Willful Optimism in the Face of Pessimism

From time to time, Morningstar publishes articles from third party contributors under our "Perspectives" banner. Here, Robert Horrocks, PhD, Chief Investment Officer and Portfolio Manager, Matthews International Capital Management, explains why he remains sanguine in the face of pessimism. If you are interested in Morningstar featuring your content, please find further details here.

?I am starting to feel that people are too pessimistic. I am somewhat of a contrarian—perhaps, in a more introspective moment, I’d admit I was a willful child. I remember, with great fondness actually, my mother, a thrifty Yorkshirewomani, pouring a bottle of fresh milk over my head in a desperate attempt to quell my unruliness. Despite her best efforts, and because there is so much pessimism around at the moment, I feel genetically programmed to take the dissenting view. Are things really as bad as all that? Maybe I am falling into a behavioral trap here and the answer is: “Yes, things are that bad and then some!” But I am unconvinced. And to explain why, let us first think about how pessimistic the markets seem to be at the moment.

A question for you: what is –0.07%? As I write, according to the U.S. Treasury, this is the real annual interest rateii at which the U.S. government can borrow money for 10 years. Sentiment is so bad about the prospects for sustainable growth in the world economy over the next 10 years that people are willing to pay the U.S. Government to borrow their dollars. Can that be right? Is that the new risk-free rate? Can the combined efforts and opportunities of the world’s labor and capital really offer no better solution than that for investors’ needs? As I read other people’s comments about the current state of the world economy and prognostications for the future, I am, more often than not, depressed by what I read. The U.S. has an unemployment problem, Europe is insolvent and China’s banking system and property developers face the prospect of rising bad loans. Indeed, in investors’ minds at the moment, the only thing that appears to be sustainable is depression. In essence, what people are saying is that you can't beat cash. But that is not just a 2012 forecast; it is a 10-year forecast!

And yet, at the same time, policymakers are not ignorant of solutions to these problems. The U.S. has underwritten a lot of its problems already. China has some room to maneuver: a fast-growing economy and the ability to take a longer-term view of restructuring the banks, which are essentially departments of the government. As for Europe: as soon as the European Central Bank (ECB) decided to take up the task of stabilization by essentially printing money and loaning it to banks—which then bought sovereign bonds—the interest rates on Italy’s sovereign debt of the same term as the ECB loans fell from 7% to 5%. A few tweaks could easily help the 10-year yields fall, too. Indeed, the ECB action was, I think, a great demonstration of what my former CIO used to say: “Things that can’t go on forever, don’t.” The ECB’s failure to implement the ready solution for Italy’s sovereign distress could not go on forever—despite all the legal and political impediments to right and proper action, it made the correct decision. All of this can be boiled down to a simple, maybe simplistic, view of the world—it is very dangerous to be going around saying: “You can’t beat cash” when it is clearly in the interests of those who control the supply of cash to frustrate your excess demand.

Expectations Coloured by Past Experiences
Analysts’ expectations for the coming years are still colored by their recent experiences. Thus, we are all looking for the next financial crisis. Growth in Asia seems destined to be faster than the rest of the world on average and yet Asia’s markets seem hostage to the fortunes of the West— I read one investment manager saying that they need to see a resolution of the European issue before they are comfortable with Asia. And it’s not just investors. In a recent surveyiii, over half of Australian consumers had news about international conditions at the front of their mind—a higher proportion than even during the 1997– 1998 Asian Financial Crisis. Are investors being short-sighted? Is it, to pervert an old saying, a case of can't see the trees for the forest? Do these big macroeconomic issues inform us or blind us to the incentives that guide people’s everyday lives? Was the global financial crisis really the scales falling from people’s eyes about the prospects for long-term growth? Or is it a panic that is preventing us all from clearly seeing the opportunities ahead?

It seems to me that for much of 2012, all the forces of stimulus are going to be arraigned against pessimism. Fiscal policy perhaps less so, but central banks in Europe, U.S. and Asia all appear to be shifting to more accommodative stances as inflation pressures subside. Even in India, where there has been a more moderate decline in inflation, there may be room for maneuvering later in the year. Last year’s rising cost pressures have depressed forecasts for margins in Asia to levels close to the 2008 trough and tight monetary policy has caused continued cuts in expectations of revenue growth. But with inflation easing and monetary policy loosening, these forces may slow or reverse.

Still Opportunities for Asia’s Middle Class
There are still many opportunities in Asia, a region where the majority of the population still lives in countries with an average per capita annual income of less than US$5,000. Years ago, when I was in Beijing, people lacked the ability to discuss things freely, publish freely, to express their individuality through the media or, for the most part, to dress the way they wanted. They lacked the ability to make the most of their education—being sent straight from university to the Marxist publishing houses or to teaching moribund political courses. Or they went straight from school to menial jobs in industry. Now, a proliferation of opportunity awaits them both in and outside of China: the ability to set up their own businesses, to consume more freely and to own their own car, home, or take vacations, and to provide personally for their future without relying on the state. It is inconceivable to me that people, given the opportunity to develop their skills, would not follow this path. It’s also inconceivable that sensible businesses would not be able to profitably provide them products to consume with the fruits of their newfound skills.

The Asian middle class numbers some 500 million to 600 million people, and that figure may almost double in the next five years. These people may spend an additional US$2 to US$2.5 trillion dollars on their new livesiv. Demographically, Asia seems well-placed as a whole. India and Indonesia have young populations, growing in skills and opportunity. Even in Japan, the demographic make-up of the population appears to be changing in a way that will support new growth and investment. Much has been made of China’s “demographic tsunami”; the commentary has been too pessimistic. Indeed, although China is aging, over the next two decades, the growing middle-aged population will probably accumulate better work skills, raise real wages and drive the development of liquid, efficient capital markets to build their savings.

Moreover, I do not see how the nations that make up Asia, which has been growing at rates in excess of much of the rest of the world, lack the ability or, more importantly, the incentives to continue to improve the lives of their people. Across the region, education levels and the quality of education have improved dramatically in the past 20 years and Asia is on average doing an increasingly good job of educating both its men and women to similar standardsv. Asia’s productivity, due to better use of technology and educational inputs, has grown at a far faster pace than elsewhere. It is growing twice as fast as the U.S. across much of Asia, three times as fast in India, and four times as fast in China. Yet, these countries are still underdeveloped and there is much more they can do to better feed, clothe, and nurse their citizens, and much more they can do to enjoy the consumption that the West does.

Valuation
The real question for the economies and markets is whether we are at the tyranny of expectations – do our own forecasts of doom condemn us to below-par performance or do they offer opportunity for surprise? So, before I get carried away with my self-serving optimism, I want to check valuations. And here, too, I see something that I am tempted to describe as unlikely to go on forever. For, Asia’s valuations are now cheap. Cheap relative to history and cheap relative to the rest of the world. Asia ex Japan trades at 10x forward earnings, more than a 20% discount to the U.S., and at 1.7x book value, a more than 25% discount to the U.S. Asia ex-Japan’s dividend yield is higher at 2.7% versus 1.8% for the U.S. Japan is cheaper than the U.S. on all metrics, too, trading at 11.5x earnings, 1x book value, and a 2.4% dividend yield.vi

When looking at equity prices relative to expected earnings for the next 12 months, Asia ex-Japan has only been this cheap 15% of the time; it is currently in the 30th percentile of cheapness for price to book and 15th for dividend yield. The fact that Asia had a disappointing 2011 is no guide to the future—down years in Asia’s stockmarkets are as likely to be followed by another down year as by an up year—but given valuations, a return to normal growth and historic average valuations means that long term investors may have some tailwind here.

Perhaps it is these valuations, which appeal to the “cheap” side of my character, that are causing me to dig my heels in and deny the pervasive negative sentiment. Consequently, with markets undeniably cheap, I am perhaps also predisposed to look for evidence that confirms my less depressed view of the world. Coming into 2012, there have, at the margin, been some better employment numbers in the U.S., with unemployment now down to 8.5%; an easing of pressures in Europe and a rebound in global equity markets, including Asia; and more robust fourth quarter performance. And what to make of the recent falter in the price of gold from US$1,900 an ounce to US$1,600? For it seems that the upward march of the gold price has been at least temporarily halted. Does this suggest at least a slight weakening in the all-pervading pessimism surrounding financial markets?

So I start 2012 if not full of optimism, then at least very sceptical of the pessimism that seems to surround me—that in Asia the impetus to bettering oneself has been subsumed by all these macroeconomic factors. I’ll admit that I am maybe being swayed by my own biases: my love of the cheap, my willful obstinacy, and a career devoted to learning about and investing in Asia. Perhaps someone needs to pour a bottle of milk over me to calm me down.

i I was taught by my maternal grandmother and will sometimes still recite: “See all, say nowt; sup all, pay nowt; and if tha ever does owt for nowt, do it for thysen!” If you want to know what it means, Google it, where you will see various versions of the 'Yorkshireman’s motto.'

ii The yield on 10-year Treasury Inflation Protected Securities, or TIPS

iii Westpac-Melbourne Institute Survey of Consumer Sentiment, December 2011

iv Based on CLSA report “Mr and Mrs Asia: Moving up the J Curves, Spring 2010”

v Source: UNESCO UIS Data | UNESCO Institute for Statistics

vi Data is from FactSet and relates to broad markets, not benchmarks

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