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First Quarter 2008 Message to ShareholdersDear Valued Shareholders, The first quarter of 2008 will undoubtedly be remembered as one of the more challenging episodes in the recent history of capital markets. Shares in the U.S. and around the world declined due to concerns over the health of the global economy. At the root of those concerns were fears about the solvency of certain segments of the U.S. financial system. Over the past several years, the U.S. economy experienced a sustained expansion in credit, particularly with respect to mortgage-related lending. During this period, banks and securities firms were keen to participate in the boom for residential credit. The extended duration of that boom tempted many companies to adopt aggressive lending practices, both with respect to how mortgages were made, and especially how they were financed. These tactics have recently backfired: During the past several months, mortgage delinquencies have risen, even as the sources of funding for such loans have dissipated. As conditions in the credit markets have worsened, many small- and mid-sized financial services firms have watched their capitalizations languish, and some have been forced to declare bankruptcy. The market took an astonishing turn on March 17, when the fifth-largest investment bank on Wall Street suffered a collapse. Bear Stearns, a storied bank whose history spanned the Great Depression, was forced to sell itself to J.P. Morgan for a small sum, or face insolvency and liquidation. J.P. Morgan was willing to complete the transaction only after the U.S. Federal Reserve took the unprecedented action of underwriting $30 billion of Bear Stearns’ worst assets, thereby shielding the acquirer from initial losses. The sudden demise of this long-running institution sent deep shivers through the markets. Stocks sagged under fears that the deterioration in the U.S. credit cycle would push the domestic economy into recession, and that, in turn, would slow growth overseas. Equities around the world declined in response. Over the first quarter, the sharp decline of markets in Asia Pacific and elsewhere acted as a substantial headwind for the Funds’ performance. The MSCI All Country Asia Pacific Index—the broadest equity benchmark in the Asian region—declined approximately 11% in the first three months of the year. Several markets in the region, such as China and India, fell substantially further. None of the Funds in the family were able to sidestep these difficult conditions, as all declined during the quarter. Importantly, though, nearly all the Funds bested their respective benchmarks, and some by a substantial margin. We have highlighted this relative outperformance not because we put much weight on a single quarter’s results. Instead, our investment philosophy aims for returns over longer horizons, and we hold a humble view of our ability to time markets. However, the performance of the Funds during the first quarter illustrates another principle we strive for: to manage our clients’ assets with a strong appreciation for risk. Except for the last several months, most markets in Asia have experienced nearly five years of uninterrupted gains. In such an environment, it has been tempting to aim for maximal returns, while turning a blind eye to the downside of markets. Yet even among Matthews’ more aggressive strategies, we have attempted to cultivate a prudent approach toward risk. Our tools are simple—we emphasize appropriate diversification, and avoid timing markets, no matter how seemingly attractive the opportunity. Although the contraction of the U.S. credit cycle has done damage to markets around the world, fundamentals in the Asia Pacific region have thus far held up reasonably well. Balance sheets of regional banks and insurance companies have declared losses due to their exposure to subprime mortgage instruments, though the cumulative impact has been much smaller than elsewhere around the world. More importantly, the credit cycle has not invoked a solvency or liquidity crisis in the region—indeed, Asian banks have been among the first to recapitalize some of the weaker financial institutions in the U.S. A point of potential weakness arises from Asia’s reliance on exports to Western economies. This, of course, remains of critical concern; yet Asian companies have done a great deal to diversify their end export markets during the last decade. Consequently, the dependency on any single market, such as the U.S., has been lessened. Critically, exports bound for intra-region consumption have also become a greater component of the region’s growth. Thus, while aggregate exports may slow, they appear unlikely to nosedive. In our view, Asia Pacific’s greater challenge arises not from the U.S. credit bust, but rather the potential for policy errors by governments in reaction to burgeoning inflation. Across the region, inflation is hovering at levels not seen in a decade. Rapid growth in personal incomes has meant that, so far, most consumers have been sheltered from the painful pinch of higher prices for food and other necessities. Yet sharp price increases on staple crops have lead many governments to introduce price controls and to ban exports—measures that will more likely exacerbate the problem. Most economies in the region, save Japan and Australia, face a dilemma: Their fortunes have been tied to the dollar for several decades via exchange-rate mechanisms designed to encourage stable prices and economic stability. However, the dollar’s status has been tarnished, and the rapid interest rate cuts in the U.S. may have stoked some of the inflationary pressures now surfacing in the region. Asia Pacific may find it difficult to maintain its ties to the dollar, but severing longstanding ties will beget unknown and probably volatile outcomes. If the region were to detach itself from the dollar, this would constitute the truest sort of “decoupling”; and contrary to expectation, it might not be a welcome event for investors. In closing, we would like to draw attention to a change made during the quarter to the Matthews Asia Pacific Equity Income Fund. To better reflect its income orientation, in March 2008, the Fund began to distribute investment income dividends on a quarterly, rather than semi-annual basis. For further details, please see the Fund's commentary. As always, it is a privilege and an honor to serve as your investment advisor. Sincerely, Andrew T. Foster G. Paul Matthews Matthews Asian Funds hold no positions in Bear Stearns. |
