen in Japan are, by their own awesome power, expected to have equally large effects. However, over time they may be seen as less consequential. Undoubtedly, there are implications for the global manufacturing supply chains and potentially severe environmental impacts from the ongoing nuclear crisis. Much of the physical damage will take years to correct; however, in the scale of Japan’s large economy, the effects are not large. The actions of the stock market, too, suggested that there is much value in Japan at current levels as the market first fell in shock and then quickly rebounded. For our portfolios, tactically, this meant that there was little opportunity for short-term trading to take advantage of the temporarily depressed prices. It also means that the key for our investment team going forward is to stick to our process for selecting good companies rather than to obsess about long-term, quake-related implications that may never materialise.
The events of the quarter did have one notable effect on most of our portfolios. Conflict in the Middle East, rising inflation and worries over the long-term viability of nuclear power all contributed to a rise in the prices of equities related to the fossil fuels industries. Our Funds tend to hold far less in the materials sector than their benchmarks, which tend to have large weightings in this sector, and also in energy. This dynamic can be a key area of relative performance risk for the Funds. Added to this was weaker performance from the health care and consumer industries and underperformance of smaller-capitalisation companies. Consequently, when measured against the popular regional benchmarks, the performance of our Funds struggled. These trends were the opposite of the tailwinds that had helped our performance in 2010, and because markets go through cycles, some reversal of fortunes was to be expected. It bears repeating, then, that we remain true to our philosophy of finding good companies that will grow over a sustained period of time and we find fewer such candidates in the cyclical industries like materials and energy than we do in health care, consumer-facing and financial sectors, to name a few. We will also often find such opportunities for sustained growth outside of the large-capitalisation businesses. Nevertheless, we sincerely believe that this philosophy is the best way to add value over time.
We thank you for your continued support, particularly during sometimes volatile climates. As always, it is a privilege to serve as your investment advisor.
Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC