Since the end of January, it has been pretty much one direction for Asia's markets—down. Of course the most common question I receive is, “Are we at the bottom?” And it is always very difficult for me to answer with any degree of certainty. I have a gut feel. And I can enumerate the various risks and opportunities. But I have no magic formula (or even any kind of track record) for picking the trough of the market. With that said, let me at least try to share with you all what's on my mind.
First, I do not believe that trade wars are the main reason for the downturn in markets. They are part of it, for sure. But not, I believe, the main part. The overall macroeconomic effects of the tariffs suggested are just too small a part of GDP for them to have such a big impact: less than 1% of China's GDP. I understand that the uncertainty may lead to CEOs postponing investments until they have a clearer understanding. But it is just too big a stretch for me to believe that the effects are as severe as the headlines might have us believe. And indeed, for every loser (some component businesses in China), there may be Asian winners too—for example, some Southeast Asian nations (ASEAN). And while the trade war may be resolved fairly quickly, if I am right, the relief rally following any resolution is likely to be milder and shorter than many might expect.
The reason is that, in the background, the main reason for Asia's bear market remains global monetary policy. Tightening from the U.S. Federal Reserve seems likely to continue. China has also employed tighter monetary policy since the end of last year (to my surprise) and we are starting to see pressure on Italy's financial markets and the European Union, resulting, I suspect, from policy that was not loose enough. Only Japan seems ready to maintain the ultra-loose policy of the past few years. But even here, political pressure on Prime Minister Shinzo Abe has been mounting and it remains possible that this could interfere with the Bank of Japan's policy. And there seems no end in sight to U.S. tightening—particularly as core inflation seems to be threatening the 2% level. This is not a mix up in policies that is conducive to global growth or to Asia's financial markets.
There are some silver linings though. It is not as if Asia went into this period overheated or overextended. In fact, it was a little frustrating that Asia's credit cycle and profit cycle had remained so weak due to minimum wage policies squeezing profits, on the one hand, and overly tight fiscal and monetary policy keeping nominal GDP growth in check on the other. The only economies that show any real weakness in the face of the stronger dollar and tighter money are some of the frontier markets of Asia and places like Indonesia and India, which have current account deficits. The rest of the region has been pretty well isolated. So, this year, again, has been a case of Asia getting caught up in notions of “emerging market contagion” and joining in the sell-off are short-term investors who have been selling out of exchange-traded funds (ETFs). This sort of influence ought to be temporary as markets eventually do adjust to reflect the fundamentals of economies and corporations. And Asian economies seem, on the whole, much better-placed than those of Latin American and Eastern Europe.
A second silver lining is that valuations have started to look cheap. I've previously written about a bifurcation in the markets between high-growth and low-growth companies—the low-growth companies being cheaply priced, whereas the higher growth companies often priced at premiums that I felt were too far in excess of their long-term growth advantages. I think that, in certain of the growth sectors, prices are starting to look more reasonable. And that has also lowered overall valuations. Price-to-forward earnings
ratios at about 12.1X for Asia ex Japan and 12.8x including Japan, compare favorably with Europe at 13.7 and the U.S. at 17.1. I think these valuation discounts are already a bit excessive. It is undeniable that the U.S. has seen superior profit growth over the last seven years, but I do not expect that to be the case over the next decade, as political and wage cycles switch in the U.S. to favor labor and switch in most of Asia to favor corporations.
What about any catalyst to the markets in terms of sentiment? I do not see this in the short term. In Asia, the marginal, often retail investors are clearly losing confidence and selling out of their more speculative positions. More institutional-type investors in Asia remain cautious. In Europe and the U.S., we still hear anecdotally that people's allocations to Asia are near the lowest levels they can remember. In these regions, I would describe sentiment as interested but not yet ready to act. This is a mixed blessing, of course, because it means that sentiment is keeping valuations low and you don't want to be trying to squeeze through the entryway along with everyone else when sentiment turns. But it does mean the markets could be devoid of a driving force for a while.
For us at Matthews Asia, though, this is an exciting time in many respects. We are always invested in Asia. And so, with our eyes remaining on the long term, and with patience as our mantra, we scour the region for buying opportunities in individual businesses. And, we are seeing more and more. Economies that have been hardest hit, such as Indonesia, have elicited some interest. But it has been China and in particular its domestic A-share market, where our portfolio managers in general seem to be finding the best ideas. Suffering from the double blow of trade headlines and tight domestic monetary policy, China's A-share market has lost about a quarter of its value. The companies in the domestically oriented market have been criticized for poor structure and governance. Whereas that may be true on average, such averages disguise some hidden gems discoverable to those with the time, resources and inclination to do in-depth research.
So, it has been a tough year—and it's a tough time now for those trying to time the market. But for those of us on the Matthews Asia investment team, we are keeping our heads down and discovering more areas of the market that we believe offer good long-term value—exciting times!
Robert Horrocks, PhD
Chief Investment Officer
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