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Tales of the Unexpected

Relatos de lo inesperado — Tom Murphy VII. Tales of the Unexpected

To the naked eye, market conditions have appeared benign during Q2 2014: returns have been largely positive across the asset mix, with some equity indices, notably the US S&P 500, inching up to make new record highs. Contrary to our expectations, investors continued their love affair with bonds, with flows accelerating in some areas of the market. Investors generally took bad news in their stride. An escalation of the crisis in Eastern Ukraine, the insurgency of Isis in Northern Iraq, and the downward revision of Q1 US gross domestic product growth to a grim annualised rate of -2.9% caused no obvious damage.

We suspect that the driving force behind investor stoicism has once again been expectations of continuing liquidity. The world’s central banks, taking their lead from the Fed, have been remarkably cautious in proceeding down the path of less accommodation, and ultimately towards policy tightening. Some have even turned retrograde: the European Central Bank (ECB)’s shift to negative deposit rates was a seismic moment. We live in strange times, indeed, when one of the world’s major central banks charges banks to deposit money with it.

Another key observation is that market volatility and trading volumes are now at curiously low levels. Rather than feeling the sense of euphoria that comes from being five years into a multi-year bull market, many investors are nervous about the eerie stillness that has developed. The S&P 500 is seeing its lowest trading volumes for eight years: the norm for bull markets is that volumes rise in tandem with prices. Concurrently, the CBOE Volatility Index is trading below 11 for the first time since 2007. Thirty-week annualised historic volatility is nearing pre-crisis levels in both developed and emerging market equity indices (see chart).

Equity market volatility near pre-crisis lows

Source: Henderson Global Investors, Bloomberg, 30-week annualised historic volatility, % per annum; weekly data from 9 January 1991 to 21 May 2014.

Analysis of the bond markets tells a similar tale: notably, volatility in high yield bonds, currency and US interest rates is at its lowest ebb in 7+ years. In the sovereign bond markets, Spain and Italy have recently been borrowing 10-year money near or below what the UK government pays. This is a stunning reversal compared to two years ago, when those two governments were paying well in excess of UK borrowing rates.

One possible explanation for these strange developments is that investors have been content to numb their minds from some harsh truths in their reach for yield. If that is the case, it may be wise for them to heed the recent warning that came from the Bank for International Settlements that subdued volatility and low interest rates have encouraged investment in the “riskier parts of the investment spectrum” even as valuations became far less appealing.

The economic and market cycle is moving on and we are arguably entering one of its more dangerous phases. Interest rates will inevitably have to rise off their lows. The timing and rate of increase remains opaque and, in certain circumstances, it is entirely possibly that policy changes could come faster and be more dramatic than investors currently anticipate. As we have seen, faith in central banks is extremely high. If it were to emerge that that confidence was misplaced – if, perchance, the Fed misjudges the strength of US growth or the risk of inflation, this could trigger a severe bout of indigestion for asset markets.

By Bill McQuaker, Co-Head of Multi-Asset at Henderson

The “Crazy” Euro, too Expensive?

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¿Es realmente la fortaleza del euro una “locura”? — CC-BY-SA-2.0, FlickrPhoto: TaxRebate.org.uk. The “Crazy” Euro, too Expensive?

In an interview with the Financial Times, Fabrice Bregier, chief executive of Airbus’s passenger jet business, called on the ECB to tackle the “crazy” strength of the currency.

Before we try to assess whether the strength of the euro is indeed “crazy”, it should be mentioned that commercial jets are priced in dollars. Airbus, therefore, faces very significant currency risks as much of its cost base is in Euros. One would thus not be surprised that someone from Airbus should complain about the euro.

Having said this, is the euro strength “crazy”. To answer this question, the logical angle is to look at long-term fair value models. Here the problems start.

First, there are several ways of determining the fair value for a currency. The oldest is based on the theory of purchasing- power parity (PPP): the idea that, in the long run, exchange rates should equalise prices across countries. More sophisticated PPP models adjust for differences in productivity or income per head, because it is natural for prices to be lower in low-income countries.

Another definition of the fair value of a currency is the exchange rate that corresponds to a trade position considered “sustainable”. One approach is to estimate the fundamental equilibrium exchange rate (FEER). This is the rate consistent with both a sustainable current-account balance and internal balance (ie, full employment with low inflation).

A third method of calculating the fair value of a currency is the so-called behavioural equilibrium exchange rate (BEER). This does not attempt to define long-term economic equilibrium. Instead it analyses which economic variables, such as productivity growth, net foreign assets and the terms of trade, seem to have determined an exchange rate in the past, and then uses the current values of those variables to estimate a currency’s correct value.

Apart from the fact that there are different approaches (PPP, FEER, BEER), there are also many different ways of estimating the models.

Therefore, one should not be surprised to see a wide range of fair value estimates. Fortunately, at this moment there seems to be quite a ‘consensus’ on where fair value of the euro-dollar exchange rate should be, meaning that they are all in a ‘narrow’ range of around 10%. We checked several fair value models of official institutions and brokers. Many BEER models indicate a EUR/USD fair value of 1.20 (with one outlier at 1.40). FEER estimates are around 1.30-1.32. Finally, PPP, the most simplistic measure, suggests a 1.22- 1.29 range. Hence, on average, fair value for EUR/USD seems to be around 1.25.

In the last few months, EURUSD was trading around 1.37, so around 10% overvalued. In general, developed currencies valuations are only seen as excessive if they are 20% or more away from fair value. Calling the current strength of the euro “crazy” seems an exaggeration.

Investment commentary by Jaco Rouw, Core FI Senior Investment Manager, Global Foreign Exchange, at ING Investment Management and Thede Rüst, Core FI Investment Manager, at ING Investment Management

J-League’s 100-Year Vision

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Invertir y jugar al fútbol: todo a largo plazo si hablamos de Japón — CC-BY-SA-2.0, FlickrPhoto: Tomofumi Kitano . J-League's 100-Year Vision

Now with the world somewhat less fixated on football (or soccer as I’ve learned to call it here in the U.S.), let us reflect on what observations may be made. Since many of my colleagues and I are from Asia, we paid a bit more attention during the matches to the Asia Pacific teams that competed—South Korea, Japan and Australia—as well as to the U.S.

Being from China, I was personally a little disappointed that China did not qualify for this year’s event in Brazil. Even with over 1 billion people, it has somehow repeatedly failed to assemble the dozen or so athletes needed to field a competitive team. In fact, the only time Team China managed to qualify was in 2002, but its World Cup dreams fizzled without a single goal.

By contrast, Japan has perhaps offered a roadmap for others. Although not considered among the world’s top soccer teams, Japan’s achievement has nonetheless been remarkable as a latecomer to the game. Its professional soccer league got its start in just 1993. The J-league, as it is known, is the brainchild of Saburo Kawabuchi, a former center forward on Japan’s national soccer team. When he helped set up the league, he projected that it would take a century to make Japan internationally competitive.

English coach Steve Darby, who has worked throughout Asia was quoted by Australian press as saying, “I would really like Japan to do well on the pitch as they tend to do everything right off the pitch. The Japanese model is the one (for Asian teams) to follow … Japan has long-term goals—unlike many countries who have such short-term ones based purely on immediate results—a strong league, underpinned by an organized systematic youth development program.”

J-League’s focus has been geared toward building a richer sporting environment that goes beyond merely entertainment. Several J-Leaguers have played in top European leagues such as Manchester United, and served as role models back home. And just last month, English champions Manchester City purchased a stake in the Yokohama F-Marinos—a milestone in foreign investment in a J-League team.

While a single World Cup match could potentially make or break a national team, elevating a national team’s overall competitiveness requires a long-term approach. Likewise, in investing, short-term factors drive individual stocks up or down on a daily basis. At Matthews, we believe that taking a long-term view is the correct approach to sound investing. Though our time horizon is not as long as over 100 years, we do constantly ask ourselves what businesses will look like five to 10 years down the road.

For many nations, professional soccer, or indeed professional sports in general, is a low value-added activity. It is only when nations are productive enough to allow a small fraction of their population to play for money that the game can really take off as a business. But more and more of Asia is reaching that stage. And when they do, Asia’s middle class may even celebrate their first World Cup winners.

Opinion column by Beini Zhou, CFA. Portfolio Manager, Matthews Asia

It is Dangerous to Assume that Accommodative Monetary Policy Alone Will Cure all Ills

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Resulta peligroso dar por hecho que la política monetaria acomodaticia es la cura de todos los males — Photo: Shinzō Abe April 2014, Chuck Hagel. It is Dangerous to Assume that Accommodative Monetary Policy Alone Will Cure all Ills

Global equities and global bonds delivered further gains in June 2014, with the MSCI World index up 1.83% in US dollar terms while the JP Morgan Global Government Bond index returned 0.69%, also in dollar terms. Regionally, UK equities were one of the main laggards during the month, as FX-related earnings downgrades weighed on sentiment. By contrast, Japanese equities performed strongly as the recent news that the Government Pension Investment Fund will increase its exposure to equities helped to lift sentiment. The announcement in relation to the GPIF is significant as it has assets of c.$1.2 trillion. Japanese equities were also buoyed by PM Shinzo Abe’s comment in the Financial Times that he is genuinely committed to the ‘third arrow’ of Abenomics (that is, committed to promoting faster rates of economic growth in Japan) rather than focusing solely on monetary and fiscal measures.

For 2014 to date, investors have benefited from low levels of volatility everywhere – which has enabled bonds and equities to rally alongside each other. The question now has to be: how much more peace and quiet can we expect? Recent developments in Portugal, while idiosyncratic rather than systemic in our view, have shown that the banking sector can continue to be a source of unwelcome and unexpected surprises; markets will now await a fuller picture of the health of European banks, which should emerge when the ECB completes its ‘stress tests’ later this year. The geopolitical environment is undeniably worse than it was at the beginning of the year, with ongoing tension between Russia and Ukraine and concerns that Iraq and Syria could be further destabilised by the growing strength of Isis, the jihadist group. In the US, the Fed has signalled that its bond-buying programme will come to an end this year. With the exception of the recent news from Portugal, markets have largely taken all these developments in their stride. While this has suited our pro-equity stance, it has left us somewhat puzzled as the rise in core yields that we expected at that start of 2014 has not materialised.

In terms of where fixed income markets go from here, we still think it is very difficult to be positive on core government markets. The weak Q1 US GDP print may well have provided some support for core bond prices but policy normalisation – albeit at a slow pace – is coming in the US and UK whether fixed income markets like it or not. In our view, corporate credit remains more attractive than government debt but there are clear signs now that non-financial corporates are starting to re-lever their balance sheets. Whilst that is generally positive for high yield (as takeovers often involve a higher-rated firm taking over a lower- rated one) it is not so positive for investment grade. Nonetheless, given the significantly better health of corporate balance sheets when compared to those of sovereign issuers, we still think that credit remains relatively attractive for now.

In equity markets, we remain constructive on the outlook for the remainder of the year, with overweight positions in the UK and Japan in our asset allocation model. UK earnings expectations have faced headwinds recently because of the pound’s strength, but in common currency terms the picture looks more positive. The UK also benefits from an attractive dividend yield, which we believe is likely to remain a favourable characteristic in a low-growth/low-return world. Japanese equities are attractively valued versus developed world equities and the recent comments from Mr. Abe show that he is serious about making Abenomics work. For us, the real challenge will be to ascertain when the valuation re-rating of equities runs out of steam. With the notable exception of the US, earnings growth is simply not coming through fast enough to allow equities to make a lot more progress from current levels. August is traditionally a quiet time for equity markets, due to seasonally low flow and volatility levels, but, as recent events have shown, it is dangerous to assume that accommodative monetary policy alone will cure all ills.

Investment strategy by Mark Burgess, Chief Investment Officer, Threadneedle

Owning Distressed Debt Outside of the United States: the Ying and the Yang of Risk and Reward

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The Case for Investing Abroad

Proponents of investing in distressed debt abroad can point to several advantages. First, foreign debt, especially in emerging markets, can have greater upside. Competition is less intense due to the higher level of research required. As a rule, buyers of debt exhibit a local country bias, preferring to buy issues of local companies that they know. This bias creates more liquidity in developed markets, which have deeper institutional markets. Foreign markets are much thinner, especially as credit quality declines. Local institutional buyers, such as pension funds, face legal restrictions that prevent them from investing in distressed debt. Hedge funds and absolute return investors are less plentiful. The shortage of investors results in a greater liquidity premium and more opportunities for adding value through research and exploiting the mispricing of debt. Second, covenants in bond indentures are often stronger. Investment banks demur from underwriting and investors balk at buying deals without extra protections, either in the form of additional security or restrictions on company behavior. Lastly, credit rating agencies penalize companies for country risk. An investor simply receives better credit quality for the same credit rating by investing abroad.

The Pitfalls

Detractors point to the complexities of investing abroad. Because markets are thin, liquidity dries up when markets are under duress and may not exist when an investor needs it. Currency risk necessitates knowing the denomination of a company’s revenues, expenses, and liabilities, which may be in different currencies and lead to a deterioration of profitability when one currency appreciates. Understanding a foreign culture and the local market can be a challenge. Legal systems are slower and often favor the local debtor. Corruption is a concern, leading to the disappearance of funds and unpredictable legal outcomes. Insiders often dominate corporate boards, limiting independence and affecting the quality of corporate governance. Labor laws may guarantee wages, pensions, and severance payments, effectively subordinating creditor claims to the claims of workers. The bottom line is a more difficult decision with many more variables, many of which are unknowable, and greater uncertainty.

The Anecdotal Evidence of Credit Spreads

What does the evidence tell us about the relative value of foreign markets? Most evidence is recent and anecdotal. Relative credit spreads offer the best metrics. BCP Securities surveyed emerging market credit spreads relative to those of the United States in January 2010. In Mexico, Brazil, and Chile, BBB credits traded at slightly tighter credit spreads than did comparable issues in the United States. In Brazil and many other emerging markets, the same pattern of tighter credit spreads held true for BB issues. But once credit quality deteriorated to B, emerging market issues traded wide of U.S. issues by 100 to 300 basis points, depending on the country. The conclusions are a lack of demand for distressed debt and investor concern about bankruptcy risk in emerging markets.

Two Models of Corporate Restructuring

The United States and foreign markets follow two different models of corporate restructuring. In the United States the restructuring process is well-defined. Bondholders and the debtor have the option of negotiating an out-of court restructuring or seeking resolution in bankruptcy court. An out-of-court restructuring usually takes the form of a distressed exchange, which grants the debtor extra time or reduces debt in exchange for additional collateral or equity. Bankruptcy filings are costly but prioritize debtor claims according to seniority in the capital structure and allow the debtor to operate under the protections of the bankruptcy court until the emergence from bankruptcy. In either case the outcome usually includes a reduction in debt, a rationalization of the capital structure, and a transfer of the equity ownership of the company from the shareholders to the debt holders.

In foreign markets, especially in emerging markets, the process is more opaque. Equity ownership rarely changes hands. Rather debt holders agree to extend or restructure debt, usually outside of bankruptcy, without gaining equity. Private ownership, especially by wealthy families, is much more common as opposed to public equity. Families are loath to surrender control or grant minority stakes. The bankruptcy process abroad is slower and more uncertain. From the creditor perspective, the poster child of the failed foreign bankruptcy is the case of Altos Hornos de Mexico, which has gone through three unsuccessful negotiations and ten years of bankruptcy. Three times the controlling shareholder reached a restructuring agreement with creditors and three times he withdrew his support at the last minute to continue operating the company as he pleased with negligible court supervision.As a result, negotiations occur outside of bankruptcy with the equity holder holding the advantage at the negotiating table. For the debtor, the reasons to resolve the default and restructure the debt are reputational and the desire to access the debt markets in the future.

The difference in process can lead to outcomes uncommon in the United States. Creditors may gain the right to appoint independent directors while the board is the exclusive preserve of shareholders for domestic companies. During tender offers foreign law often negates the right of smaller bond holders to hold out and demand payment of their bonds on the original terms, allowing debtors to cram down all debt holders at the same time. The concept of equitable subordination, which protects creditors against shareholders using debt purchases to manipulate the bankruptcy, does not exist. Holding company/subsidiary guarantees are less meaningful.

The Strategy of Successful Investors

Despite the minefield of potential issues, many investors succeed in investing abroad. What are their secrets? First, they ask the age-old questions about the viability of the business and the competence of management. No amount of financial engineering will rescue a business from bad management and poor execution while good management will take advantage of what opportunities exist. Next, successful investors evaluate the incentives and character of management and the controlling shareholders. Distressed companies fall into two groups: those with morally corrupt ownership and those with concerned, responsible owners going through a tough period. Successful investors spend a great deal of time shunning the former and seeking the latter. Country risk is another component. The objective is to find a good company when a country is in trouble. If the company is well-run, it should survive the hard times and appreciate in value once the economy recovers. The ability of the government to support the private sector is another factor. A country with deep foreign currency reserves has greater ability to support industry than a country that does not. Lastly, the successful investor prefers a just and efficient legal system in order to fairly balance the rights of creditors and shareholders.

Thomas P. Krasner is Principal and Portfolio Manager at Concise Capital

Twenty Years Battling over Pensions

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One size does not fit all. Such is the corollary of 20 years of experimentation with pensions all over the world. Did the world need two decades to reach it? Unfortunately, yes. Twenty years ago, in 1994, the World Bank published its Averting Old Age Crisis, a detailed study with basically one recommendation: everybody should follow the Chilean pension model, that is, a totally privatized system.

Averting Old Age Crisis signaled the climax of the so-called Washington Consensus: the idea that Latin America should follow a ‘laundry list’ of basic precepts to achieve economic growth. It was presented in the World Bank and IMF Annual Meetings that took place in September 1994 in the capital city of a country that at the time was a poster child of the effects of liberalization and opening and economy: Madrid.

Nowadays, however, nobody wants to follow the Chilean system. In 2005, the World Bank announced that the recommendations of Averting Old Age Crisis were not longer valid. Of the 11 countries that have adopted the Chilean model, only Chile keeps it untouched. And that will probably not last too long: next month Chile will start a review that could end up triggering the creation of a government-owned pension fund that would compete with private financial institutions.

So, this is a good time to analyze what is happening with pension systems in Latin America. This is the aim of a course to be held in Miami from July 14 to July 18, organized by the London School of Economics, Santander Asset Management and Novaster.

The ‘all privatized’ pension systems have failed precisely in the areas where they were supposed to win. At a management level, pension costs have not fallen in spite of the fact that, at least in theory, competing management funds should be more efficient than government bureaucracy. From a macroeconomic perspective, private pension plans have not always meant a better allocation of capital, perhaps because in many developing countries there are not too many markets to invest in. That lack of investment opportunities creates another problem: often, the returns of the private pension funds are low, or even negative. So, instead of helping to fight the demographic time bomb that public pensions face, they worsen it.

Another risk is Government interference. Argentina’s Government forced the pension funds, created in 1994, to buy assets denominated in pesos to prop up the country’s beleaguered debt. That was a catastrophe for savers in 2001, when Argentina defaulted on its debt and saw the peso collapse, and paved the way for the late President Néstor Kirchner’s renationalization of the system seven years later. In small countries, such as Bolivia and El Salvador, the private system ended up creating a duopoly, simply because there are not enough savers to keep six or seven fund managers. The problem is not just a Latin American one: pension reform in Hungary, in 1997, ended up in disaster.

Why did it work in Chile and failed in so many other places? Carmelo Mesa, Distinguished Professor Emeritus at the University of Pittsburgh and one of the speakers at the LSE event, points out at two elements that made Chile different: “First, its informal economy is relatively small. In other countries there are a large number of workers who are self-employed in the informal sector and do not contribute to their pension plans. Chile does not have to deal with that. Second, Chile has a functioning stock market since 1898, that has provided investment opportunities to the pension funds”.

However, even the Chilean system faces hurdles, among them the stubbornly high management costs. This defies traditional economics, but, put in the light of behavioral economics is not that surprising. “Empirical experience shows that citizens have usually more urgent matters to think about than to analyze the different options offered by financial institutions”, explains Professor Nicholas Barr, from the London School of Economics, who remembers how, in the early Nineties, while at the World Bank, he tried unsuccessfully to avoid making Chile the example for everybody.

The fact that people cannot manage their accounts properly to lower their costs can sound counter-intuitive, and even patronizing, but it is a fact: if hedge funds are regularly accused of abusing their investors—who are supposedly the most sophisticated and wealthiest—, why should average citizenry with little or no financial background know how to manage their pensions?

Twenty years after the universal acclamation of the Chilean pension model by the World Bank, it has become clear that it is not the magical cure that its advocates pretended. Pensions need reform—including extending the retirement age, and combining private and public plans—but the one size fits all formula was never sound.

The Eye of the Beholder

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Todo depende del cristal con que se mira — Photo: Kino. The Eye of the Beholder

2014 marks the 450th anniversary of Shakespeare’s birth. In one of his early comedies, Love’s Labour’s Lost, the bard wrote that “beauty is bought by judgement of the eye”, which seems a very fitting comment for current market conditions: we are at a point in the economic and market cycle where perceptions and starting points are very important.

For one thing, US equities have reached an all-time high, having nearly tripled in value since the market’s post-crisis low in March 2009. After a very strong performance in 2013, many investors are banking profits and looking for reasons to sell. Under these circumstances it must be questioned whether good economic news is genuinely ‘good’ or in fact ‘bad’, because it portends monetary policy tightening. Economic conditions are far from homogenous globally and with so much central bank intervention having occurred (US), still occurring (Japan), and indeed likely to occur (eurozone), there appears to be a natural growing distrust of the current equity bull market. Most importantly, market volatility is at very low levels and is ‘spooking’ investors. Thus, we are at an interesting, if not perplexing, juncture for the global economy and more pressingly for global markets.

Fair is foul…

After the first quarter’s weather-induced slowdown in North America, current economic data points to an aggressive snap-back in the underlying US economy. Certainly we see nothing to temper the desire of North American policy makers to begin the process of normalising interest rates once quantitative easing has ceased. The picture is more complicated in Continental Europe, with purchasing managers’ indices generally favourable, albeit with weakening momentum. Moreover, with the euro elevated beyond the level that the European Central Bank considers optimal and with inflation soft, the threat of unconventional monetary policy, just as the Federal Reserve scales back its policy, is intriguing and potentially very helpful. Is, however, Europe’s tepid economic position really ‘good’ news because it means more policy stimulus? Or is it just outright worrying that despite the tumultuous declines in output, that demand remains so lacklustre? For bottom up stock specific investors, finding idiosyncratic mis-valued stocks has never been more important.

…Foul is fair

If the balance between policy and growth in the Western world seems finely poised then consider the East, especially China and Japan. The latter seems to have weathered the April consumption tax rise well – so well in fact that further economic stimulus in the shape of QE seems an unlikely prospect in the near term. In the space of the past three months, investors have moved from seeing this as ‘bad’ news to instead seeing it as ‘good’ news. Prime Minister Abe seems to be fleshing out the details of his third arrow of economic stimulus and with the potential for the world’s largest pension fund (Japan’s Government Pension Investment Fund) to materially add to its equities weightings, the prospects for the Japanese economy are certainly on an improving trajectory. The potential for it and indeed the wider global economy to be derailed by a significant slowdown in China remains a key danger, however. Targeted stimulus appears to be positively impacting the Chinese economy, but concerns remain that larger structural challenges abound and risks are elevated.

Infinite riches

Certainly, in the interim, corporate cash is starting to be deployed. The long-awaited turn in the capital expenditure (capex) cycle is still struggling to gain momentum, but while companies seem reluctant to build they seem much more willing to buy. With cash balances swelling and the cost of money still so cheap, we have witnessed a wave of corporate activity during the second quarter. This has occurred across a variety of sectors and very often involving US companies seeking to either utilise their stranded overseas cash or indeed more aggressively ‘invert’ their underlying tax jurisdiction, which helps increase the efficiency of their capital structures. With investors generally greeting such deals favourably – the share prices of acquiring companies have typically risen – the cost of money remaining low, and economic conditions on balance remaining satisfactory, we would expect more such deals in the second half of 2014.

In this update Matthew Beesley, Head of Global Equities at Henderson Global Investors, gives a brief recap on events in 2014 and his outlook for markets for the second half of the year.

Asia’s Thirst for Milk

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La sed de Asia por la leche — Foto: German Federal Archive. Asia's Thirst for Milk

When I was a boy growing up in Northeastern China, I recall waiting every morning for the fresh milk delivery. A man from a local “milk station” would ride up in a three-wheeled cart and hand a glass bottle of milk to my mother. She would then heat it, as was customary then, so I could have it with my breakfast. While I wouldn’t say the milk was necessarily a luxury item in those days, it was still considered precious enough that my parents never really drank it themselves, saving it instead for me and my sisters.

Asia’s per capita milk consumption is still very low compared to most of the developed world. But demand for dairy has increased over the years with income growth and changing tastes. As a result, the dairy industry across the region is flourishing, new brands are entering the market and expanded product lines are adding to the number of choices for consumers. Analysts have predicted that consumption of dairy products for the six main Association of Southeast Asian Nations (ASEAN)* should grow by 2.4% per year through 2020.

Today, I am amazed by the ever-widening selection of milk products my father purchases for my son when we visit him in China. He stocks up with boxed milk known as Ultra-High Temperature (UHT) milk, yogurts, flavored milk drinks as well as gallons of fresh milk in plastic containers. Milk is no longer the precious commodity that parents reserve for their children. Almost everyone at the breakfast table now drinks milk, and also seems to enjoy it later in the day.

A couple decades ago, milk in China typically came just from local dairies. More recently, regional and even, national firms have emerged. In the face of rapid growth, some manufacturers have had their share of misfortunes. Over the past decade or so, Japan and South Korea both have experienced sporadic outbreaks of foot-and-mouth disease, which harmed their respective dairy industries. The Korean government culled hundreds of thousands of cattle, which led to a shortage of raw milk and depressed the production of certain milk products.

Chinese firms were also marred by a series of scandals over milk and milk formula quality. Following the incidents, China’s government tightened regulations and inspections. Some dairy companies collapsed, and those that survived began to pay greater attention to safety issues in attempts to regain consumer confidence.

For the sake of quality control, many Chinese dairies have built their own cattle farms. While this has alleviated some supply shortages, it has also allowed firms to branch out into other areas such as cattle feed and alfalfa planting. Some farms have, thus, become more integrated, and may allow for greater profitability by capturing a broader spectrum of the value chain.

Companies today have expanded and are working toward creating strong brands. They seek to build the same level of trust among their consumers that my mother had in our local dairies.

Hardy Zhu, Research Analyst at Matthews Asia

Don’t Skip the Homework: High Yield’s Overlooked Risks

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Many investors have taken on more risk in their quest for higher returns—especially as signs have pointed to interest rates staying stable until next year. But two key elements are often overlooked: default risk and underwriting standards.

The prolonged low interest-rate environment has continued to drive more investors toward high-yield securities. But all too often, they focus on interest rate risk, even though the high-yield sector has been fairly insulated from rising interest rates historically. Yield spreads—the extra yield above similar-maturity government bonds—often decline as rates rise, providing a cushion against rate increases. Lower-rated bonds, such as CCC-rated debt, usually have the most cushion because their spreads are higher.

An Unsettling Complacency

Today’s low overall level of high-yield spreads means this insulation is getting thinner and high-yield’s interest-rate sensitivity is increasing. Still, it’s far lower than that of investment-grade bonds, and any losses due to rising rates are generally offset rather quickly by the passage of time as investors collect coupons, and as bonds roll down the yield curve.

The spread cushion in high-yield bonds has obviously drawn in investors worried about rising rates. But what’s being missed is that the spreads are compensation for the likelihood of default—and the market has begun to feel complacent about this credit-related risk. In our view, it’s important that investors focus on bond default risk and high-yield issuers’ underwriting quality in order to prepare for the next phase of the credit cycle.

Monitoring Default Risk

As we’ve mentioned before, myopically chasing yield can be a dangerous game. We still believe that it will be at least a couple of years before we’re in the phase of the credit cycle when bond defaults are a serious concern. But investors shouldn’t disregard this risk just because default rates remain low. Companies have defaulted in the past year, and the lower the credit quality, the greater the probability of default.

There are warning signs to watch for. Price declines have always preceded the default phase of the credit cycle by a considerable amount of time, and we’re beginning to see issuer-specific events occurring. These are a telltale sign of the coming shift in the credit cycle. For example, a major retailer recently saw its bond price fall by 15%, and its outlook for recovery doesn’t look positive.

Looser Underwriting Standards

As underwriting standards diminish and poor-quality junk bond issues surface, an increasing number of investors are putting money into questionable securities. And even for creditworthy issuers, there’s reason for concern. According to Moody’s Investors Service, North American high-yield bonds reached an all-time low in covenant quality in February, which means there were fewer—and weaker—contractual safeguards to protect investors’ interests.

In her recent testimony before the US Congress, US Federal Reserve Chair Janet Yellen mentioned the loosening underwriting standards for high-yield bonds. Declining standards are a greater worry in the bank-loan market, but high-yield bonds aren’t exempt. And that means investors need to be selective.

Break Out the Books: Homework Is Key

Despite the current stable interest-rate environment and low default rates, we think it’s wise for high-yield investors to do their homework and research potential issuers carefully instead of simply jumping into high-yield bonds. Disciplined credit selection is more important than ever—arguably more important than investors’ focus on interest-rate risk—and in-depth research will determine success or failure for high-yield portfolios when the cycle turns.

Gershon Distenfeld, Director of High Yield at AllianceBernstein

China is Not Export-Driven

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Yes, nearly everything does come from China. But exports contribute relatively little to its economy.

It is easy to see why most people think China is dependent on exports. After all, almost everything in your neighborhood shop does come from China. But many of those goods are just processed or assembled in China, adding little value and contributing very little to its GDP. Moreover, exports are a small share of output: most of what China makes, China consumes.

Assembled, not really ‘Made in China’

Although the share of China’s exports that are just processed or assembled there has been declining, it still accounts for 38% of the total, down from 50% in 2001.

A good example of processed exports is Apple’s iPad, which is assembled in China but creates little value there. In 2011, the Personal Computing Industry Center of the University of California, Irvine took apart an iPad and worked out its value chain.

Net vs. Gross exports

You may remember from Econ 101 that GDP = investment + consumption + exports minus imports. This formula, which applies to all economies, is designed to ensure that GDP excludes, for example, the value of a hard drive that is made in Japan, imported into China and snapped into an iPod, which is then sold overseas. That hard drive cost US$73 (back in 2005, when Apple still used hard drives) and accounted for half of the factory value of an iPod, but it was not made in China and did not contribute directly to the Chinese economy. The indirect contribution—including the jobs for the assembly and testing of the iPod—added up to US$3.70 and was counted in the net export calculation.

During the decade prior to the Global Financial Crisis, China averaged about 10% annual GDP growth, with net exports contributing only about 1 percentage point of that growth. Today, China is even less dependent on exports. Last year, net exports actually posed a -4.4% drag on GDP growth, and in the first quarter of this year, net exports left a -19% contribution to growth.

From the perspective of GDP, as opposed to GDP growth, net exports also play a relatively small role. In 2007, net exports accounted for 8.8% of China’s GDP, but this share fell to only 2.4% in 2013. Additionally, we estimate that only about 10% of China’s industrial output is exported, with 90% consumed domestically. (It is also worth noting that last year, 47% of China’s exports were produced by foreign firms.)

Our message is not that exports do not matter. They do, especially to the tens of millions of workers assembling iPads and other gadgets. But it is important to understand that China is a continental, domestic investment and domestic consumption-driven economy, where exports play only a supporting role. The overwhelming majority of goods made in China stay in China.

Is China still competitive?

Despite rapid wage growth and currency appreciation, China’s remains competitive, with the Chinese share of total U.S. goods imports rising to 19% last year from 13% in 2004.

Andy Rothman, Investment Strategist at Matthews Asia

Please see the attached document for full column.