Commentary

Period ended June 30, 2010

For the first half of 2010, the Matthews Asian Growth and Income Fund gained 1.51%, outperforming its benchmark, the MSCI All Country Asia ex Japan Index, which fell –3.60%. For the quarter ended June 30, the Fund declined –2.51%, while its benchmark fell –4.86%.

The volatility that characterized markets during the early months of 2010 grew only more pronounced as the year wore on. During the second quarter, equities around the world retreated as fears grew that high levels of indebtedness would swamp the recent recovery in global economic activity. Though Europe and the U.S. were at the epicenter of such concerns, fear also spread to China, where investors worried that the beneficial impact of recent stimulus projects was beginning to fade.

Having toured China recently, it was indeed clear to me that the economy is undergoing a broad transition. It was evident that the country’s past reliance on major capital investments to fuel growth (e.g., construction of infrastructure and property development) is waning. Likewise, the country has also utilized an export-centric growth model, where domestically manufactured products were shipped overseas for consumption. This model’s ability to generate additional growth also appears compromised. China's already substantial level of development in its urban centers means that it cannot indefinitely sustain its rapid economic gains by undertaking ever more construction; nor can the country hope to export its way to ever greater levels of prosperity.

To be sure, China will shift away from these two economic models only gradually—in the years ahead, there will undoubtedly be more investment in poorer, inland areas. Meanwhile, other modes of growth are untested. Consequently I do not expect an abrupt shift, where policymakers abandon familiar investment-led and export-driven growth models. Yet my observations suggest a transition is nonetheless underway: China is beginning to shift its focus from external to domestic consumption, from manufacturing to services, from incremental capital investment to boosting human productivity. This change is most notable in individual companies, where we are beginning to see business models modified toward a greater service orientation. Examples include companies placing new strategic emphasis on software procurement. Other businesses, traditionally focused on equipment installation, have begun providing outsourced services for the ongoing operation and maintenance of that same equipment.

For this reason, the Fund has begun to emphasize investment in industries in which the economic potential is derived either from rising consumption, or from new, service-driven business models. Such industries are generally nascent within emerging Asia. If they prove successful, they have the potential to generate sustained, long-term growth. Furthermore, such industries are typically underrepresented or even absent from typical benchmark indices, as well as investor portfolios. The Fund thus strives to present a relatively unique set of economic exposures to its shareholders.

The Fund’s focus can be illustrated by a common-stock position that was substantially augmented during the first half of this year: China Pacific Insurance Company (CPIC). Once a privately held insurance company, CPIC was launched as a subsidiary of one of Shanghai’s leading commercial banks. Later, under Communist rule, CPIC was spun out of that bank and its ownership transferred to the municipality of Shanghai. Like many state-controlled financial institutions in China, CPIC sought a public listing via an IPO. The company first listed its shares in the local A-share market, accessible only to domestic investors. However, late last year, CPIC also successfully listed on the Hong Kong H-share market, accessible to foreigners. While the Fund does not invest in A shares, it participated in the Hong Kong IPO, and has grown its position steadily since.

The Fund’s investment decision was motivated by the desire to build exposure to a fledgling set of financial services in China: namely insurance, pension services, and wealth planning and management. Insurance markets, while not new to China, are still relatively underpenetrated. As household wealth grows, so too should the demand for better insurance coverage and diversified products. Meanwhile, wealth planning and pension services are wholly new to the landscape. CPIC is an emerging leader in what are admittedly still very small markets. It has entered the trust and wealth management industries via acquisition, and it will likely be one of the companies engaged in a pilot program for a tax-deferred, defined contribution-style savings program akin to some U.S. long-term savings plans.

As we enter the latter half of the year, we do so with more reasonable valuations. We have been cautious over valuations in the last three quarters, which seemed excessive given the potential for sub-par growth, as well as the possibility of accelerating inflation. Valuations are now approachable for steady, long-term investors, but near-term risks remain: expectations for profits in the latter half of 2010 are still elevated, especially given inflation in materials and wages. Revisions in earnings forecasts may follow, which could well create volatility in stocks in the coming months. Meanwhile, as we have previously commented, inflationary pressures have surfaced, with wages and food prices undergoing sharp increases in some of the region’s major economies. Happily, policymakers in Asia have finally begun to address this problem, though their response may ultimately invoke unwelcome measures such as credit rationing, or even capital controls. Amid this environment, the Fund continues to pursue a defensive approach while still seeking exposure to Asia’s emerging growth industries.

The views and opinions in this commentary were current as of June 30, 2010. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Funds' future investment intent.

Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.

As of 6/30/2010, China Pacific Insurance Group Co. represented 2.0% of the Matthews Asian Growth and Income Fund.