Horizon Asia Opportunity commentary for the second quarter ended June 30, 2015.
During the second quarter of 2015, the Horizon Asia Opportunity Institutional Composite (“Strategy”) returned 7.3%, net of fees, compared to the MSCI All Countries Asia Index (“Index”), which appreciated 1.7% over the same period. Our holdings in the Financials sector in Hong Kong, and Consumer Staples and Consumer Discretionary names in Japan contributed positively to returns, while our positions in Thailand companies detracted from performance.
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Horizon Asia Opportunity: Chinese A share bubble
What goes up quickly may come down quickly as well. The Chinese A share market is the poster child of a speculative bubble forming and bursting. The Shanghai A share market measured in Chinese Yuan went up 37.8% from the end of March 2015 to June 12, 2015, then dropped 20.8% from its peak. However, it still appreciated 14.1 % in the second quarter of 2015, as seen in Chart 1 (right). This bubble was fueled by easy margin loans provided by the Chinese brokerage firms and some unofficial financing sources (i.e. wealth management products, known as WMPs and umbrella trusts). At the market peak, the margin loan to total market capitalization ratio was 9 %, which was unusually high compared with that of more developed markets (in the United States, this ratio was 3 % at its peak).
Judging from the volume statistics of the stock exchanges in China, unfortunately, most retail investors got involved in the markets in the latter stage of the market’s appreciation, and therefore are most likely sitting on losses in their accounts, which were surely made worse by the high leverage employed.
The Chinese government introduced a series of policies to stop the decline, such as establishing a 120 billion yuan stock market fund to buy A shares, suspending trading for about a half of the shares listed, and halting IPOs. We expect more measures from the Chinese Government to stabilize the markets.
However, the valuation of the A share market is not very appealing at current levels, and the companies in general show relatively low profitability and returns. We are not sure how long the artificial measures to support the market by the government can sustain the A share levels.
Horizon Asia Opportunity: The peak of margin loan frenzy
The real future concern is its impact on the Chinese economy. The good news is that even at the peak of margin loan frenzy, the total volume of the margin loans (2.2 trillion Chinese Yuan) represented only about 4% of consumer bank deposits outstanding, out of the total of about 53 trillion Yuan. Regardless, even before the stock market decline, the domestic economy had been slowing since Premier Xi’s corruption crackdown got started in earnest in 2013. We cannot believe that China can escape some negative ripple effects on its economy going forward. First, once-hot real estate markets have cooled down nationally, and now the stock markets have followed. We expect some negative impacts on discretionary spending, such as cars and luxury goods. So far, some European auto makers have lowered their total car sales targets due to the Chinese slowdown. We continue to monitor Chinese consumption trends carefully, even though we do not own any A shares in our Asia portfolio, as some of our Asian consumer holdings have been the beneficiaries of increased Chinese consumer spending. We still expect that the Chinese government will pursue the economic reform agenda presented by Premier Xi two years ago, but the pace of reform should slow down to accommodate some of these newly emerging forces destabilizing the Chinese economy. In addition, valuations of A shares are not particularly attractive with the government manipulating the stock markets price discovery process (see Chart 2, right). We remain cautious with respect to the Chinese local share markets.
The smaller Asian markets performed poorly as, in the second quarter, investors rotated out of strong performing South East Asian stocks into Chinese stocks. With the exception of some resource-related and high tech companies in Asia, the direct earnings impact from the Chinese market correction and likely subsequent economic slowdown will be limited for the Asian markets in general. However, the psychological impact should not be overlooked, and until the Chinese market stabilizes, we expect some volatility in the rest of Asia as well.
In the second quarter, Japan stood out as a safe haven during the violent gyration in the Chinese equity markets. The main reason that the Japanese markets have been getting more attention has been perceived and real corporate governance improvement. During the annual shareholders meeting season in Japan, many corporations announced increased dividends and share buybacks using the cash on their balance sheets instead of taking loans to pursue buybacks, as many US companies have done. Returns on equity have been improving thanks to better earnings and balance sheet management over the past 2 years. Still, small to mid-size companies in Japan have been left behind and valuations remain very attractive. We believe that this segment of the Japanese equity markets will provide us with interesting long term investment opportunities in Asia.
In the third quarter of 2015, we believe that investors will be increasingly paying attention to the timing of the inevitable interest rate hike by the Federal Reserve Bank (“FRB”) in the US. This will impact the US dollar and the Asian currencies pegged to the US dollar. The last time this rate hike scare occurred, the emerging markets were hit the hardest. However, given the not so robust global growth outlook, we do not expect the FRB to employ very aggressive rate hikes in the near future. Any volatility caused by FRB interest rate action might provide us with better entry points to deploy our cash position in the portfolio.
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