Q3 2022 CIO Review and Outlook
CIO Robert Horrocks, PhD, says emerging markets, including China, are better equipped than previous years to endure a global economic slowdown.
Forgive me for paraphrasing the late Queen Elizabeth II but the summer of 2022 is not one which investors will look back on with undiluted pleasure. During the quarter, the markets suffered one wave of bad news after another and indeed emerging markets, particularly China, took the news worse than most.
So what were the issues that most affected the Matthews Asia portfolios? Well, first was inflation and interest rate policies. The question of how much inflation was supply-side driven and how much was demand driven seemed to have been resolved. For, as freight rates tumbled and supply bottlenecks were uncorked, services inflation remained stubbornly high. The Fed reacted with more rate rises and much harsher (or determined) rhetoric.
The Fed’s hard line hit many currencies. Why? Because other central banks are not tightening as fast as the U.S. Europe’s inflation woes contain much more supply side issues which central banks are powerless to prevent. China and Japan do not have inflation problems—supply or otherwise. And the Aussie dollar is getting no support from its own central bank which is more concerned about a global recession. So currencies—developed and emerging—tumbled against the dollar. So often in moments of greatest stress in equity markets, stock price falls in emerging markets are magnified by a strong greenback. This certainly seemed to be the case by the end of September when many markets seemed to have such severe price dislocations, that is to say prices that were so delinked from what we believe is fundamental long-term earnings power, that they can only be understood as a hostage to fear.
Another challenge has been tensions between the U.S. and China, which seemed to escalate further during the quarter. While Russia’s war on Ukraine was the main source of friction earlier this year, the focus is now on Taiwan and America’s desire to be seen to be protecting the only freestyle democracy in current Chinese societies. To this end, the U.S. sent House Speaker Nancy Pelosi to Taiwan and she was closely followed by the Governor of Arizona, whose state is home to much of the U.S. semiconductor industry and also a location for Taiwanese chip industry investment.
China’s zero COVID continues to be the policy that has the biggest drag on Chinese holdings. Here, there still seems to be little respite. Although the frustration with the leadership in cities like Shanghai and among the young urban office workers seems to be boiling over, it is not at all clear that the rest of China feels this way. It seems less and less likely that there will be a significant loosening of policy, particularly as winter approaches. We can only remain hopeful for next spring. But if this is really just a waiting game, at these prices, it should pay to be patient.
Outside of China, things were a little different. Normally, India and Indonesia would suffer at a time of higher oil prices, rising inflation and interest rates, and a stronger U.S. dollar. This time, Indonesia’s resilient economy has been supported by government policy reforms and the commodity cycle.
In India, capital spending in the economy continued to strengthen and domestic consumption remained robust. Our only issue with India’s prospects in the short run is the degree of outperformance by its equity markets compared with much of Asia as well as the valuation differentials with other markets. However, India looks set to maintain perhaps the fastest growth rates of all the major economies in which we invest.
Meanwhile, Vietnam remains a favorite investment idea of ours from a top-down perspective. Finding the right companies with the right liquidity is more challenging than in many other geographies although this is improving over time.
As for Latin America, the domestic markets of Brazil and Mexico have been stable and have put paid to the notion that any global crisis must necessarily hit all emerging markets the hardest. As their currencies have weakened against a strengthening U.S. dollar, the economic growth of Latin American countries—and for that matter much of the Middle East as well as parts of southeast Asia—has been surprisingly resilient. Their currencies have taken the pain wrought by a strong dollar without the impact spreading too much into their economies. This shows an enormous improvement in the caliber of emerging markets compared with previous liquidity squeezes. Yes, raw materials prices have contributed a lot to this resilience but these are not the same emerging markets which existed when I began my career.
As the world slows and the dollar strengthens, emerging market economies will become more attractive, in our view, both on a valuation basis and on a dollar-cost basis even though the quality of companies and relative macroeconomic stability has improved.
As the summer came to a close, it would be churlish not to note a couple of rays of autumn sun. In Ukraine, the war seemed to be turning decisively against Russia and the hope of an earlier end to the conflict did raise the somewhat admittedly feint probability of a risk-on rally. Like with China’s COVID policy though, winter may put this on pause.
Another possible pause may be more welcome—that of a Fed pause. The data on inflation, which has been confusing all along, has suddenly became a little clearer in its confusion. There are reasonable arguments to be made that core inflation may fall rapidly to 4% or even below. This does not mean rate rises are over but it would mean that they are nearing a peak.
As we look at the markets, we see evidence of strange pricing. Some utilities, which have consistently paid dividends for over a decade and where current double-digit yields are fully covered by annual cash flows, are at bargain valuations. Opportunities seem to abound at the corporate level. All we can do is to try and take advantage of these where appropriate. However, we do so in the knowledge that the macroeconomic and political environment may still dominate for some months. We are striving to see through that and to profit from the pervasive sense of fear.
The economic and financial climate is undoubtedly difficult, but these are the times when opportunities arise. We continue to comb our investment universe for these opportunities. We do so not by trying to time markets or industry cycles so much as trying to identify where true quality secular growth might be on sale.
Robert Horrocks, PhD
Chief Investment Officer