Market Review
The benchmark MSCI AC Asia Pacific ex-Japan declined -8.2% during the fourth quarter of the year.
What a difference a few months can make. In our Q4 letter we had to report the pressures some emerging markets are under, including most of the Asian countries under our coverage – and a few weeks later things are looking a lot better. The degree of progress in China-US trade relations continues to be the main pace setter for global market sentiment, and it is noticeable that the Chinese have been redirecting imports from other suppliers to US sellers (e.g. soybeans). While a comprehensive trade agreement is still some way off, markets are no longer discounting the adverse cliff scenario. Regardless of that timing, the trend of investment, manufacturing and trade re-routing from North to South Asia will not be reversed, providing investment opportunities across the region.
Performance Review
The strong absolute and relative outperformance of the NESTOR Far East fund was driven by positions across the portfolio, with a particular contribution made by Chinese e-commerce and Southeast Asian consumer names. Performance detractors were primarily Myanmar equities.
On average, 2018 financial results of companies in the portfolio came in exactly in line with market expectations. Looking back throughout the year, we observed strong revenue growth, with commensurate but relatively weaker profit growth – reflecting last year’s story of currency headwinds and rising inflationary pressures in selective markets. As we wrote in the last letter, these pressures appear to be abating. We thus now have less reason to doubt profit forecasts for the region for this year.
Outlook and Strategy
In the current market, the signals are very much that short-term rates may have peaked, and long bond yields are inching lower. Despite concerns about yield curve shifts signaling a potential recession in the US according to observers, we see these developments as positive, not negative for emerging markets.
It is the absolute level of the risk free rate and alternative “safe” developed market investments in US Dollars and Euros that are the main competitors to an allocation into Asian capital markets. If the Republic of Indonesia today can issue 10yr paper in US dollar at around 4.5%, this is largely because investors are looking for a premium over the risk-free investment, e.g. 5-10 year US Treasuries below 3%.
A minor US slowdown and continued low long-term yields are not inconsistent with positive performance of equities in our region, which benefits from many long-term secular trends, and valuations in particular among small-caps are the opposite of expensive to begin with, in particular in China and the Philippines.
Counterintuitively, a booming US economy that results in a stronger Dollar could be potentially negative for the emerging markets investment case. High US treasury yields certainly would be a challenge for most emerging market bond portfolios, thus raising the cost of capital on equity markets. A light US recession thus need not be bad either, so long as it’s accompanied by low interest rates and low bond yields.
We are thus very constructive on our universe and see our portfolio of thematic ideas well positioned.
Further, the recent news of the water shortages in Manila highlight an important aspect of our investment approach. Investments into the water theme have produced strong returns for the fund so far, but there are much broader aspects to consider. Due to its size, Asia will be the decisive battleground not only for climate change, but localized environmental challenges, foremost water. We see significant economic benefits as a long-term equity holder in incorporating sustainability concepts into the investment process – something we have been doing since inception.