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A Surprising Gift for Chinese New Year

Un regalo sorprendente por el Año Nuevo Chino — Wikimedia Commons. A Surprising Gift for Chinese New Year

Beijing-based China Credit Trust Company, a firm that operates as a non-banking financial institution in China, announced this week it reached an agreement to restructure a risky high-yield product that had earlier ignited worries over the health of China’s trust industry. Just in time for the Lunar New Year, investors in the troubled trust may receive a big (metaphorical) red envelope—a monetary gift traditionally given during Chinese New Year or other special occasions—or at least avoid a financial hit.

China Credit Trust unveiled its plan to arrange a bailout for buyers of the product. It plans to restructure the loan behind the approximately US$496 million high-yielding investment product that is slated to mature on the Lunar New Year holiday, January 31.

Trust products in China are privately placed investment vehicles similar to private equity or hedge funds in the West. These products are not allowed to solicit public investment, and are available only to certain qualified (sufficiently wealthy) investors through commercial banks and securities companies. Given the flexibility of their investment universe, ranging from commodities to equities, the trust industry has seen rapid growth in the past several years. The industry’s total assets under management now stands at about US$1.6 trillion (or 9.6 trillion renminbi).

One factor behind this significant growth has been the off-balance sheet lending activity of Chinese banks. During the phase of rapid credit expansion since 2009, Chinese banks increasingly found that their own lending capacity no longer satisfied strong loan demand. To escape regulatory constraints, some banks moved loans into trust products, then sold them to investors who were attracted to generally higher annual yields of approximately 10%.

The problem came when these products went bad. Who should be held responsible for the loss to investors? Bankers who sold these products said they were just helping to distribute the products. Trust managers blamed banks, often the entities from which the products originated. In reality, several trusts facing the risk of default were bailed out by local governments. This is partly because borrowers were state-owned enterprises, and valuable collateral assets can be auctioned.

The situation with China Credit Trust is a bit different. The struggling private coal mining company, which was the borrower of the funds from the trust, recently found the value of its mining assets collapse with the slumping price of coal. It is therefore surprising that “strategic investors” would be willing to take over the assets and pay back investor principal in full. It has been widely reported that local government officials helped arrange the bailout behind the scenes. However, the financial market is clearly nervous over whether the potential for default of a trust product may trigger more serious systematic risk. This concern might be overblown for the following reasons:

Unlike many troubled structured products during the global financial crisis, trust products in China were primarily simple straight-forward credit instruments. Trust products do not employ leverage and there are no derivatives linked to trust products. Thus, the ripple effect caused by a default on a trust product tends to be better contained.
In contrast to wealth management products, which were sold to mass market retail investors as a deposit alternative, trust products are sold to qualified individual and institutional investors. Such investors generally have a higher risk tolerance than the average investor. Losses suffered by such investors are generally unlikely to result in street protests and widespread unrest. Instead, they may lead to legal court disputes.

In my view, the moral hazard that comes from bailing out these investors outweighs the short-term stability of a bailout. So long as trust investors continue to believe their high returns are implicitly guaranteed by Chinese banks or the government, China‘s real risk-free interest rate may be much higher than the current government bond yield suggests. Thus, the cost of borrowing for many Chinese companies has exceeded the lending rate set by the central bank. At the same time, equity investors of Chinese banks continue to worry about the potential risk of bailing out troubled trust products. If China’s government is serious about economic reform, based on true market principles, then allowing the market to allocate credit, based on the risk/reward analysis of its market participants, is the possibly the most important step it needs to take.

Even in the spirit of the Chinese New Year tradition, red envelopes are primarily for children. It may be time for trust product investors to face consequences as grown ups.

Sherwood Zhang, CFA, Research Analyst at Matthews Asia

The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change. It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. In addition, single-country funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small- and mid-size companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.

Short Term Squalls But Long-Term Outlook Still Fair

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Chubascos a corto plazo pero claros de cara al futuro — Philip Apel, Head of Fixed Income at Henderson. Short Term Squalls But Long-Term Outlook Still Fair

It was unlikely that the relative calm that had characterised markets in the latter part of 2013 was going to last. Most notable has been the correction in equities, with the bullish tone punctured, perhaps only temporarily, by the US Federal Reserve pursuing its tapering of asset purchases and fresh fears about the strength of emerging markets.

Citi’s widely-followed US economic surprise index has dipped slightly but its still elevated level betrays the fact that the media have been quick to promote negative stories and linger on earnings disappointments even when much of the hard economic and earnings data remains positive. This is not too surprising given that a change in tone is eminently more readable than a continuation of yesterday’s news.

In our view, little has fundamentally changed. Our key strategic themes remain as previously. We continue to expect the global recovery to strengthen, led by the US, Japan and the UK. Europe should be better in 2014 than last year albeit still facing the headwinds of a banking system that needs to shrink and the ongoing requirement to implement structural reforms to improve fiscal sustainability.

Whilst core government bond yields pulled back in January, they are likely to resume their rising trend if, as expected, the US economy continues to improve and tapering is completed by the end of the year. That said, we are closely watching inflation, which is forecast to remain at low levels, particularly if disinflationary forces emanate from emerging market economies.

The current environment lends itself to some key themes within our portfolios. Core European bonds are expected to outperform US bonds given the divergent growth and monetary policies of the two regions – Europe is at an earlier stage to the economic cycle than the US and this gives the European Central Bank greater capacity for further monetary policy accommodation. We expect higher yields in the long end of the UK rates markets. We also expect a steeper European yield curve (rates lower for longer at the short end but longer maturity bonds underperforming) versus a flatter yield curve in the US where we expect the 5-year part of the curve to come under pressure as an improving economy puts upwards pressure on rates.

In emerging markets, we have been relatively cautious on local debt markets in general, although expressing bullish views in Mexico. We started to acquire some short maturity bonds in selected emerging markets that are offering value i.e. where we do not expect the degree of rate hikes currently priced in to be delivered, for example in South Africa. We may have been a little early, given the broader emerging market sell-off but we have kept some powder dry because of just such a possibility.

At the currency level our preference is to be long the US dollar, whilst short the Australian dollar, Euro and yen.

Within credit markets, the longer-term theme of low interest rates and improving economic data continues to lead demand for higher-yielding corporate securities, particularly in Europe. With low default incidence and good corporate liquidity, that should sustain the popularity of lower-rated corporate bonds over 2014. We are, however, aware that credit markets have been more resilient than equities in the latest shake-out so there is some near term vulnerability for credit should the ‘risk-off’ phase be prolonged.

In our Euro credit strategy, we are continuing to favour subordinated bonds, BBB-rated bonds and high yield because these sectors of the market have a higher spread and lower interest rate sensitivity. Investment-grade non-financial sector valuations are less compelling than a year ago and consequently we are more cautious about these sectors, particularly the cyclicals. Another aspect of non-financials is the degree of potential event risk from merger and acquisition activity and re-leveraging, especially in the telecoms sector. This may offer some upside in the high yield market but in investment grade the key will be to avoid the poor performers rather than picking winners.

Looking ahead, with duration the bigger threat to bond returns than defaults, floating rate and multi-asset credit strategies are likely to remain in vogue given their lower rates sensitivity and attractive yield.

Philip Apel, Head of Fixed Income at Henderson

Three Worries for 2014, and They’re All About Credit

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So far in the cycle the US economy has done well without the extra adrenaline of private credit creation. In other words, growth has been occurring organically since 2009 without consumers adding debt to their balance sheets to buy goods and services, or companies radically expanding bank borrowings and issuing new bonds to boost sales. Profits have been the key to sustaining this situation.

Not everything is going swimmingly, however. There are signs that the low volume of private credit creation could be changing for the worse. The potential use — or misuse — of credit could indicate what might happen during the next phase of the business cycle.

Let’s consider three concerns about credit that should keep investors on the alert, and where we are now:

Private credit acceleration can bring bubbles

Private credit growth reaching 6% to 8% of US GDP has historically been a warning sign of an aging and decaying business cycle. Why? Too much credit causes the economy to grow beyond the capacity that is in place, and bubbles become a concern. When that happens, too much capacity may come on line, often leading to a recession and a cooling in profits, which is generally preceded by a stock market collapse.

Now, credit growth is low, and the US Federal Reserve’s efforts to create some credit growth have not been working as planned. The velocity of money — or the movement of cash and bank lending throughout the economy — is still slow, but speeding up.

Excess corporate issuance can impair credit quality

When corporations use credit to drive earnings growth, their credit quality goes downhill and their ability to repay debt deteriorates. Buyers of riskier credit bonds expect a spread over safer Treasury securities. As that spread widens, credit issues underperform Treasury benchmarks.

Now, companies are starting to issue more debt in the bond market, and we are beginning to see significant increases in commercial and industrial loans. While this is quite normal, it usually occurs in the early part of an economic expansion, when credit can help to revive growth. As debt burdens increase, however, credit quality can become impaired, especially in the high-yield market. For now, credit measures are still solid, but the key measure of debt to cash flow is starting to rise for the first time in this cycle.

Credit can be linked to inflation

Credit growth can lead to economic growth, but if credit accelerates too quickly, it can lead to inflation, which is usually not welcomed by investors. In the initial phases of inflation, stocks can go up and credit quality can improve. However, when wages start to increase, profits begin to fall.

Now, there is no sign of inflation pressures building, nor is there any evidence of excess capacity in US factories, shops or the labor market. Yet this benign environment can change if credit expansion accelerates.

Credit is not a bad thing; rather, it is necessary to fund current needs against future income. Consumers and corporations alike have legitimate reasons for borrowing to finance big-ticket items, such as automobiles, and to expand inventories and capital plant, such as computers, software and factories. The growth of credit can help kindle the expansion phase, but as the business cycle progresses, the growth and use — or more precisely, misuse — of credit can lead to contraction and even recession, which is the worst outcome for investors.

Now, the use of credit in the United States is within normal bounds, but the lure of credit could ruin the investment story of 2014 if accelerating credit growth is accompanied by deteriorating credit quality. Credit excess is a storm warning, something we at MFS watch keenly. And we think it may make sense to build some conservatism into stock and credit portfolios, just in case.

Extract from James Swanson’s blog On The Outlook – James Swanson is Chief Investment Strategist at MFS Investment Management

Growth of The Web

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El crecimiento de la red — Stuart O'Gorman, Portfolio Manager of the Henderson Global Technology Sector. Growth of The Web

The internet can provide secular growth at an attractive price

We hold a long-term bullish view on the internet sector, having been overweight the sector for the last ten years. Two major factors underpin our thesis. Firstly, the internet has and will continue to take market share as it disintermediates old economy competitors by removing the ‘middle man’ given its radically lower-cost business model. The internet is also ever more accessible with speeds increasing and device prices declining. Demographic factors are also a major tailwind as ‘digital refugees’ (the older generation who have not integrated into tech culture as they feel it is threatening and dangerous) age and die, and are replaced by the tech savvy ‘digital natives’ (who view technology as a necessity and have a high level of tech spend).

Old economy casualties from the increasing use of the internet surround us, from struggling newspapers, along desolate high streets to bankrupt video stores and bookshops. We believe the move from the old to the new economy still has a long way to run, as even now the bulk of spending is still done offline. For example, US online sales still represent less than six per cent of total retail sales. Add to this the huge potential of emerging market internet penetration catching up with the West and we have a very exciting growth story.

Bigger can be better

However, history is littered with great ‘stories’ that end up as bad investments. The second (and more important) factor that makes the internet an attractive investment are the large and growing barriers to entry that many internet companies possess. A surprisingly small number of companies dominate the profits of the internet. Scale, brand and network effects are enormous competitive advantages, and as an area of the internet matures one or two players tend to lead.

For example, in keyword search advertising in the developed world, Google generally has over 60 per cent revenue share – and more significantly more than 90 per cent profit share. In retail, it is now incredibly expensive to compete with the distribution infrastructure and buying power of Amazon in the major Western markets it is present in; in China, Alibaba holds an equally strong position. The hotel reservation market, the most lucrative area of the online travel industry, is dominated by websites controlled by Priceline, Expedia and TripAdvisor. The same story is true in internet radio (Pandora) and UK real estate (Rightmove). This we believe really differentiates the internet from other popular growth areas such as cloud computing.

Here, competition is extremely fierce, resembling that which the internet went through during the technology bubble and bust, and we fear a similar outcome for many of these high-flying names. We agree that the cloud is a major change in technology and some cloud-based names, like their internet brethren ten years ago, will emerge from this competitive war as winners but for every winner there will be many losers, and all players seem priced for success.

Mind the hype

Ultimately, however good the story and however strong the barriers to entry, valuations must be taken into account. While some areas of the internet have become rather expensive, most internet companies are highly profitable with price/earnings multiples that are reasonably in line with their earnings growth potential. This again contrasts rather sharply with cloud computing companies. Here, while there is extremely strong revenue growth (accompanied by lots of investor excitement) there is a distinct lack of profits, even when the vast stock options grants that these companies grant to their employees and management are excluded. For secular growth in technology, we strongly suggest that the real profits of the internet are far more attractive than the hopes of the cloud.

Demystifying the Oracle’s Value-Added

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Desmitificando el valor añadido del Oráculo — Warren Buffett. Photo: trackrecord, Flickr, Creative Commons.. Demystifying the Oracle’s Value-Added

This month we participated in The Wharton School, University of Pennsylvania’s first Private Wealth Management course held in Miami. One of BigSur’s cornerstones is education: educating our clients on themes most relative to them, and also continually educating ourselves. One of our objectives in attending Wharton’s PWM course was to learn about the latest advancements in financial analysis and try to be at the cutting edge of investment techniques and manager performance evaluation.

From a strictly practical standpoint, one of the most interesting and extremely relevant parts of the course was the discussion on the performance of one of our core equity investments: Berkshire Hathaway. Finance Professors from the Wharton School of Business, Chris Geczy and Craig MacKinlay, discussed a new and very in-depth working paper from the National Bureau of Economic Research (by Andrea Frazzini, David Kabiller and Lasse H. Pedersen), which dissects the great historic performance attribution of the Maestro, Warren Buffett.

First Look: Typical Risk Measures

Buffett’s track record is clearly outstanding. A dollar invested in Berkshire Hathaway in November 1976 would have been worth more than $1500 at the end of 2011. Over this time period, Berkshire realized an average annual return of 19.0% in excess of the T-Bill rate, significantly outperforming the general stock market’s average excess return of 6.1%.

Berkshire stock entailed more risk, realized a volatility of 24.9% (higher than the market volatility of 15.8%). However, Berkshire’s excess return was high even relative to its risk, earning a Sharpe Ratio of 0.76 (19.0%/24.9%), nearly twice the market’s Sharpe Ratio of 0.39. Berkshire realized a market beta of only 0.7, an important point that we will discuss in more detail when we analyze the types of stocks that Buffett buys. Adjusting Berkshire’s performance for market exposure, we compute its Information Ratio to be 0.66.

Chart 1: Value Generated by BRK from 1976-2013

While this Sharpe Ratio is very good but not super-human (like for example Bridgewater’s Dalio above 1), then how did Buffett become among the richest in the world?

Looking Beyond: Leverage, Selection and Succession

The answer is that Buffett has boosted his returns by using leverage, and that he has stuck to a good strategy for a very long time period, surviving rough periodsmwhere others might have been forced into a fire sale or a career shift. The authors of the National Bureau of Economics paper estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion.

This leaves the key question: How does Buffett pick stocks to achieve this attractive return stream that can be leveraged? They identify several features of his portfolio: He buys stocks that are “safe” (with low beta and low volatility), “cheap” (i.e., value stocks with low price-to-book ratios), and “high- quality” (meaning stocks that profitable, stable, growing, and with high payout ratios). Thus, Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks.

The performance of the publicly traded companies is a measure of Buffett’s stock selection ability whereas the performance of the privately held companies additionally captures his success as a manager. Buffett relies heavily on private companies as well, including insurance and reinsurance businesses. Why? One reason the academics demonstrate might be that this structure provides a steady source of financing, allowing him to leverage his stock selection ability. Indeed, we find that 36% of Buffett’s liabilities consist of insurance float with an average cost below the T-Bill rate.

One of the largest risk factors affecting BRK/a is succession risk, as Mr. Buffett is 83 years old. However, newly published information confirms that the pupils are beating the master at Berkshire Hathaway. The two managers seen as potential successors to Warren Buffett have netted better returns than the renowne investor.

Both Todd Combs and Ted Weschler outdid both Mr. Buffet and the S&P500 in the last 2 years (since they’ve took over the management of $14B of the total $100B in public equityportfolio). With Berkshire’s market value approaching $300B and around $200B being tied to operating businesses, it has gotten harder for the company to get a big percentage gain in net worth expressed in book value per class A share, Mr. Buffett’s preferred yardstick.

Extract of January’s 2014 edition of “The Thinking Man’s Approach”, by Ignacio Pakciarz, CEO of BigSur Partners

You may access the full report through this link.

2014: The Year of Latam Startups

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Some of the biggest investment news in 2013 came from the technology sector and from startups across the globe. While the US, Europe and Asia still dominate the market with new startups launching every day, Latin America is bursting with innovation.

Startup Stock Exchange, a pioneer exchange and crowdfunding vehicle dedicated to startups, is experiencing tremendous demand and development in Latin America. In 2013 there were over 100 new companies that applied for seed investment funding. Additionally AngelList, an online social media community dedicated to linking investors with startups, has over 4,000 companies from Latin America alone.

Here are my top five startups to keep an eye on in 2014.

Puerto Finanzas – Argentina

Puerto Finanzas is at the top of my list, as it combines two sectorsthat are rising within the startup industry: Investment and Social Media. Puerto Finanzas enables users to connect with financial sector experts, companies and fellow investors. The site features social media techniques in order to be up-to-date with the latest investment trends such as following stocks, advisors, companies orinternal blogs by selected members. www.puertofinanzas.com

Nubelo-Chile

Nubelo is an online employment platform focused on Latin America. Companies and direct clients can hire freelance professionals invarious industries and evaluate the right candidates for each project. Nubelo also takes care of the hiring, tracking and even payment of the freelancer. Nubelo is now well established in the market and everyone is looking forward to new developments in Brazil and the rest of Latin America. www.nubelo.com

Cine Papaya – Peru

Cine Papaya is both a platform for online and mobile sales of movietickets and an online community for movie lovers. The cinema marketis well-established in Latin America, and Cine Papaya is making it easier to know what is available without suffer through long lines at the movie theater. www.cinepapaya.com

Tripfab – Costa Rica/USA

Tripfab is a collaboration between entrepreneurs from Costa Rica and the United States to create an online travel platform that connects travellers directly with travel businesses without the need for online or offline travel agents, or any other middleman involved. The niche exists because the most desired travel destinations in LatinAmerica are not currently offered via the large online travel agencies. www.tripfab.com

Unipay – Brazil

UniPay allows merchants to accept credit cards with a mobile application. The payment system is fast growing all over Latin America and being able to accept payments via credit card is good for both businesses and consumers. UniPay is growing very fast and I look forward to their growth in 2014. www.unipay.com.br

By Jonathan Rivas, Managing Partner of DCDB Group

Asia’s Evolving Science and Tech Space

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The main growth drivers of Asia’s science and technology industries are changing to become more domestically driven and service-oriented. These changes are happening as rising disposable income enables more Asian consumers to embrace new technologies.

Asia’s Internet-related industries have lately been seeing strong entrepreneurship activity. As the region already is home to the world’s most Internet users (collectively) and rising penetration growth, it may be no surprise that there have also been several recent initial public offerings for Chinese IT-related companies in the U.S. The proliferation of smartphones and tablets is adding more users in emerging markets, especially in Southeast Asia, where traditional high-speed Internet access has been too expensive. Compared to more developed parts in Asia, India and Southeast Asia still have seen relatively low overall Internet penetration rates. But they are expected to lead the next phase of Internet user growth for the region.

Rising Internet adoption is also enabling Asian consumers to leapfrog to the next level. For example, many emerging countries are skipping landline-based broadband and going directly to mobile-based broadband.

E-commerce in China is gaining fast popularity over traditional brick-and-mortar modern retailing in second- and third-tier cities. In fact, it seems, almost as if overnight, China has become one of the world’s biggest e-commerce markets. It now holds the distinction of being the second largest e-commerce market behind the U.S. in terms of transaction value. E-commerce’s share of total retail sales is actually bigger in China than in the U.S. In just a few years, China could become the world’s largest e-commerce market.

Let’s now consider China’s productivity rates. Not long ago, a manager I spoke with in China told me that it was far cheaper to hire additional workers to increase production volume since the payback period of installing a robot to replace labor was more than 10 years. But now, with strong wage inflation over the last few years, the payback period has lessened to about five years, meaning that it may make more economic sense to start replacing humans with computers and robots.

Over the past 10 years, physical labor and capital inputs have been major sources of GDP growth in Asia. But over the next decade, we believe productivity growth could play a bigger role in its development.

Currently, the level of automation in China is comparable to Japan in the 1980s. This trend of rising factory automation could continue to drive growth for Asia’s technology sector for many years to come.

Rising demand for technology products in Asia has been driven by rising Asian incomes. As incomes have risen in Asia, so has demand for high definition televisions, smartphones and tablets. The specification of smartphones that are selling well in China is nearly identical to those in the U.S. Asian consumers are also demanding better health care, better hospitals, better services and better products to treat illnesses—all of which could spur demand for more advanced medical and life sciences products. Most Asian countries still spend only a fraction of what the U.S. spends on health care per capita. We believe the health care sector could be one of the biggest beneficiaries of rising income as demand for such products and services rises.

But these positive trends are not without challenges. For example, Asia’s intellectual property protection has been weak, often deterring innovative companies from realize profits. To try to counter some of these issues, entrepreneurs in Asia focused on innovating different ways to monetize products. For example, online game makers offer games for basically free and they make money by selling virtual items.

Smartphone makers in China sometimes offer phones at cost and make profits by selling apps. As a result, there are some Internet-related business models that are unique to Asia. As Asia’s science and technology industries continue to evolve, we remain excited about the sector’s future and its potential to further Asia’s growth.

Opinion column by Michael Oh, CFA. Portfolio Manager, Matthews Asia

The views and information discussed represent opinion and an assessment of market conditions at a specific point in time that are subject to change.

It should not be relied upon as a recommendation to buy and sell particular securities or markets in general. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews International Capital Management, LLC does not accept any liability for losses either direct or consequential caused by the use of this information. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchangerate fluctuations, a high level of volatility and limited regulation.

In addition, singlecountry funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific geographic location. Investing in small and midsize companies is more risky than investing in large companies, as they may be more volatile and less liquid than large companies. This document has not been reviewed or approved by any regulatory body.

You Missed the US Equity Fat Pitch. Now What?

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Te perdiste el mega rally de la bolsa americana. ¿Y ahora qué? — Photo: Keith Allison. You Missed the US Equity Fat Pitch. Now What?

Nearly five years after the panic of March 2009, when stock prices dropped to the lowest levels in recent history, the U.S. equity markets have returned to the range of fair value. At around 1,800 the S&P 500 Index is trading at about 16.5 times estimated 2013 earnings, priced for a fair rate of return in the long run of between 7 and 9% – in line with historical averages. As such, the equity markets look neither cheap nor overvalued.

This poses a quandary for those investors – institutional as well as retail – who missed the massive rally off that 2009 low (the “Fat Pitch,” to use a baseball analogy) and with it a whole generation of investment gains. “If we buy U.S. equities now, are we setting ourselves up to buy at the top?” they may be asking themselves. “And if we don’t get in, will we miss yet another Fat Pitch?”

In attempting to answer that question we start with the premise that the investment landscape around the world is in much better shape than it was in the dark days of 2008 and 2009. As bottom-up stock pickers we do not attempt to make macroeconomic and geopolitical forecasts. But we do believe that the U.S. economy is relatively well placed when compared to the rest of the world. Consider:

House prices have recovered sharply from their dramatic decline six or seven years ago.
Gas prices continue to fall as crude oil drops further below its recent peak.
The employment situation is improving even if the upward trend remains sluggish.
The Fed’s injection of liquidity into the system through quantitative easing has clearly benefitted major financial institutions. They have been able to boost their capital while at the same time credit quality has improved and non-performing loans are falling.

Further, we do not believe the U.S. equity market has formed a bubble as it did between 1998 and 2000, with the exception of a few highly priced small and mid cap stocks. The U.S. bond market, on the other hand, does look to be artificially inflated as the likelihood of higher rates increases.

Set against these favorable factors is the continuing disagreement in Washington over U.S. fiscal policy which has done significant damage to business confidence. Rather than increase capital expenditure on plant and equipment, and research and development, major corporations are opting to return cash to shareholders by way of buybacks and dividends. This lack of expenditure is one reason why GDP growth in the U.S. is running below trend.

Extract from a white paper by Robeco Boston Partners published in January 2014

A More Market-Friendly China

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Un mercado chino más atractivo para los inversores — Photo: Steve Evans. A More Market-Friendly China

My last visit to Beijing happened to coincide with the Communist Party’s Third Plenum Meeting. General business sentiment was just as upbeat as it had been earlier last autumn. But through my discussions with different businesspeople, I came away with a distinct new optimism over the leadership’s more market-oriented stance on policies.

To give an example of the new administration’s improved focus on marketplace best practices, let us look at policies that have impacted China’s toll road operators. As car ownership has grown with rising incomes, China’s toll road industry has experienced consistent growth in recent years. However, in 2012, major toll road operators were negatively affected by a government policy enacted by China’s former administration that mandated toll exemptions on all major Chinese holidays.

Besides contributing to severe traffic congestion on the country’s main roads, the holiday policy failed to stipulate any compensation measures to offset losses that toll road companies would have to endure. While China’s new administration has maintained the toll exemption policy for major holidays, immediately after taking office, new government officials began working with the industry to offer compensation that may help offset any related losses. During my trip, I got the sense that toll road operators are generally pleased by the new administration’s understanding of their concerns.

The current leadership seems very committed to reducing government intervention in the economy. One of the highlights that came out of the Third Plenum communique is a government endorsement for the market to play a more “decisive” role in allocating resources. In addition, the new administration will further deregulate sectors that have traditionally been dominated by large state-owned enterprises (SOE). It plans to adopt an approach to allow private investments in most industries unless they are on the official list of industries restricted from private and/or foreign investment. The government also promised to simplify business registration and approval processes and level the playing field for non-SOE companies to better compete.

While I am encouraged to see an ambitious reform package coming from China’s new leadership, the key to the country’s future success will lie in implementation. Counter to the new initiatives (and not long after the Third Plenum meeting), several cities in China rolled out some administrative measures that aimed to curb increasing local housing prices. Different localities may continue to struggle with more market-friendly reforms, but in general, we are hoping the broad business environment in China will gradually move in the direction of a market-oriented economy. If so, non-SOE companies could become major beneficiaries of this long-term trend.

Henry Zhang, CFA, Portfolio Manager at Matthews Asia

Disruptive Innovations in Indian Politics

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“A man may die, nations may rise and fall, but an idea lives on. Ideas have endurance without death.”
–John F. Kennedy

The sweeping victories for India’s pro-business opposition party, the Bharatiya Janata Party (BJP), in recent state elections were largely expected. But more stunning, to say the least, were unexpectedly strong gains in Delhi by a nascent, novice and underfunded political party known as the Aam Aadmi Party, or Common Man’s Party. The party ran a grassroots campaign, taking a page from U.S. President Barack Obama’s “get out the vote” efforts. With a narrow political agenda of providing clean governance, the party won a near majority in the polls, beating candidates with far more financial backing and organizational strength. One wonders how that happened and what that implies for Indian politics.

The party is relatively inexperienced, but on the other hand, has been able to sustain a clean image, which appeared to be more important to today’s Delhi electorate than a long track record or religious affinity. In fact, this party fielded candidates with religious identities or castes not necessarily aligned with the electorate. Furthermore, the party made no effort to appeal to such affiliations. Perhaps India’s largely young population was less concerned with these issues.

The Aam Aadmi Party’s funding strategy was also unconventional. It raised funds from local citizens, who gave large volumes of small amounts, and Indian nationals living overseas, who gave larger amounts in the hope of seeing some change back home. Typically parties have fundraised primarily from self-interested corporations. But to reinforce its transparency, the Aam Aadmi Party posted donations received and their usage on its website—something most other parties did not do. The party also encouraged a more direct and participatory form of democracy in the devising and execution of their agenda. In contrast, most parties have a more hierarchical and dynastic style. Aam Aadmi’s success suggests that there has been a vast unmet need for good grassroots governance in Indian politics, and the party’s credible promise of this swayed many voters.

Many skeptics think that over time, the Aam Aadmi Party may become just like any other. Nonetheless, the implications for the party’s debut electoral performance are enormous for Indian democracy. First of all, the party has demonstrated a viable way of winning an election using transparent means without resorting to short cuts. No matter how this party evolves over time, this disruptive idea will hopefully prevail and continue to bring fresh doses of clean politics into the system. Secondly, the party has brought to forefront the issues truly important to constituents, something other political parties are still struggling with. Additionally, in my opinion, the fear that unless they improve, they will perish, will alone bring a huge change in the mindset of politicians. Hopefully, the Aam Aadmi Party’s success in this election will change the ways in which all Indian politicians conduct their business.

Notwithstanding the success of this kind of politics, one has to bear in mind that Delhi is largely urban and this party’s movement had strong backing of middle class voters that are dominant in this region. Whether this will be replicable to largely rural and poor Indian constituents outside Delhi is something worth watching.

Sunil Asnani, Portfolio Manager at Matthews Asia