The monetary tightening is indeed happening. And it is happening in the two biggest economies in the world, the U.S. and China, simultaneously. Let’s remember that the monetary stimulus introduced by the Fed and China was in response to a financial crisis. And, the question was never if, but when, the Fed and China would taper.

In the last few weeks, we have seen clear evidence from both the U.S. and China that the time has come. The Fed was clear yesterday in noting that the U.S. economy is getting stronger and that it is planning to taper off quantitative easing. There is also clear evidence that the Chinese resolve to tighten is finally happening. Shanghai interbank offer rates, also known as Shibor, have shot up, indicating a short-term liquidity squeeze. The significance of this increase is not the magnitude of the rise in interbank rates, but the duration of the rise. Why? Because the People’s Bank of China (“PBOC”) has had days, indeed weeks now, to inject liquidity in the interbank market. The prolonged rate increase indicates not a lack of ability, but lack of willingness to do so. This to me is a telltale sign that the PBOC is finally serious in its resolve to tighten.

So what does this all mean to Asia’s credit, currency and interest rates?

First, while yields have come off their historical lows in the U.S. and Asia, there is substantially more room for rates to continue to rise.

Second, in terms of credit spreads, we have seen investment grade and high yield spreads widen. We believe that spreads will have some room to widen given a repricing of risk across the globe. However, credit spreads are unlikely to spike as long as default rates stay low. Global high yield rates are still hovering around 3%, with recovery rates better than average. As the availability of capital falls, increasing the cost of capital, this would be negative. However, if U.S. growth is indeed solid, this should eventually have a positive spillover into higher cashflows for global companies.

Finally, rising yields and a solid U.S. recovery bodes well for the U.S. dollar. As such, we expect local Asian currencies will underperform the U.S. dollar in the near term. This is especially true for fiscal and current account deficit countries. However, the silver lining is that it is also precisely tough times like these that push governments to take on tough reforms. Indonesia comes to mind. This week, the country’s parliament passed a controversial fuel price hike. While this will likely increase inflation and inflation expectations in the near term, the long-term positive effects far outweigh the negative. Removal of the subsidies frees up much needed funds for other sectors more critical for future growth such as infrastructure and education. This serves as a reminder that crisis begets change, and it is precisely these seeds for positive change that we hope will blossom in the long term.

Teresa Kong, 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, 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.

When your economy is depressed, with high rates of unemployment, and interest rates at close to zero, you need aggressive monetary policy to keep activity ticking over. And what you say you will do matters just as much as what you actually do. Thus, the markets became very skittish when first U.S. Fed Reserve Chairman Ben Bernanke and then Japanese Prime Minister Shinzo Abe made public statements from which speculators inferred they were going to be less aggressive in monetary stimulus than had been expected.

Lowering peoples’ growth expectations and causing them to bid up the U.S. dollar is about the worst combination for Asian equities historically

First, Bernanke spoke about tapering off quantitative easing (“QE”). What he meant, or what he actually said, was that quantitative easing would taper off if U.S. growth continued to improve. All well and good, but the markets are not yet “sold” on the idea that U.S. growth is going to be all right. After all, we have just had a round of tax hikes and also some spending cuts—surely that means there is downside risk to anyone’s forecasts of the economy? Then, Abe spoke. Speculators were already selling Japanese equities after Bernanke’s comments, for fear that if the U.S. were thinking of withdrawing stimulus, what hope would there be that Japan would persist with its own money-printing experiment? Abe exacerbated their concerns because he said he was aiming for 2% real growth and 3% nominal growth, the difference, 1%, being inflation. Yet, in the market, inflation expectations were already above 1% and it is primarily through those expectations that monetary stimulus gains its force. Speculators, hearing that the authorities were planning to be less aggressive than expected, caused another abrupt sell-off in Japanese equities. If that were not enough, we then had a second round of Bernanke’s public comments that tied withdrawal of monetary stimulus to a fall in the unemployment rate to 7%. Now, 7% is hardly full employment—that is probably closer to 5% or 6%; in addition, so many people have left the workforce recently, that the “true” unemployment rate may be much higher than stated. Indeed the U.S. unemployment situation may have improved only marginally since the trough of economic activity.

So, in a matter of weeks, these two policymakers managed to dash the hopes of faster global growth and rising prices of goods and assets that were being built into the markets. Investors now fear that as soon as growth starts to pick up, central bankers will move to prevent it from accelerating, even though the economy is rising from a depressed base. The situation was further exacerbated by spikes in interbank rates in China that are a symptom of the government cracking down on domestic liquidity in an attempt to rein in credit growth. Whilst this tightening may be desirable, its timing couldn’t have been worse, given the comments from the U.S. and Japan. Indeed, it looks as if global monetary policy chiefs all “got out of the wrong side of the bed” this week. So, speculators sold everything—bonds, equities, gold, and bought U.S. dollars.

Some of the moves in the market were, in the short run at least, a little puzzling. Falling equity markets make sense in a world of “premature” monetary tightening. So does a rising U.S. dollar. But rising bond yields? Yields may well rise in the short run as part of a run to cash, but if growth does indeed slow, they will fall back down again, and, one assumes, the Fed will then need to launch QE 4, 5, 6… and 7. So, we are in a bit of a holding pattern here. Which is right? Bonds or equities? If growth is indeed picking up, the bond moves seem appropriate but equities would surely enjoy an environment of faster growth! If growth is about to disappoint, then equities are right and yields will surely fall back down—even then, the likelihood of further stimulus to correct the premature tightening would help cushion equity markets.

Very occasionally, global events like these may offer up a few bargains along the way

Now, what does this mean for Asia? Historically Asian markets have done well in periods of a weaker U.S. dollar and faster growth, so lowering peoples’ growth expectations and causing them to bid up the U.S. dollar is about the worst combination for Asian equities historically. And I do not think that Asia’s relation to global markets has changed significantly enough to nullify this past relationship. However, there are reasons to think that the effects on Asia’s equity prices may be a little more muted this time. First, valuations are already low—we have gone through a period of weak growth and a slightly appreciating U.S. dollar for the past two years. The impact on the markets has been to cause Asia’s price-to-earnings to fall close to its historical lower bound, even as earnings are depressed by cyclically weak margins. Consequently, Asia’s discount to the U.S. has widened to about 30%. In addition, Asia’s economies are in reasonable shape in regards to external exposure—only Australia, India, and Indonesia run external deficits—and levels of external currency debt of both sovereigns and companies are substantially less worrying than they were on the eve of the 1997 Asian crisis. So, Asia’s economies are not as stretched as they were going into the U.S. dollar strengthening in the late 1990s and its equity markets, particularly North Asia, are priced quite reasonably.

In the short run, the reaction of the markets may have been induced in part by fears of the past. Nevertheless, Bernanke and Abe did no favours for Asia with their recent comments and China’s tightening will slow growth and dampen expectations further. However, for us at Matthews Asia, we are not going to try and guess the short-run fluctuations of GDP growth, nor will we try and anticipate the nervy reactions of short-run speculators or attempt to predict the future public statements of global policymakers. As always, we will continue to look much longer-term and try to identify the companies that will themselves sail through the short-term changes in economic policy and adapt themselves to the evolving aspirations and demands of their Asia customers. Very occasionally, global events like these may offer up a few bargains along the way.

Robert Horrocks, PhD, Chief Investment Officer and 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, 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.