Country Updates

For the month ending August 2008

Assessing Asset Location, Part II

Last month’s article highlighted the challenge of creating a globally diversified portfolio, and our contention that many U.S. investors are underweight in the Asia region, relative to its economic contribution to the world. We noted the option of the “traditional” approach of adding more emerging markets to an existing portfolio, but then pointed out that other allocation schemes may be equally, or more, relevant in today’s world.

While there can be many ways to define equity investment, the three most common categorizations are size, style and geography. Size is the least contentious, and most easily measurable (though you still have the thorny issue of investability, using free float instead of total market cap). The “traditional” approach in the U.S. has been to blend large and small, though beginning in the early 1990s, mid cap came to be defined as a distinct third category. Style is generally plotted on a spectrum of growth/value, but active managers may not fit neatly along this single dimension, and portfolios may appear different if plotted based on holdings or performance methodologies. Geography might appear straightforward, but country of incorporation vs. listing vs. activity adds a wrinkle. Is HSBC a British company or Hong Kong company? An Asian company or a global company?

Constructing a global portfolio using these three dimensions takes the standard style grid and turns it into a cube. The rest of this article focuses on the one aspect of geography, and explores the relevance of using GDP per capita as a tool for country allocation. However, the cube analogy is important. Whatever geographic approach you implement, you need to remain aware of the style/size dimensions.

Regarding country allocation: Let’s begin with a little history to help put the current popular developed/emerging approach in context. For U.S. institutions, international (non-U.S.) investment began in the mid to late 1970s. The original investors (endowments and corporate pension plans like those of Stanford, Xerox and GTE) used EAFE as a benchmark, which made perfect sense given that the useful, investable universe at that time was dominated by Western Europe, Japan and Australia. Australia had a greater relative importance in the world at that time because of the commodities boom. The one anomaly was the absence of Canada. There is no definitive answer as to why it was omitted, but presumably Canada was seen in the context of a “51st state,” meaning it was deemed too similar to the U.S. to be considered foreign. It may also be that the dominant professional investment managers of international equities at that time were European, so they had less expertise and/or interest in Canadian stocks.

In the early 1980s, there wasn’t much interest in expanding international investment beyond these major markets, given the problems with Mexican debt at the time, Hong Kong’s decline during that same period and the strength of the U.S. dollar. But in 1985, the Plaza Accord engineered the fall in the dollar. At that point, there was a new and renewed focus on smaller, developing countries, especially the Newly Industrializing Economies (NIEs) of Asia (Hong Kong, Singapore, South Korea and Taiwan). While European interest in developing markets focused on Asia in the mid 1980s, it wasn’t until the 1989 fall of the Berlin Wall that the phenomenon of emerging markets really became global. At that point, Global Emerging Markets became the benchmark for U.S. investors going beyond the original EAFE developed markets. At the time, it all made sense, particularly given that the vast majority of countries outside of the U.S., Western Europe and Japan had a GDP per capita level that defined them as “emerging markets” according to the World Bank. One point worth noting is that the World Bank breaks the categories of country wealth into four levels: low, lower middle, upper middle and high. Until recently, the investment world only recognized two for the purposes of asset allocation. These were “developed” (equivalent to high) and “emerging” (the other three). Now, the term “frontier” has arrived as a way of parsing out the low end of “emerging.”

So why has GDP per capita perhaps lost its relevance? Four very important events have occurred in the last 20 years, two in Asia, two in Europe. The two events in Asia were the rapid economic growth of the four original NIEs, and the rapid growth of India and China. The first has meant that there are now a group of Asian nations that have joined Japan and Australia as developed (though the investment world doesn’t like to think of South Korea and Taiwan as developed), and two giant economies that in another 10 years will have cities that are close to developed, but remain in countries that will be emerging for several more decades. That doesn’t even take into account the fact that Hong Kong can arguably be considered both developed and emerging, depending on your viewpoint of its status as a “Special Administrative Region.” So, accurately breaking Asia into developed and emerging is almost impossible, and more importantly, irrelevant.

Turning to Europe, the two events have been the single currency in the late 1990s, and the enlargement in 2004. The single currency generated rapid growth and wealth for the lower income countries like Spain, Ireland, Portugal and Greece—the corollary of developments in Asia. The enlargement means that investing in Europe today means investing in a group of 27 countries that encompass most or all of the developed and emerging markets that were targets for investment 20 years ago.

Therefore, GDP per capita is arguably an outdated methodology for dividing up the world. You could instead select one or two managers who invest across the world—all markets, all cap. But few U.S. investors are going to be comfortable delegating the total allocation decision, especially the home market, or U.S. exposure. So how can you gain exposure to the major markets of the world in a way that approximates their economic importance?

1. Invest Regionally: Split the world into three main blocs—U.S., Europe and Asia Pacific. It allows an allocation much closer to the world GDP breakdown, and investors can select experts in particular regions. Disadvantages: it doesn’t capture Canada or Latin America, the Middle East and Africa. Some may feel this is not important or, in the case of Canada, is covered by U.S. investments. Otherwise, a completion portfolio, regional funds or perhaps a resources fund would help address the deficiency. Today, there aren’t a wealth of vehicles available to U.S. mutual fund investors to cover the world this way. In addition, investors may still consider there to be mismatches within regions against their preferred strategic allocation.

2. Invest in one or more core international funds, and add regional or single country funds to the mix: as we noted in last month’s article, core international is very likely to leave you underweight in Asia. Depending on the particular funds, it might involve adding Asia Pacific as whole, just Asia ex-Japan, or just China and India (which tend to be most underrepresented relative to their economic size). This has the advantage of more customization, but the disadvantages of complexity, as it may require investors to take on more of the allocation decision than desired.

Neither approach is perfect, and you have to strike a balance between controlling and delegating allocation decisions. But the key here is to develop a methodology that fits the ultimate goal. If that goal is global diversification, then investors need to determine an appropriate long-term strategic allocation (economic size being as important, or more important, than investible stock market size). They should understand whether heir combination of investments gets them the appropriate exposure, taking into account the tactical tilts they may wish to retain against that long-term allocation.

David Harding, CFA
Managing Director
Matthews International Capital Management, LLC

China/Hong Kong

As popular as the Olympic Games in Beijing were, the enthusiasm did not help lift China’s stock markets. As investors fretted over the widespread global slowdown and the lack of stimulus packages from the central government, the markets tumbled sharply in August. During the month, the MSCI China Index dropped –8.2%, and Hong Kong’s Hang Seng Index was down –6.2%. China’s domestic A share index slid –14.8% in thin trading volume. China’s currency, the renminbi (RMB), declined –0.1% against the U.S. dollar in August—its first monthly decline in over two years. RMB was at 6.84RMB/USD at the end of the month.

During the much-watched Olympics, China demonstrated both its economic and athletic accomplishments to the world. The government did face some criticism regarding human rights issues, including freedom to protest and travel restrictions implemented during the event. However, the spectacular opening and closing ceremonies and innovative stadiums impressed many around the globe, and China’s lead in gold medals boosted a sense of national pride and unity among Chinese to a new level.

China’s consumer inflation continued its deceleration for the third straight month after it reached 8.5% in April. The consumer price index in July rose only 6.3% from a year ago, down from 7.1% in June. However, China’s producer price index accelerated 10.0% in July, up from 8.8% in June, primarily due to increases in energy and raw material prices.

On the trade front, July exports were unexpectedly strong, up 26.9% from a year earlier, while imports rose only 3.7%. Domestic consumption was also encouraging with July retail sales rising 23.3% on a year-over-year basis, up slightly from 23.0% in June.

India

India’s gross domestic product (GDP) grew at 7.9% in the first quarter, ending in June, compared to a rate of 8.8% in the previous quarter. The moderation in growth was evident across several sectors with industrial production, slowing to a rate of 6.9% in June from 7.6% in the previous quarter, and 9.1% in the same period last year. Investment activity slowed considerably, growing year over year by 9%, the slowest pace in the last five years. The slowdown is perhaps a reflection of the sustained increase in the cost of capital. Since last month, the Reserve Bank of India (RBI) has revised its forecast for fiscal year 2009 GDP growth, down from about 8.5% to 8.0%. Inflationary levels remain elevated although the most recent weekly data point indicates a slight softening in trends. The Wholesale Price Index (WPI) eased from 12.6% to 12.4%, marking the first decline in five months. That said, weekly readings of the WPI can be uneven in shorter time periods.

Separately, the RBI has introduced the trading of currency futures, with the National Stock Exchange carrying out the first trade on August 29. For the first time, Indian entities can trade currency futures although it is restricted to trades only between the U.S. dollar and Indian rupee. Previously, Indian companies seeking to hedge foreign currency exposure (for instance, export-oriented companies) were restricted to using forwards and/or swaps. This initiative to launch currency futures is likely to enhance the efficiency of the market by improving transparency and price discovery. That said, the new guidelines are somewhat restrictive, with lower contract sizes and trading limits. This might keep bigger importers and exporters out of the market for now. In a parallel move, the Securities and Exchange Board of India increased the cumulative debt investment limits for foreign institutional investors from $3.2 billion to $5 billion, and from $1.5 billion to $3 billion in government securities and corporate debt, respectively.

Japan

The negative news for Japan continued in August, sending the Tokyo Stock Price Index (TOPIX) down –3.75% for the month. The credit contagion that began in the United States has spread to Japan, and companies are finding it increasingly difficult—if not impossible—to get loans from banks. The lack of access to credit has resulted in a number of bankruptcies so far this year, particularly in real estate.

With weak and weakening export markets, some investors have sought haven in Japanese domestic shares, but the gloom in the property market there is quickly dampening sentiment. Miki Shoji, a large real estate brokerage firm, announced this month that central Tokyo office rents fell in July from the previous month’s level —the first such decline in nearly three years. Commercial real estate transactions also fell to three-year lows in July, according to Nikkei Business Publications.

Inflationary pressures have continued dampening consumer and business sentiment, with the most recent corporate services price index (CSPI) showing a rise of 1.3% from year-earlier levels. The CSPI has shown positive year-on-year inflation for the last 20 months, but wages are not keeping up with inflation, and thus, spending power is eroding. Large industry groups are feeling the pinch: in August, truck drivers staged nationwide demonstrations, seeking lower fuel taxes and highway tolls.

On August 29, the government announced a 11.7 trillion yen ($107.8 billion) economic stimulus package, first since 2002. This stimulus plan is centered on assistance in the form of governmentbacked loans and tax breaks for smaller companies and households suffering from higher gasoline and food prices. The actual government spending will be limited to 2 trillion yen as a part of supplementary budget for the current fiscal year.

The Financial Services Agency has also asked for a 10-year tax exemption on up to 1 million yen of stock dividend income per shareholder, and up to 5 million yen in annual capital gains tax exemptions for the elderly. With over two-thirds of individual investors in Japan earning annual incomes of 5 million yen or less, and with inflation rates now higher than returns from 10-year Japanese Government Bonds, this measure may serve as a great incentive for individuals to return to the Japanese stock market and encourage companies to pay out more of their earnings.

Korea

In August, the Korea Composite Stock Price Index (KOSPI) declined –7.6% and Korea Securities Dealers Automated Quotation (KOSDAQ) fell –12.8%. The Korean won also lost 7.6% against the U.S. dollar during the month. Exporters and industrial stocks, which tend to benefit from a weaker currency, were sold off due to a gloomier outlook on the world economy in the second half of the year. Investors sold off some financially stretched chaebol groups that have been active in acquisitions.

Though exports grew 20.6% during the month, imports still outpaced exports by 16%, leaving an August trade deficit of $3.2 billion, higher than July’s $2 billion.

Strong import growth may have resulted in part from a time lag in adjusting imported crude oil prices. Though average crude oil prices during the month fell to $113 a barrel from $131 a barrel in July, the average import price dropped to just $128 per barrel during the month because of oil import contracts, which tend to be long-term contracts, reflecting the previous month’s price. It is expected that when import oil prices are adjusted in September, it should work to improve the trade balance figure.

Korea’s consumer price index rose 5.6% over a year ago. Though inflation was higher than the policy rate, it was slightly lower in August compared to July. During the month, the Bank of Korea raised its policy rate by 25 basis points (0.25%) to 5.25% to cope with inflation.

During the month, government debt of $7 billion, maturing in September, and a rising household debt level of 67% of GDP has caused concerns among the foreign media, which has drawn parallels to the Asian Financial Crisis of 1997. However, Korea’s heavily regulated banks have been selective in their requirements for consumer lending. Most corporations also now have overcapitalized balance sheets. Korea’s foreign currency reserve—the sixth-largest in the world—was $243 billion as of August. Given that its foreign currency reserve in 1997 was just $8.8 billion, concerns over Korea’s economy may be overblown.

August 30, 2008

The views and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investments vehicles.