First Quarter 2023 CIO Review and Outlook
1 month ago
Learning: UnstructuredMatthews Asia CIO Robert Horrocks, PhD, discusses the impact of inflation on Asian markets and its effect on growth companies.
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Hi, my name is robert Horry the CIA at Matthews Asia. And I wanted to give you an update on how we're thinking about the markets at the moment. Now the main thing that's influencing market movements right now is inflation. What's causing inflation? Where is it going? How long it will last? How does that impact the different countries that we look at and how does it impact the different sectors in which we invest and those are the topics I want to cover today. First of all, inflation is nothing to worry about. In fact, in many senses it's something to welcome. I've been arguing for a long time that the economies of AsIA have been under stimulated inflation is something to worry about if it's about supply side shortages and things like that. And of course coming out of a pandemic, there are shortages, shortages of labour, shortages of some goods and inventory levels across the world have declined to levels not seen for many, many years. But some of these influences are going to be more permanent and some of them are going to be more temporary. And I want to try and take you through that and explain how we look at these things when it comes to putting the portfolios together. Let me talk first about Japan. Japan is actually an economy that's been teetering on the brink of deflation for many, many years now. The stronger performance we've seen in Japan over the last decade goes back to the ascendancy of Prime Minister Abe and the reflationary policies put in place by the bank of Japan under his guidance. Now with the global pandemic and the deflationary effects of that, Japan has once again fallen back into deflation and this has had a, a deleterious impact on the profits of Corporates, particularly those of small companies and those focused on the domestic economy. And Japan is one of those countries that seems to need a lot more stimulus, a lot more inflationary pressure before it starts to get going. And so we shouldn't be surprised if it is the last to emerge out of this deflationary funk when we look at performance across various geography ease. I am still hopeful, however, that Japan will continue to perform not least because it is a center of manufacturing excellence. And as you see, the global economy try and rebuild some of the inventories that have been drawn down over the past 18 months that ought to suit some of the specialist manufacturing that you get out of the Japanese economy. As yet, the market still seems to be one of the Lagarde's in the region on to India. And India's a strange case. India is one of those economies where you could almost argue the worst that the covid problem gets that, the better the market is and why is that? Well, India doesn't actually benefit so much from higher rates of inflation. It has a current account deficit under normal times when inflation rates are high, bond yields are high and the cost of financing that deficit increases. So what we've seen in India is in fact as the covid situation is worse than domestic demand has declined, that current account deficit has shrunk. In fact, it's even gone into surplus and it makes the economy looks superficially or maybe temporarily, much more robust than it actually is. India still has an underlying problem of supply because of its poor infrastructure. And although India has been one of the best performing markets this year, I just throw in a note of caution because maybe as things get better on the covid front, maybe as the economic numbers get better, domestic demand rises, that current account starts to slip into deficit again. And because of the supply side constraints, inflation starts to pick up and it's the wrong kind of inflation. It's the inflation that comes from too little supply and weak infrastructure finally china which is the other big market in our region. And here is the market that I have the most short term confidence in. Why? Because it's the most normal looking of all of our markets bond yields haven't moved much, they're still at the levels comparable to what they were before the covid pandemic began. In the meantime, earnings growth has been pretty strong. The only concern I have about China is that the core inflation rate is still less than 1% and that's too low. But that means that this is an economy that welcomes more inflation, welcomes moderate stimulus. And so long as that inflationary environment persists I think will continue to get pretty strong earnings growth coming out of china already because of the weaker performance of some sectors this year. Valuations in china is starting to look pretty reasonable and in a global context actually quite attractive. So I'm happy that China remains the main part of the bulk of our portfolios here at Matthews Asia. Now I'd like to talk a little bit about sectors and styles and how they're influenced by inflation. The main story of the last five years has been the dominance of growth stocks or what I like to think of as conceptual businesses. Those are businesses where you have to paint a picture around what future profitability will look like because they're not necessarily generating profits here and now or they're actually reinvesting into the business much more than the cash flows that they're making. So these are companies where the profit is a long way off. But the growth profile of those companies, at least in terms of sales, can be quite strong now when you have inflation pick up. That feeds into the sales numbers of all companies, whether they have a high growth profile or a low growth profile and all of a sudden growth is everywhere that you look and because growth is everywhere that you look, you tend not to have to look that far out or you tend not to want to pay up for the faster growing companies. And I believe that is one of the main reasons why you've seen some of these mega cap online companies in china and other countries around the region struggle a little bit in terms of their share price performance, the so called switch from growth to value, but it's really inflationary pressures and the rising bond yields that have been driving that secondly, when it comes to sectors and stocks, what you tend to find in a more reflationary environment. As I said, growth broadens, that tends to favor small cap companies and we've seen pretty strong performance from the small cap arena over the last few months. Why does this happen? Many small cap companies are in marginal industries. They may be a big player, but they're in a niche market. That means it's much easier for them to generate profits in an inflationary environment. In addition, many of them don't have access to the major banking systems, so financially, they're dependent on their own cash flows to grow and to sustain the business. And in an inflation environment with that better top line growth, that financial vulnerability is far reduced. So again, we've seen a recovery in the prices of small cap businesses across the region and not only in the tech sector, which has been the strongest performing sector for some time now, The other area of the market that has been influenced by a reflation environment has been the IPO market lots lots of new companies coming to list and we have been active in this market, but we're not active in the sense of looking for that first day pop in the share price. What we're looking for in these IPOs are exciting new businesses that weren't available for investment beforehand. So yes, we've been more focused on the tech area, the online area and in particular in healthcare and biotech, where you're starting to see new businesses reached the stage where they can list on the stock exchanges and they are being pressed to do so by policy promoting the development of the health care sector across the region. But this is where most evident again in china, we will continue to look at those ipos with a view as to which businesses we think are sustainable for the long run and where we can get allocations to them, we will try and do so. So how long is this inflation environment likely to persist? Well. It really depends. Is it inflation that comes from monetary policy? Is it inflation that comes from supply side shortages? I think a lot of what you're seeing now is indeed supply side shortages. People haven't gone back to work yet. So prices in the service industry are going up, factories are not yet running at full capacity. So the demand for inventory build up means that they're having to raise prices. But this whilst it does impact inflation should be a temporary factor. People will go back to work when the stimulus checks stop or when they feel safe in doing so, inventories will be rebuilt to levels that are more consistent with normal economic activity. That kind of inflation therefore I think will only last a short time and may be over in a few quarters. one of the inflation that comes from monetary monetary stimulus, well that will only get out of hand if people's expectations of inflation run ahead of what the central banks are willing to countenance. There simply isn't the case right now inflation expectations for the long term have people thinking that inflation will settle back down to a normal level. But the central banks have shown their willingness, particularly the Fed to allow inflation to run above that 2% level. In the short run. If you look across Asia at core rates of inflation, they range between 0% to about 3%, That's still too low. Those core rates of inflation can still move up. So I think for the near term was we face some supply constraints where we face some bottlenecks in the economy over the medium term, you're still going to see moderately stimulative policies that are actually a positive for greasing the wheels of the regional economies. But I'd like to emphasize that the way we invest is by buying businesses for the long term, not trying to time economic cycles. Nevertheless, inflation is, in my view, nothing to be worried about and even could be positively beneficial for our economies. So as we look for those high quality companies, it's nice to have a little bit of a macroeconomic tail.