Asia Insight

March 2008

Running Hot and Cold

Andrew Foster
Acting Chief Investment Officer and Portfolio Manager
Matthews International Capital Management, LLC

It is nearly three months into the new year and global stock markets are still in a slump. For the most part, stock prices around the world are in decline—and this is hardly surprising, given that the slide in equities mirrors the broader decline in prices we see around us every day now. Housing markets around the U.S. continue to sag, some precipitously so. Reports also suggest employment is soft: The U.S. economy appears to have slowed the rate of new job formation. Anecdotal reports suggest that wages are also stagnating, as the jobs that remain in the economy pay less than they once did. Retail sales are still expanding, but primarily at discount club stores, suggesting that the retail sector may incur pricing weakness. And, of course, the price that has fallen fastest is that of the dollar itself: It now takes more than $1.50 to buy one euro, and Canada's "loonie" trades at parity with the dollar. Demand for goods, services, houses, labor and even the dollar itself has softened, and this in turn has led to lower prices. Is it any surprise that stocks have declined in sympathy?

At the root of this broad-based decline in prices is the unwinding of excess leverage. Over the past few years, credit markets around the world have undergone a period of sustained expansion. Banks and other financiers grew their balance sheets rapidly during this business cycle, driven by a boom in securitization and structured finance. Though the products created in the process had esoteric acronyms attached, the underlying business model was fairly straightforward: By shifting credit exposure off their balance sheets, financiers were able to extend ever greater levels of credit, without necessarily increasing their regulatory capital in proportion. Worse still, securitization may have altered the behavior of such institutions in a detrimental fashion. As banks and other financiers were able to shift credit risk to third parties, they had an incentive to favor volume over quality when originating new credits. Thus not only has too much credit been generated, but also too much of it extended to the wrong sorts of borrowers.

In the short run, this excess of credit had the beneficial effect of sustaining consumption and investment, which in turn supported prices across the economy, especially in housing markets. However, now that the securitization model has faltered, the economic activity it spurred may contract, with a corresponding effect on prices. The unwinding of leverage can thus be a painful process, and it is usually deflationary in nature. The Asian region underwent a similar experience during the financial crisis of 1997, when prices were forced to adjust sharply lower, falling to levels at which the market could clear. In anticipation of a difficult environment, the U.S. Federal Reserve has acted aggressively, cutting the benchmark federal funds rate by 2.25% in only four months. The Fed appears to believe that by lowering rates it can stem the contraction in credit, bolster consumption and ultimately arrest a broad decline in prices.

Yet falling prices are only part of the story. Plenty of prices are rising around the world—especially in Asia. It has been well publicized that measurements of certain prices in the U.S are rising, especially for food and energy. Some commentators have suggested that lower growth and higher prices could result in "stagflation." Yet stagflation is nowhere on the horizon in Asia Pacific, as growth rates are for the moment high, and prices are accelerating, perhaps too rapidly. For example, Australia's recent experience stands in stark contrast to that of the U.S.: rising inflationary pressures have prompted the Australian central bank to raise rates, not cut them. The central bank's rate now stands at its highest level in 12 years. Japan, too, is experiencing higher levels of inflation. Measurements of core prices there suggest inflation has climbed to its highest level in a decade. Salaries in Japan are also beginning to rise again, with the strongest growth seen in the last four years.

The conditions present in Australia and Japan are not unique to those countries. Across the Asian region, inflation is hovering near levels not seen in a decade. This is especially clear in China, where inflation has just touched 8.7% in February, the highest level experienced in 11 years. Rising prices are of such concern that the topic was directly addressed by Prime Minister Wen Jiabao during China's annual parliamentary session. Wen stated that taming inflation would be a key goal of the government for the year ahead; he even announced a forward inflation target of 4.8%. Many analysts and strategists have for self-interested reasons been keen to talk down expectations for inflation. They argue that most of the current inflation observed is due to a series of "one off" events. However, as their forecasts have proven consistently wrong, and inflationary pressures have continued to build, those arguments have rung false.

We have written a good deal about inflation in Asia during the last three years. The gist of our argument has been that a modest degree of differential inflation in Asia (i.e. higher rates of inflation in Asia versus the U.S.) is not necessarily unwelcome, particularly given that so many countries in the region have pursued exchange rate policies that manage their domestic currencies in a relatively narrow band versus the dollar. However, in the past 18 months, the inflationary pressures in Asia have built up to a degree that may become problematic. Inflation poses the same challenge to Asia as it does to every other economy in the world: If the marketplace develops an expectation for sustained price increases, inflation will likely feed on itself and escalate out of control.

Where Asia differs from the rest of the world is in regard to its policy options. With the exception of developed markets such as Japan and Australia, the rest of the region tends to suffer from relatively less sophisticated financial systems. Consequently, central banks seeking to tame inflation are more likely to resort to blunt tools that may curb inflation, but also inadvertently hamper growth. Stuffing the genie back into the bottle is always a difficult task—and when your only tool is a sledgehammer, you may end up smashing the bottle in the process. Thus countries such as India or China may be tempted to tolerate a higher degree of inflation for longer than would otherwise be desirable, with potentially detrimental consequences.

So what we have in the world is two taps, one running hot (Asia Pacific), and one running cold (the U.S. and some other developed markets). How these two forces will interact is unknown. The only thing clear to me is that the two conditions are unlikely to coexist very long. It is possible that the two temperatures will cancel each other out: Inflationary heat from Asian demand may cancel out the disinflationary / deflationary consequences that are likely to accompany the contraction of credit underway in the U.S. This would be the equivalent of temperate water mixing in the sink basin. However, such a tidy solution is unlikely in my view. I would expect that one condition will eventually dominate the other. Which it will be is impossible to know at this juncture. However, I imagine that as these conditions collide, turbulence will be the likely outcome, as markets seek a new and more sustainable temperature.

March 11, 2008

The view and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investments vehicles.