Editor’s Note: With controversy between the U.S. and China heightened since the beginning of the pandemic, Rethinking65’s Dorothy Hinchcliff thought it would be a good idea to talk with a portfolio manager about the outlook for Asia and whether it makes sense for clients who are 50 and over to invest there. She recently caught up with David Dali, head of portfolio strategy at Matthews Asia, on these very topics.
Dorothy Hinchcliff: Thanks for speaking with me, David. I’d like to start by hearing your investment outlook on Asia for the short, medium and long term. Which particular countries stand out and why?
David Dali: I would say that one year from now, we’re not going to be talking about Chinese regulation. We believe strong regulatory oversight will be prevalent for many years to come. We also believe that the severity and cadence, the damaging Chinese regulatory headlines, probably have peaked. And going forward, positive company fundamentals should outweigh macro related headwinds in China.
Overall, I think emerging markets, in Asia in particular, are compelling over the short term, and that’s really because of their exposure to cyclical recovery. Now in my mind, the easy money was made primarily in 2020. But we do expect earnings growth to stabilize at a fairly attractive 10% to 15% growth rate, which makes the next year or so also promising, especially in countries like China.
Over the next five or 10 years, I also believe M&A should look fairly compelling. First, government governance, transparency and the recognition of shareholder rights is certainly improving, which means that a larger share of profits is finally making it into shareholders’ pockets.
Secondly, people forget that Asian companies are profitable, and not just in times of cyclical recovery. The profitability of Asian companies, especially those in North Asia, like Korea, Taiwan and China, can rival those in any developed market.
Lastly, you know the reason why I’m so optimistic longer term is I believe that the best investable theme in emerging markets open to investors today is to invest in companies and sectors connected to innovation, especially innovation in China and the rest of North Asia.
Obviously, as allocators, we need to ask ourselves constantly will this investable trend and theme continue. We think it will; in fact, we think the innovation theme in Asia is just beginning. We equate Asia’s stage of innovation today to what the U.S. was like back in the 1970s, ’80s and ’90s. And I always say, imagine if you could have purchased U.S. innovation companies like Microsoft, Genentech, Apple and Nike back in the late 1980s. Well, that’s exactly where we believe Asia’s current stage of development, their buying power, their consumer preferences, are today.
Hinchcliff: You touched momentarily on the regulatory picture in China. How do China’s proposed rules to prevent data-heavy tech companies from listing IPOs in the U.S., as well as other steps it’s taken to limit technology, affect the outlook/opportunity for U.S. investors?
Dali: That’s a great question. Clearly, Chinese regulation is on the minds of investors. About 70% to 75% of all of our investor questions have been related to China in the last several weeks so it’s certainly on people’s minds.
And I would say, especially in regard to IPOs listed in the U.S., we believe personally that it’s mutually beneficial to allow Chinese companies as well as other foreign companies to list on the U.S. exchanges. Now as professional investors, we’re not restricted to invest only in the U.S. If Chinese companies choose to list in Hong Kong as opposed to the U.S. just to access foreign capital, we don’t believe this reduces the opportunity, or dampens the outlook for U.S. investors whatsoever. Most of us, including individual investors through their advisors, have super easy access to Hong Kong-listed companies.
We believe that the Chinese government is actually going to be much more transparent in their regulatory oversight. In other words, companies will have a much better idea of how to adhere to regulation. And what we’re seeing is some of these large companies, especially the large-platform companies and social media companies, have been very, very forthright in their willingness to comply. If regulations are more transparent, we believe that regulatory risk will fall. And when you combine that with the company’s willingness to comply, we just believe that the worst could be over.
However, we also believe that regulatory headwinds and oversight are here to stay. The fact is that companies will just need to comply. We believe that the negative surprises will start to diminish because of the transparency of regulation. We’re not going to get these headlines surprise because companies will know how to comply. And that’s a big deal.
Hinchcliff: What percentage of your investments are in China in your current portfolios?
Dali: We have 17 different mutual funds at Matthews and other separate accounts. I can tell you that China is certainly a significant part of our overall business. China is almost 40% of the emerging market benchmarks, and is a bit higher than that in Asia-dedicated benchmarks. We have very significant resources dedicated to the Chinese effort. I think at this point we have over 15 sets of Mandarin-speaking eyes looking at our investments.
Hinchcliff: That’s impressive. Speaking further about the countries where you think there is an opportunity, you did mention Taiwan in your report. How big of a risk is there that China might take over Taiwan? Where would that leave investors?
Dali: Well, it’s a great question. Clearly a military conflict in Taiwan would be negative for investors. However, our view is that the risk of a military conflict across the strait of Taiwan today is extremely low.
First, from a domestic politics standpoint, we don’t see that Xi Jinping is under any pressure at home to use force against Taiwan. If you ask most Chinese people, they would tell you that Taiwan is already part of China. So why do we need to use force anyways?
Secondly, from an economics perspective, we believe it would be almost a disaster for China to use force against Taiwan. To give you just one example, China is largely dependent on imported semiconductors. On a dollar basis, they import more semiconductors than they import oil, and about a quarter of all those semiconductor chips come from Taiwan. So we think that would be an economic disadvantage.
Lastly, from a military perspective, it would be highly risky for the Chinese to invade Taiwan, given it would require a massive amphibious effort, one that is not guaranteed to succeed. What could change our mind is if governments both in Taipei and Washington were to change their view about Taiwan’s international status. Right now, Taiwan clearly has de facto independence. Legal, formal independence could change the domestic political outlook in Beijing. But frankly, we don’t see that happening in the medium term.
Hinchcliff: Getting back to talking about the last year and a half or so, everyone knows companies with a strong digital presence really benefited during the pandemic. What is your outlook on how COVID-19 will affect world markets going forward? What risks and rewards do you see as a result of COVID-19 in Asia?
Dali: My guess is over time, populations and policy will migrate from an “eradicate COVID” mentality to a ”living with COVID” mentality. And this means that certain behaviors have probably been changed forever. For example, I believe that the digital economy you referenced has been accelerated and its progress is probably irreversible.
At the same time, that brick-and-mortar economy will need to further adapt in order to just survive. So what that means for Asia is similar to what it means for other geographies. How we work, shop, socialize, communicate, entertain had been forever changed, and the acceleration of the digital economy will create opportunities across industries. We’re going to see new dominant companies. We’re going to see innovation and entrepreneurship flourish.
The risk is that the “living with COVID” mentality could also create victims within certain industries. As consumer behaviors are forced to adapt, the risk is certainly more pronounced within Asian countries that have been slower to respond to the pandemic or were unable to acquire a vaccine. And that’s caused their economic recovery to be significantly delayed.
Now the good news is that the economies that drive Asia’s growth, especially those in North Asia, have largely recovered from COVID and are well on their way to economic normalization.
Hinchcliff: I’m going to switch to talking specifically about our readership at Rethinking65. We’ve really focused on advisors who serve clients 50 and over. There’s a lot of diversity in that group, and I’d like to hear why you think people 50 and older should consider allocations to Asia.
Dali: Well first, you know, I’m included in your readership as someone who is 50 and over. The majority of my personal investments are in the U.S., and I do have a home-country bias.
If I do invest outside the U.S., I typically do it for a couple of different reasons. No. 1, I’m attempting to find higher growth in hopes of higher return. And secondly, I invest outside the U.S. to find something I can’t readily find within the U.S.
Now, to answer your question, I believe, Asia can provide both of those things. Asia’s economic leaders, led by China among the advanced economies including Japan, Hong Kong, Singapore, Korea and Taiwan, are the home of some of the world’s fastest-growing and most innovative companies. These companies can generate earnings that rival the most successful U.S companies, yet most don’t compete with U.S. companies. Investors are able to tap into new and massive domestic markets of Asia, which have the potential to provide earnings support for years to come.
In addition, older investors like myself can find attractive sources of income within Asia. As of today, over 85% of the companies within the MSCI Asia Pacific index paid dividends. So in addition to sovereign and corporate entities, most of which are investment grade, they pay attractive fixed-income rates. So not only do the vast majority of companies pay dividends, but I’m able to find really attractive fixed-income rates versus those available to the U.S.
So my bottom line is that for older investors, Asia has the potential to provide important growth, as well as reasonable income, to combine for a fairly potentially attractive total return. And that combination is pretty difficult to replicate elsewhere outside of the U.S.
Hinchcliff: The next couple of questions go a little deeper into what you’ve talked about already. You mention that you believe innovative companies should be a core allocation instead of a thematic trade. How might the innovation allocation fit into an older person’s portfolio?
Dali: Unfortunately, older investors like myself cannot only rely on income to retire. Interest rates are far too low. We also need sources of growth within our portfolios to generate reasonable rates of total return.
We believe that innovative companies, especially those within healthcare, IT, education services, discretionaries, can be a source of long-term growth within investor portfolios.
Innovation doesn’t necessarily equal excess risk. What I mean by that is a well-diversified portfolio with well-run, innovative companies across industries and quality income-generating businesses in Asia has the potential of generating attractive total returns, with a level of risk, by the way, that’s commensurate with the S&P 500. So I’m not taking asset excess risk to get innovation, especially if I combine it with other quality income-generating businesses.
Hinchcliff: What do you see happening in the U.S. that might result in inflation, and could Asia investments act as a hedge against it, particularly for retirees?
Dali: Obviously, recent inflation data points to broader higher prices across a spectrum of goods and services. We expect the recent step up in prices will hold and such higher prices will remain a reality.
But that said, it’s certainly not our base case that prices and inflation data in the U.S will trend higher at the current pace. We expect interest rates to stay fairly low and fears of inflation to diminish.
That said, if we’re wrong, and the unprecedented historical stimulus leads to persistent inflation, places like emerging markets in Asian equities really could benefit. And the fact is, moderately higher inflation can lead to higher nominal GDP growth, which has been correlated to higher corporate earnings, especially for those with companies with pricing power. Higher corporate earnings over the long term can bring higher equity prices for retirees. The firms buying their equity exposure in geographies and companies that can adapt to inflationary pressures can certainly be beneficial within asset location.
Hinchcliff: So for advisors looking to help older clients invest, what percentage should they think about — a ballpark number — for investing in Asia?
Dali: I believe that 25% to 30% of an investment portfolio should be allocated outside the U.S. Historically, the majority of that international allocation has gone to Western Europe through allocations to EAFE.
At the end of the day, Asian companies to me have much more attractive fundamental metrics: higher historical EPS growth, higher historical sales growth, forecasted higher EPS growth, etcetera. Even return on equity is higher and valuations are lower today.
So the bottom line to answer your question, how much should an older investor have in Asia? I believe your international allocations should still be around 25% or 30%. But only a third of it should be in developed Europe, and two thirds should be in Asia and emerging markets. How you slice up your Asia and EM depends on your current holdings and risk tolerances. But remember the most important part: Active managers like ourselves can create portfolios with both growth and income components.
Hinchcliff: We touched on income before, and you talked about how Asian investments actually do generate a lot of income. I want to talk about that a little bit more. Yields in Asia are approaching zero or negative. For older investors, would you still look at some sort of fixed-income investments or do you think Asian equities with dividend streams are the way to go?
Dali: That’s a good question. The good news is that older investors like myself can still find income-producing investments in Asia, in both equities and fixed income. In Asian equities, I mentioned before that 85% of companies within the Asia Pacific index pay dividends. Dividend yields within sectors like utilities and real estate have averaged over 4%, trailing in the last 12 months. Companies within financials and energy have generated trailing dividends of over 3%.
So there are certainly sectors within Asia and EM that really do pay. And in addition to relatively attractive dividend-paying companies, there’s also a significant choice of companies that are growing their dividends consistently, especially in the consumer discretionary sector. In other words, in addition to dividend payers at reasonable rates, you can also find dividend growers, and that’s really important for total return.
If you like fixed income, many investors might be surprised that Chinese-government bonds are single A+ rated. We think about China as an emerging market, but in reality in fixed-income land, government bonds are single A+ rated or super high investment grade. Many other government and corporate bonds in the region have similar ratings, and yet also provide yields well above U.S. Treasury rates.
I think the bottom line here is that financial advisors for older clients like myself have choices in Asia that can provide attractive income generation or potentially additional capital gains, or both.
Hinchcliff: We have really covered a lot of ground in our conversation, and I want to make sure we’ve covered all the points that you think are important. Is there’s anything we haven’t touched on that you think is important to highlight for our advisor readers?
Dali: I believe that Asia is quickly replacing Europe as the second sphere of influence in global investing. In addition, I believe that most investors are underweight China by almost any metric. To summarize, I believe that the most well-rounded, best-performing, risk-adjusted asset allocation going forward for older investors will have a foundation of investments in the U.S., but they’ll be supplemented by the growth and income-generating markets of Asia, and that’s going to include an increased weight to China. Five or 10 years from now, I think we’re all going to look in the mirror and say, “Oh geez, I should have owned more China,” and the benchmarks are going to reflect that. Anyways, let’s just get there sooner rather than later.
Hinchcliff: OK, that’s great David. Thanks!
Dorothy Hinchcliff is publisher and CEO of Rethinking65.