CIO Annual Letter

by Robert Horrocks of Matthews Asia, 1/9/17

The last few days of 2016 have receded amidst continued pain for Asia's markets. The year had begun with a rally in Asia's equity and fixed income markets, but it ended in a slump. I wish performance had been better, but the sectors that rallied—materials, energy and other cyclicals—did so less due to fundamental reasons than due to expectations of inflationary conditions rising once again. Sectors with more robust secular growth profiles, such as health care, have recently suffered. This environment has been a difficult one for investors, including our team at Matthews Asia, which is focused on making long-term strategic decisions to buy secular growth at reasonable prices. But it is also an environment of which we have warned investors, one that I believe is transient, and so we intend to stick to our investment philosophy and our commitment to long-term growth, not short-term trading. But sentiment is against us right now.

Indeed, as markets have marched on since the victory of President-elect Donald Trump, each footstep seems to bring new confidence into the U.S. market, just as it sends tremors through the East. Expectations of higher inflation, easier regulations, and an America-first trade policy are being priced in as being a boon to the U.S. and a burden to Asia. But have the markets been marching blindly? Is the focus too much on NOW and too little on the far future? Has the market been relying too much on conventional wisdom, what it feels is true, rather than spending the time to think through the issues in a cooler, more logical fashion? If it has done so, it would not be surprising—given the shock and emotional reaction by many over Trump’s surprise win. And yes, I do believe that the market has gotten some things wrong.

First, the markets may be overestimating the inflationary stimulus from President-elect Trump’s economic policy. Tax cuts will raise the budget deficit, yes. But that will be offset by a faster pace of interest rates hikes by the Federal Reserve. Tax cuts that save money for the wealthiest and broaden the tax base at the bottom are more likely to be saved than spent. That is not stimulative. Plus, many on the new administration's economics team are advocates of hard money and tighter control over, even auditing, the Fed. This is not an environment in which it will be comfortable for the Fed's doves (those happy to see higher inflation) to operate.

Second, the markets may be overestimating the effects of looser regulation. Yes, there are costs associated with it, but it is not as if profits are at a low level. Indeed, they are close to peak levels of GDP. Where is the evidence that regulation has imposed high costs? The effect of tax cuts in the corporate tax rate are real—but for how long are they likely to persist? Perhaps the market is overestimating the boost to valuations from these potential events.

And the effect of trade tariffs? They are likely to impose costs—a one-off jump in import costs, on the U.S. consumer and businessman alike. The reaction in the markets has been stark—as if the U.S. was isolated to this effect and Asia is incredibly exposed. This is the old canard about Asia being an export-led economy. It is not. Asia grows because it saves, it invests and it reforms. The excess that it produces beyond its immediate needs, it exports. But that is not vital to its citizens' standard of living. Indeed, Asia would simply consume even more of what it produces (and it already consumes the vast majority) if tariffs became punitive. The short-term impact is likely to make the U.S. dollar stronger—but less trade means less cross-border investment and that could weaken the dollar further down the line.