Crouching Tiger, Hidden Profit

A look at Korea's success in navigating crises and the challenges it faced to grow into one of the wealthiest economies in the region.

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The recovery in Asia ex-Japan equities that began toward the tail end of the first quarter gained momentum in the second quarter. The second quarter's rally was broad based but the appreciation in the financial sector was particularly noteworthy and an important contributor to the relative performance of the Fund.

Since the [Matthews Pacific Tiger (MAPTX)] Fund's inception, one of its key strategies has been to pursue growth from the region's domestic consumption. As a result of this approach, the portfolio's holdings have proven to be more resilient in the current downturn than some of their peers. The earnings performance of the Fund's holdings has largely met expectations; such steady performance exceeded the low expectations that were embedded in stock prices at the start of t

he year.

Retail sales-a key barometer of household consumption-has demonstrated positive growth so far this year, particularly in markets like China, India and Indonesia. Consumer-related companies seem to be benefiting from relatively more stable demand from smaller cities and rural areas. Some of this rural growth is being driven by direct government subsidies and may not be sustainable over the long term. At the same time, rural income has also been bolstered by the price of agricultural commodities, as well as other measures including improved availability of credit, enhanced property rights and overall economic growth. The strength of Asian economies located outside metropolitan areas is a sign that those economies have greater depth. That fact has probably surprised some in the investment community who have been fretting about the region's dependence on exports.

That said, the challenges resulting from shrinking export demand are intense, but not insurmountable. As we have highlighted before, the response by Asian governments to the current economic challenges is very different when compared with the Asian financial crisis-this time, most governments have tried to enact measures to stimulate their economies. Furthermore, the execution of these measures has been more decisive than in other regions of the world. Most notably, China has experienced sharp recoveries in its real estate and automobile industries, facilitated by increased bank lending.

The surge in commercial bank lending in China also merits close attention. There is concern that non-performing loans will spike in coming years if today's loans are not deployed in a productive fashion. Against this backdrop, it is worth noting that although the Fund has carried a 12% weight in Chinese/Hong Kong financials, we have been selective when investing in commercial banks. China Merchant Bank (CMB) is the only Chinese/Hong Kong commercial bank in the portfolio and is more oriented toward retail loans. CMB's management has been cautious in expanding their loan portfolio in the current environment. In fact, during the current phase of heady growth in loans, CMB has lagged the rest of the industry. This gives us some comfort that the quality of CMB's loan portfolio will be superior to its peers over the long term.

Political events also impacted the markets in the region-some were more transient than others. The relations between China and Taiwan received a fresh impetus with the largest Chinese wireless company seeking a stake in a Taiwanese telecommunications company. This is the first instance in recent history of a direct investment by a mainland Chinese company in Taiwan, and may be a precursor to greater integration between the two economies. Meanwhile, the favorable outcome of general elections in India and Indonesia catalyzed the equity markets in both countries-which were among the best performing in the region this year. The Fund's exposure to these countries helped the relative performance of the portfolio. The portfolio has maintained greater exposure to both India and Indonesia compared to the benchmark, while having less exposure to Taiwan relative to benchmark. This decision was not predicated on forecasting political outcomes but on the investment merits of secular earnings growth, and the potential of the domestic markets.

The recent rally in Asian markets has also been a result of a surge in inflows to the region as investors have not only recognized the excellent fundamentals of Asia's companies, but also have increased their appetite for risk. To the extent that investors are chasing short-term performance, some of these flows may be temporary, and stock markets may take a turn for the worse. However, we intend to remain fully invested and will continue to invest for the long term.

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