Times Like This – The China-U.S. Market Turmoil by Robert Horrocks, PhD, Matthews Asia
Times like this in the markets can be unsettling. We are accustomed to dealing with risk, that is to say we are familiar with “normal” market swings from year to year. But when there is a sudden abrupt fall in markets, investors may find themselves at a loss. This is not about risk, as such, but about uncertainty: “What is going on?”
To answer that question, we reach for times that seem familiar to us to try to make sense of what is happening and what the immediate future might hold. But we also need a logical framework within which to guide us—to show us where history can be helpful and where it might be misleading. I am happy to outline the ways in which I am viewing recent developments now, and the way the team at Matthews Asia is thinking about what’s going on.
It is not that unusual, when investing in Asia, to see drawdowns on the scale that we have witnessed recently. In 2013, we experienced a somewhat more restrained version of the recent volatility. There was also the 2007–08 bear market; violent declines following the Severe Acute Respiratory syndrome (SARS) outbreak; the technology bubble in the U.S.; and before that, the 1997–98 Asian Financial Crisis. All serve as historical markers for comparison today.
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Let’s begin with comparisons to 1997. Why? Because that was the most abrupt of the aforementioned crises. Potentially, the worst-case scenario. And, as we will see, there are plenty of similarities with that period—but some big differences, too.
What is Going on?
The analytical framework behind what’s going on is used in my outlook for 2015. From my point of view, ever since the U.S. Federal Reserve started talking about tapering in May 2013, it has been tightening monetary policy. So we’ve gone through 24 months of tighter monetary policy in the U.S. and there have been debt problems in Europe on top of that. I would be surprised if we weren’t seeing weakness in global economic numbers. And the drop in commodity prices is likely just another canary in the coal mine. All this has naturally, eventually, begun impacting China, and here’s how: China pegs its currency to the U.S. dollar. So when you have tight monetary policy in the U.S., you also force one upon China. As China starts to open up its capital markets to cross border flows, any attempt to use its own independent monetary policy would cause the relative value of the currency (i.e., the exchange rate) to move. So, while China has attempted to keep its currency stable versus the dollar, we have seen the total assets of its central bank (an indicator of growth in money supply) grow at the meagre rate of 2% over the last 12 months. This is extremely tight for an economy that is growing in high, single digits in nominal terms. And this is at least part of the reason behind the devaluation.
I do believe China is doing some technical things to try to get it in the group of currencies used by the International Monetary Fund as a kind of shadow reserve currency. But I also think China is trying to allow the renminbi to move more, so that it has a little bit more freedom to pursue its own monetary policy. And yes, we’re seeing weakness among China’s manufacturing companies. But now, China has the ability to respond, by stimulating its own economy. And I do think that what’s been happening in the stock markets will prompt a response from central banks around the world, including that of China. I suspect the European Central Bank will respond and I suspect the Fed will respond, either by delaying a rise in rates, or by some kind of modification of the language about the tightness of policy going forward.
A Global Monetary Issue
So, what we have really is a global monetary issue. And that would impact real economies. You will likely continue to see earnings downgrades in the region, as we already are seeing. And that does give a certain amount of justification to some of the falls in prices. But we are also getting to a situation where stocks are looking outright cheap for certain names. Not necessarily across the board, because we already went into this with valuations that were reasonable, but not outright cheap. At this point, then, it becomes a matter of who has the patience to buy at lower valuations and wait out the volatility and whether or not the world’s central bankers will step in to reflate economies. We are seeing some structural reform across Asia. But this is part of a long-term plan, not a reaction to short-term events. The flaws that we see across the world’s economies are not severe or fundamental enough to warrant long-term pessimism. Nor do they need fundamental fixes (with the possible exception of the Eurozone).
Now, what exactly is in the back of people’s minds when they’re looking at the markets in Asia? Compared to 1997, amid the crisis of that time, there are similarities—tight monetary policy, a rising U.S. dollar, falling commodity prices and exchange rates in Latin America and Asia under pressure. But there are also distinct differences. Going into the 1997 crisis, the degree of overheating in Asia was evident to all—we saw big current account deficits and high rates of inflation. Equity markets were trading at high valuations. The degree of pressure on Asia’s currencies to devalue was perhaps much greater than it is now. Asia is mostly in current account balance or surplus; inflation is low; and stock market valuations, whilst not cheap, have been reasonable. Even back in 1997, however, the deflationary pressures could have been borne by exchange rates without a dramatic impact on business profits and employment, and ultimately GDP growth, had it not been for one thing—large amounts of U.S. dollar debt. As currencies depreciated, corporates across Asia started cutting staff (leading to high unemployment) and selling goods at a loss just to raise cash to repay U.S. debt. But of course, these redundancies and fire sales of goods and assets added to deflationary forces, further depressing currencies, and adding to the U.S. debt burden. People knew they were selling goods and assets too cheaply but they had no option. The balancing mechanism provided by exchange rates was not allowed to work.
Where History Can Mislead
Another big difference is the role of China. And here is where history can be very misleading. China devalued its currency in 1994. Some blamed that devaluation for the crisis of 1997. And many now draw the same conclusion today. But I don’t see things that way. China devalued in 1994 partly for technical reasons—it had a dual currency regime and the devaluation basically brought the official and the black market exchange rates closer together. But also, it had gone through a period of high rates of inflation and its goods were being priced out of markets. Back then, China was much more dependent on export markets in order to relearn capitalism and to get back into the global trading system. Thereafter, having devalued, China tried to squeeze inflation out of the economy. China’s consumer price index, which had been growing in excess of 20%, fell to negative rates of change on the eve of the crisis. It was not the devaluation that added to Asia’s woes, it was the deflationary monetary policy.
But today, China’s devaluation is fundamentally reflationary in nature. It allows China to use more stimulative monetary policy. This is a huge difference between 1997 and today. In addition, by and large, Asia’s U.S. dollar debt is manageable. There are some countries that are going to be more hard-pressed than others—Southeast Asia is generally more exposed to commodity price falls and runs current account deficits; North Asia doesn’t have the same kind of issues. But nowhere in Asia would I say the issue is as extreme as it was back in 1997 and 1998. On average, countries are running current account surpluses. That is, they’re living within their means. Inflation is at low rates. These are economies that would benefit from a further stimulation of monetary policy. And now we have the prospect of two of the region’s major economies, Japan and China, both pursuing a more reflationary policy. The framework tells us that despite the superficial similarities, the actual environment is very different.
This brings us to the topic of valuations. Here, it is less science and more art. For there is no way for me to tell how fearful people may become and how far short-term selling might drive down valuations. Valuations going into the market sell-off were not cheap—but no more than a bit above average. Today, Hong Kong’s stock market is trading more attractively (at 8.4X forward earnings1) than it was at the end of 2008. On average, the markets are now moderately cheap, I would say—dividend yield for Asia ex Japan2 is above 3% (it peaked briefly at close to 4% in Q4 2008) but has seldom been this high in the past 15 years. On a forward price-to-earnings ratio3 basis, Asia ex Japan is at 11.6X, versus a historical average of 13X and a low in 2008 of 8.7X. The trailing price-to-book4 in Asia ex Japan is 1.5X, below its 2X historic average and now not far off the lows reached at 1.1X during Asia’s homegrown 1997–8 debacle. These valuations seem quite cheap when compared to forward price-to-earnings ratio in the U.S. at 15.7X and Europe at 14.8X. But valuations are no guide to short-run timing. They can only tell you how much you are paying for the long-run.
But it is precisely the long-term where Asia looks relatively well placed. Asia still remains the part of the world where productivity is growing at the fastest rate. It still maintains high savings rates and a thriving manufacturing industry. It is still bringing millions and millions of people into middle-class lifestyles—providing a huge tailwind to the growth of the service industries and the consumer-focused industries and businesses in which we, at Matthews Asia, like to invest. So, whereas the markets can seem scary or unsettling at times like this, it’s at times like this where we start to see the opportunities emerge for long-term investment.
Robert Horrocks, PhD
Chief Investment Officer