Q1 CIO Review and Outlook

CIO Robert Horrocks, PhD, discusses what a rising interest rate environment means for Asia’s markets.  


April 2021

Dear Shareholders,

It has been a volatile year for the markets—in the true sense of the word. The markets went up sharply and then came down sharply. And what is more they probably went up and down for the same reason. If this sounds like I’ve lost my mind, then, fair enough—I probably won’t have an easy time convincing you otherwise.

However, as I said in my last message, be careful what you wish for. I suspect that it is the recovery in near-term economic conditions that caused the markets to rally and then also caused them to sell off again. One way of intuitively thinking about this is that when there is limited economic activity now, then all my efforts can be focused on the future. Any news that makes that future seem more certain and nearer can have a comforting effect. However, there comes a time when I get so busy in the here and now that I have less effort to expend on the future. The mechanism for distributing this effort and resources over time are interest rates. And so it has been that the rise in economic activity has pushed up interest rates and all of a sudden, the cost of deflecting our attention to the longer term has risen. This has made it very challenging for some highly priced mega-cap stocks. After all, I might be more inclined to wait for a trillion-dollar, thousand P/E stock to grow into its valuation if there is nothing much to do in the meantime.

Do I think that this poses more sustained problems for Asia’s markets? I don’t think so. First, I remember a former colleague when I was in the U.K. who was incredulous when the U.K. market took a dive because of strong growth numbers: “Surely that is good news?” It is. I think that we are still set for a strong earnings recovery in Asia and a sustained recovery. Asia may have dealt with the virus more efficiently and therefore we might reasonably expect a muted recovery compared to the West. However, Asia’s economies have much more room for a moderate inflationary stimulus without the fear of rising short rates than we have in the U.S. the region has a lot more room for margin expansion, particularly as the U.S. is belatedly looking to follow some of Asia’s pro-labor policies. With core inflation in China fluctuating around zero percent, there seems to be no need for tighter policy anytime soon, whereas in the U.S., the question has become: “How far will the Fed allow inflation to exceed 2%, and for how long?” I do think any spike in inflation ought to be temporary— simply a sign that post-COVID, demand is coming back instantly, whereas supply will take time to ramp up. For now, central bankers will stay their hands—but they must surely be getting itchy fingers.

In addition to the fact that short-to-medium term opportunities favour Asia over the developed West, the longer-term trends are also a tailwind for Asia. Asia still boasts some of the highest rates of Total Factor Productivity growth—the kind of productivity that comes from the creative application of labor and capital. While it is conventional wisdom that faster economic growth does not translate into higher market returns, it is a wisdom that hides the correlation that faster economic growth does mean faster profit growth. And so long as you can tame the beasts of valuation and corporate governance, that economic growth is a powerful ally.

From a relative sense, valuations in Asia are still reasonable and at a discount to much of the developed world. We have made the point previously that this is the case on depressed margins in Asia and expanded margins in the West—this continues to be the case. So, we are comfortable with overall valuations from a relative viewpoint across regions. For particular sectors, however, we do see huge discrepancies in the way the market is discounting the future prospects of some untried and untested business models versus the steady track records of more established businesses. This is absolutely not to say that one should abandon the former in favour of the security and predictability of the latter. Nevertheless, it is true that some parts of the markets seem to be moving on hype, momentum, news flow and speculation. Here, it is most assuredly a case of buyer beware! I do not, however, subscribe to the notion that the markets as a whole are overvalued, but with a rising long bond yield, we will have to work even harder for returns.

One question that I get a lot at the moment is: “Are higher interest rates bad for the Asian markets?” Well, everything else being equal, the higher the interest rate the lower the valuation and that is true in Asia as well as anywhere else. However, when higher interest rates are a sign that global growth is accelerating, Asia has tended to do well. If higher interest rates are a sign that monetary policy has been loosened (we are talking about long-term rates that move with inflation expectations and not the short-term rates controlled by central banks), then the effect has been positive for Asia and emerging markets too. So, outside of the effects on some highly valued sectors and stocks—effects that may continue—I am fairly sanguine about the current economic environment and the opportunities for Asia and emerging market economies and policy makers.

So, what is the challenge for our analysts and portfolio managers at the moment? To be a little more sensitive to valuations? Yes. Where we are dealing with new businesses that have yet to prove themselves with real profit growth, to run the rule again over business models and markets? Yes. To continue to allocate capital where we think the long-term prospects have been under appreciated by the marginal investor? Yes. But we are not defensive! The stance in the portfolios is to continue to expect strong long-term growth in our target markets and companies—we have just emerged from some very trying global economic conditions. It is normal that there should be some frictions in the system as things start to improve. It would be wrong to interpret them as permanent changes to the investment landscape. I remain optimistic about Asia’s economic prospects and believe it is an exciting place to find new investment opportunities.

Robert Horrocks, PhD
Chief Investment Officer



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