I came across an interesting article by Andrew Forster from Matthews Asia which is pretty highly thought of when it comes international investing. The article warns that despite the fact that the future of the Asian economies may be much brighter, in the short term and especially during duress investment performance in the Asian markets is likely to be closely linked to the developed economies/markets. http://www.matthewsfunds.com/perspectives-on-asia/asia-insight/article-328/default.fs
For investors in Asian equity markets, the popular “decoupling” term is as elusive as it is promissory. There is no standard definition for the term, and nearly every investor holds a unique expectation as to what decoupling could mean for his or her portfolio. For most, the idea is underpinned by a belief that Asia’s largest markets—led by China—could somehow produce performance that is differentiated from the rest of the world, particularly during times of distress. This pleasant but vague definition suffers from two glaring omissions. First, it does not distinguish whether one should expect divergent performance from financial markets (e.g., stocks), or from the underlying “real” economies. Clearly, the two do not always move in tandem. Second, the definition does not specify the time period during which one might reasonably expect benefits of decoupling to be evident. Should decoupling be measured over days and weeks, months and quarters, or years and decades?
As we have stated in the past, we believe that with no clarity over what “decoupling” means, this notion is little better than a myth at this time. Evidence from the last decade upsets any facile belief in decoupling (see table above). During each of the major financial crises that struck during the last decade, Asian equities were anything but resilient: in every case, they declined further and faster than global counterparts. This finding is hardly surprising. Asia’s economies have grown precisely because they have coupled with the world, and because they have opened their markets to both foreign and domestic investment, trade and competition. Meanwhile, for the better part of the past decade, Asia’s capital markets were best described as nascent, and consequently they were easily swamped in a global panic. To harbor hopes for a sort of instant gratification via decoupling—where investments in Asia were immune to events elsewhere—was to bet against both the odds and reason. In the table, only the “Decade in Entirety” row offers evidence of divergent performance, and even that is conditional upon on a long-term horizon. Only investors who held steady for the entire decade (despite pronounced volatility, and through periods of high correlation) have benefited from any meaningful decoupling.
In the September 2010 issue of Asia Insight, Matthews’ Chief Investment Officer Robert Horrocks, PhD, presented a new, more realistic definition for decoupling—one that describes the gradual evolution we see underway in the Asian region. Importantly, this new approach to decoupling rests upon the fundamental changes that are reshaping the region’s economies. The revised definition still, however, does not propose unrealistic hope for divergent short-term performance from equities or other asset classes. Furthermore, the definition underscores that the benefits of decoupling will materialize gradually, over longer periods of time. The definition hinges on three inter-related ideas:
o Resilience: have Asian financial markets sufficiently matured so as to be resilient during periods of distress?
o Uniqueness: has the development of Asian economies presented unique opportunities of material benefit to global investors?
o Independence: can domestically driven demand, fiscal strength, intra-region trade, regulatory reforms and technological advances allow Asia’s economies to grow independently of the global business cycle?
These ideas are abstract, but they represent critical dimensions with which to assess the potential for decoupling in Asia. They can be mapped directly to present events, thus forming a sort of “roadmap” for the region’s economic future. “Resilience” can be measured by the continued broadening and deepening of capital markets in the region, especially by the growth of bond markets. “Uniqueness” is evident in the expansion of service-related industries (as opposed to those industries based on manufacturing and investment). These economies are still nascent, and their development is wholly unique to the region. Lastly, “independence” is fostered by enhanced domestic demand, spurred by rising personal incomes and greater consumption among households.
These developments could be considered prerequisites, essential “pillars” upon which the notion of decoupling rests. If any of the three pillars fails to materialize, decoupling will remain an elusive myth, and all bets are off. Happily, we see evidence that all three pillars are intact and growing stronger. Let’s briefly examine each, and their relevance to decoupling.
Deepening of Capital Markets, Led by Fixed Income
Asia’s equity markets have been notoriously volatile, and have rarely exhibited any meaningful short-term resilience during times of crisis. The reasons for this have been manifold, but foremost among them has been the absence of large-scale corporate bond markets in the region. In the past, many governments in Asia have pursued policies that stunted the natural development of private bond markets. Instead, they developed large-scale, state-driven banking systems that allocated their respective nation’s savings according to political preference, often at the expense of efficiency and economic merit. This meant that during times of stress, private enterprise lacked a stable source of long-term capital. Government-run banks shunned private companies in favor of state-owned enterprises. Meanwhile, equity markets were too small and fickle to serve as an alternate source of financial capital. Thus any credit crunch or economic contraction was likely to be exacerbated, consigning the region to sharp boom-and-bust cycles. Without deep, liquid bond markets to offset such swings, Asia’s markets stood like a stool with only two legs: inherently unstable.
The good news is that all of this is beginning to change. During the Asian currency crisis in 1997, governments in the region began to recognize the importance of private markets to allocate long-term capital; since that time they have reversed course, introducing policies to foster the development of fixed-income markets. As a consequence, bond markets have grown at a 21% compounded rate since that time, which is equivalent to an eleven-fold increase. From humble and insignificant beginnings, Asia’s fixed-income markets now stand at more than US$5 trillion. More importantly, domestically based investors play a more important role in driving demand for new issuance. In the past, foreign investors played an outsized role in Asian bond markets; this meant that capital flows were likely to be whipsawed by global events, and at risk of sudden flight. Now Asian-based investors, led by institutional managers, dominate marginal demand for new bond issuance.
All of this has meant that the size, scope and quality of Asian bond markets have improved markedly. In recent months, yield spreads on Asian corporate bonds have fallen slightly below those of their U.S. counterparts, signifying that Asian companies have ready access to low-cost, long-term funding in a manner that was previously unimaginable. Still, the region is not immune to crisis: Asian bond and equity markets were shaken along with the rest of the world during the European-induced panic last spring. However, as fixed-income markets deepen and mature, they will likely foster a greater degree of resilience that has been lacking in the past.
Expansion of Services
The expansion of Asia’s service industries comprises a key pillar for decoupling for two reasons. First, without broad-based expansion in services, Asia’s economies will remain inherently unbalanced. Many analysts and commentators have rightly called for Asian economies to strike a better balance between domestic demand and external, export-led growth. However, many equate this shift toward greater demand for household goods and other consumables. In truth, Asia does not so much suffer from a lack of “stuff” as it does from underdeveloped service industries.
In the past, a complex set of factors (including heavy-handed regulation, industrial policies that favored manufacturing, weak legal systems, immature business practices and a lack of discretionary household income) inhibited the development of many service-based industries in the region. Most of these factors are still prevalent, but Asia’s economies have matured sufficiently enough for service industries to emerge. The largest and most important of these services is undoubtedly the delivery of health care, but it is complemented by new business services (e.g., wholesaling, retailing, engineering, logistics, technology services, software and advertising) as well as household services (consumer financial services, tourism, entertainment and media).
Service industries are also essential to decoupling for the unique opportunities they afford global investors. Our research suggests two valuable characteristics associated with Asia’s service industries: first, these industries tend to be dominated by domestically based companies rather than foreign competition, as the former are more aligned with market conditions and local requirements; second, these industries are intrinsically domestic in nature, and thus are less prone to the swings of the global business cycle. For these reasons, Asian service industries may represent an important addition to one’s investment universe, as they may enhance diversification and insulate against global financial shocks.
Enhanced Domestic Demand
The final pillar that underpins Asia’s potential to decouple is increased domestic demand, particularly as it is spurred by rising incomes that beget greater household consumption. This is a core investment theme for our firm: we have long sought to capitalize on the evolution of the Asian household, particularly as it accumulates wealth and enhances its consumption patterns. We believe this source of growth will ultimately prove the most substantial and most sustainable over the coming decades. We further believe that growth in household consumption will create better balance in Asia’s economies, and consequently, add a degree of independence and insulation from global business cycles.
However, it is important to note that not all forms of consumption are equal: where possible, we seek consumption-based industries whose growth has been promoted by the private sector, rather than government subsidy or public industry; and in general we favor broad-based, mass-market consumer industries, in lieu of those that might be associated with substantial wealth or “conspicuous consumption.” We do this for a simple reason: in our view, the most powerful and sustainable source of growth to harness in one’s portfolio is the type that arises from private enterprise, especially where it is promoting households to escape poverty and to claim a better standard of living.
Be Wary of What You Buy, and What You Pay For It
Given this discussion on decoupling in Asia, one may feel more inclined to invest in the region. However, we would advise doing so only with the greatest caution. Decoupling is a long-term trend, and it has more to do with a gradual shift in the economic landscape than it does with short-term portfolio performance. Meanwhile, there are a myriad of clever product-pushers that will be all too happy to sell a “decoupled” product with a nifty acronym, whether they are “BRICs” (Brazil, Russia, India and China) or “CIVETs” (Colombia, Indonesia, Vietnam, Egypt, Turkey, South Africa).
Even if you avoid the product-push, you must still be wary. Emerging market equities— particularly those sectors most associated with decoupling themes—are now subject to elevated valuations. It appears that some investors have grown overly convinced that decoupling is a one-way, short-term bet. Don’t bet on it. Instead, take your time, and set any expectations for decoupling over the longest horizons. Meanwhile, contrary to popular perception, consider focusing your attention on the greatest imperfections in the economic landscape. Rather than concentrate on the sectors that are today’s “growth darlings,” you should instead consider those industries that are in the greatest disrepair, those that seem the most broken and backward. It is those industries that have the most need for new capital to improve and modernize; it is also those industries that stand to gain the most from economic development, and from any future decoupling.
Andrew Foster
Portfolio Manager
Matthews International Capital Management, LLC
For investors in Asian equity markets, the popular “decoupling” term is as elusive as it is promissory. There is no standard definition for the term, and nearly every investor holds a unique expectation as to what decoupling could mean for his or her portfolio. For most, the idea is underpinned by a belief that Asia’s largest markets—led by China—could somehow produce performance that is differentiated from the rest of the world, particularly during times of distress. This pleasant but vague definition suffers from two glaring omissions. First, it does not distinguish whether one should expect divergent performance from financial markets (e.g., stocks), or from the underlying “real” economies. Clearly, the two do not always move in tandem. Second, the definition does not specify the time period during which one might reasonably expect benefits of decoupling to be evident. Should decoupling be measured over days and weeks, months and quarters, or years and decades?
As we have stated in the past, we believe that with no clarity over what “decoupling” means, this notion is little better than a myth at this time. Evidence from the last decade upsets any facile belief in decoupling (see table above). During each of the major financial crises that struck during the last decade, Asian equities were anything but resilient: in every case, they declined further and faster than global counterparts. This finding is hardly surprising. Asia’s economies have grown precisely because they have coupled with the world, and because they have opened their markets to both foreign and domestic investment, trade and competition. Meanwhile, for the better part of the past decade, Asia’s capital markets were best described as nascent, and consequently they were easily swamped in a global panic. To harbor hopes for a sort of instant gratification via decoupling—where investments in Asia were immune to events elsewhere—was to bet against both the odds and reason. In the table, only the “Decade in Entirety” row offers evidence of divergent performance, and even that is conditional upon on a long-term horizon. Only investors who held steady for the entire decade (despite pronounced volatility, and through periods of high correlation) have benefited from any meaningful decoupling.
In the September 2010 issue of Asia Insight, Matthews’ Chief Investment Officer Robert Horrocks, PhD, presented a new, more realistic definition for decoupling—one that describes the gradual evolution we see underway in the Asian region. Importantly, this new approach to decoupling rests upon the fundamental changes that are reshaping the region’s economies. The revised definition still, however, does not propose unrealistic hope for divergent short-term performance from equities or other asset classes. Furthermore, the definition underscores that the benefits of decoupling will materialize gradually, over longer periods of time. The definition hinges on three inter-related ideas:
o Resilience: have Asian financial markets sufficiently matured so as to be resilient during periods of distress?
o Uniqueness: has the development of Asian economies presented unique opportunities of material benefit to global investors?
o Independence: can domestically driven demand, fiscal strength, intra-region trade, regulatory reforms and technological advances allow Asia’s economies to grow independently of the global business cycle?
These ideas are abstract, but they represent critical dimensions with which to assess the potential for decoupling in Asia. They can be mapped directly to present events, thus forming a sort of “roadmap” for the region’s economic future. “Resilience” can be measured by the continued broadening and deepening of capital markets in the region, especially by the growth of bond markets. “Uniqueness” is evident in the expansion of service-related industries (as opposed to those industries based on manufacturing and investment). These economies are still nascent, and their development is wholly unique to the region. Lastly, “independence” is fostered by enhanced domestic demand, spurred by rising personal incomes and greater consumption among households.
These developments could be considered prerequisites, essential “pillars” upon which the notion of decoupling rests. If any of the three pillars fails to materialize, decoupling will remain an elusive myth, and all bets are off. Happily, we see evidence that all three pillars are intact and growing stronger. Let’s briefly examine each, and their relevance to decoupling.
Deepening of Capital Markets, Led by Fixed Income
Asia’s equity markets have been notoriously volatile, and have rarely exhibited any meaningful short-term resilience during times of crisis. The reasons for this have been manifold, but foremost among them has been the absence of large-scale corporate bond markets in the region. In the past, many governments in Asia have pursued policies that stunted the natural development of private bond markets. Instead, they developed large-scale, state-driven banking systems that allocated their respective nation’s savings according to political preference, often at the expense of efficiency and economic merit. This meant that during times of stress, private enterprise lacked a stable source of long-term capital. Government-run banks shunned private companies in favor of state-owned enterprises. Meanwhile, equity markets were too small and fickle to serve as an alternate source of financial capital. Thus any credit crunch or economic contraction was likely to be exacerbated, consigning the region to sharp boom-and-bust cycles. Without deep, liquid bond markets to offset such swings, Asia’s markets stood like a stool with only two legs: inherently unstable.
The good news is that all of this is beginning to change. During the Asian currency crisis in 1997, governments in the region began to recognize the importance of private markets to allocate long-term capital; since that time they have reversed course, introducing policies to foster the development of fixed-income markets. As a consequence, bond markets have grown at a 21% compounded rate since that time, which is equivalent to an eleven-fold increase. From humble and insignificant beginnings, Asia’s fixed-income markets now stand at more than US$5 trillion. More importantly, domestically based investors play a more important role in driving demand for new issuance. In the past, foreign investors played an outsized role in Asian bond markets; this meant that capital flows were likely to be whipsawed by global events, and at risk of sudden flight. Now Asian-based investors, led by institutional managers, dominate marginal demand for new bond issuance.
All of this has meant that the size, scope and quality of Asian bond markets have improved markedly. In recent months, yield spreads on Asian corporate bonds have fallen slightly below those of their U.S. counterparts, signifying that Asian companies have ready access to low-cost, long-term funding in a manner that was previously unimaginable. Still, the region is not immune to crisis: Asian bond and equity markets were shaken along with the rest of the world during the European-induced panic last spring. However, as fixed-income markets deepen and mature, they will likely foster a greater degree of resilience that has been lacking in the past.
Expansion of Services
The expansion of Asia’s service industries comprises a key pillar for decoupling for two reasons. First, without broad-based expansion in services, Asia’s economies will remain inherently unbalanced. Many analysts and commentators have rightly called for Asian economies to strike a better balance between domestic demand and external, export-led growth. However, many equate this shift toward greater demand for household goods and other consumables. In truth, Asia does not so much suffer from a lack of “stuff” as it does from underdeveloped service industries.
In the past, a complex set of factors (including heavy-handed regulation, industrial policies that favored manufacturing, weak legal systems, immature business practices and a lack of discretionary household income) inhibited the development of many service-based industries in the region. Most of these factors are still prevalent, but Asia’s economies have matured sufficiently enough for service industries to emerge. The largest and most important of these services is undoubtedly the delivery of health care, but it is complemented by new business services (e.g., wholesaling, retailing, engineering, logistics, technology services, software and advertising) as well as household services (consumer financial services, tourism, entertainment and media).
Service industries are also essential to decoupling for the unique opportunities they afford global investors. Our research suggests two valuable characteristics associated with Asia’s service industries: first, these industries tend to be dominated by domestically based companies rather than foreign competition, as the former are more aligned with market conditions and local requirements; second, these industries are intrinsically domestic in nature, and thus are less prone to the swings of the global business cycle. For these reasons, Asian service industries may represent an important addition to one’s investment universe, as they may enhance diversification and insulate against global financial shocks.
Enhanced Domestic Demand
The final pillar that underpins Asia’s potential to decouple is increased domestic demand, particularly as it is spurred by rising incomes that beget greater household consumption. This is a core investment theme for our firm: we have long sought to capitalize on the evolution of the Asian household, particularly as it accumulates wealth and enhances its consumption patterns. We believe this source of growth will ultimately prove the most substantial and most sustainable over the coming decades. We further believe that growth in household consumption will create better balance in Asia’s economies, and consequently, add a degree of independence and insulation from global business cycles.
However, it is important to note that not all forms of consumption are equal: where possible, we seek consumption-based industries whose growth has been promoted by the private sector, rather than government subsidy or public industry; and in general we favor broad-based, mass-market consumer industries, in lieu of those that might be associated with substantial wealth or “conspicuous consumption.” We do this for a simple reason: in our view, the most powerful and sustainable source of growth to harness in one’s portfolio is the type that arises from private enterprise, especially where it is promoting households to escape poverty and to claim a better standard of living.
Be Wary of What You Buy, and What You Pay For It
Given this discussion on decoupling in Asia, one may feel more inclined to invest in the region. However, we would advise doing so only with the greatest caution. Decoupling is a long-term trend, and it has more to do with a gradual shift in the economic landscape than it does with short-term portfolio performance. Meanwhile, there are a myriad of clever product-pushers that will be all too happy to sell a “decoupled” product with a nifty acronym, whether they are “BRICs” (Brazil, Russia, India and China) or “CIVETs” (Colombia, Indonesia, Vietnam, Egypt, Turkey, South Africa).
Even if you avoid the product-push, you must still be wary. Emerging market equities— particularly those sectors most associated with decoupling themes—are now subject to elevated valuations. It appears that some investors have grown overly convinced that decoupling is a one-way, short-term bet. Don’t bet on it. Instead, take your time, and set any expectations for decoupling over the longest horizons. Meanwhile, contrary to popular perception, consider focusing your attention on the greatest imperfections in the economic landscape. Rather than concentrate on the sectors that are today’s “growth darlings,” you should instead consider those industries that are in the greatest disrepair, those that seem the most broken and backward. It is those industries that have the most need for new capital to improve and modernize; it is also those industries that stand to gain the most from economic development, and from any future decoupling.
Andrew Foster
Portfolio Manager
Matthews International Capital Management, LLC
