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Schroder AsiaPacific navigates a volatile year

Schroder AsiaPacific Fund has announced its final results for the year ended 30 September 2018. Its chairman, Nicholas Smith, says that, during the year, “the Company retained the gains made in the two prior exceptional years, despite difficult market conditions generally”. The NAV produced a positive total return of 4.2%, very slightly trailing the benchmark, which returned 4.4%. The fund’s share price also produced a positive total return of 2.2%. The manager’s review describes a volatile year.

Modest progress disguises a volatile year

The manager’s review provides the following commentary on performance and the market backdrop:

Echoing the Chinese curse, it has been an interesting time in Asian markets over the year. Modest overall progress in both sterling and local currency terms for the Benchmark disguised considerable volatility over the period, not least in the value of sterling. A recovery in the pound on Brexit optimism in late 2017 largely cancelled out local currency strength in regional markets; conversely in the second half of the fiscal year sterling’s retracement masked significant weakness in underlying indices in 2018.

The reasons for the second half weakness will be familiar to many shareholders. Foremost was the rapid deterioration in Sino-US relations, with initial assumptions that this represented a mere trade dispute giving way to realisation of much more fundamental differences. Rising US interest rates, a stronger dollar and tightening credit conditions also contributed to downbeat sentiment across the whole region, allied to signs of economic slowdown in developed markets outside the US, emerging market volatility (Turkey, Argentina), and fading momentum in global trade.

The slowing of economic activity in China was a particular focus. To an extent, this is the result of a deliberate policy on the part of the Beijing authorities to rein in credit growth and instil greater investment discipline, partly through a shift towards the private sector and away from government-led infrastructure spending. However, a more hostile global environment has injected an unwelcome degree of uncertainty surrounding a soft landing in the region’s most important economy.

Unsurprisingly, amongst the major regional markets, China has underperformed, while other North Asian markets such as Hong Kong and Korea clustered near the average. Emerging ASEAN (Association of South East Asian Nations) markets have been among the more striking outliers. Both the Philippines and Indonesia experienced considerable currency weakness. In Indonesia’s case, the chronic current account deficit and heavy selling of bonds by overseas investors were the key factors, while weakness in the Philippine peso and stock market reflected an over-heating economy and insufficient policy tightening from the central bank, the BSP. In contrast, investors welcomed the return of Mahathir Mohammed (aged 93) as prime minister of Malaysia, ending over 60 years of UMNO-led coalition government. Thailand benefited from a strong energy sector and its defensive nature given a sizeable current account surplus. Similarly, solid external finances and attractive dividend yields supported Taiwan.

Manager’s commentary on performance and portfolio activity:

“It was a mixed year for the Company’s relative performance. After a solid first half, there was a reversal in the summer as quality growth stocks sold off, including in the China “A” share market where tight liquidity and US grandstanding undermined investor confidence. For the year as a whole stock selection was positive in Hong Kong, China and Taiwan, offset by shortfalls in India and Thailand. The Australian exposure was helpful, as was the underweighting in China, the Philippines and India.

In terms of portfolio positioning, the Company remained underweight China, exposure to which was reduced over the year. Hong Kong has remained a significant overweight, and we moved to an overweight stance in Korea. Key underweights include Taiwan and most of the ASEAN markets apart from Thailand. Key sector overweights include consumer discretionary, information technology and real estate, offset by underweights in consumer staples and telecoms.”

Manager’s outlook commentary

“Arguably all purely financial forecasts and considerations are trumped (pardon the pun) by major, and by their nature unpredictable, political considerations. The most significant is the breakdown in relations between the US and China, which goes far beyond mere trade considerations. However, other imponderables include whether Italy will ever have the political will to do what it takes to create a competitive economy, Brexit, and (in our mind of very fundamental global import) whether the Chinese leadership hold the line accepting lower trend growth as the price for long-term financial sustainability.

Some or all of these issues may be amenable to at least short-term outcomes that are better than the consensus would suggest. However, the global economic and financial fundamentals are troubling, namely, an unbalanced growth picture (US vs the rest), tightening liquidity, and the rising risk of more systemic financial shocks resulting from mis-priced risk eg. loan funds, peer-to-peer lending, ETFs, remarkably low spreads in the high yield market, and multi-layered “risk free” infrastructure funds.

A stronger dollar, rising interest rates, trade tariff pressure from the biggest bilateral trade partner, and related faltering in investor and corporate confidence are not a great combination for the relatively trade-dependent and open economies of Asia. In general, the vulnerability to external financial shocks are lower across the region, certainly when compared with the 1997/98 crisis, and also with 2013 as markets became frightened by the prospect of the end of Western monetary easing.

We have made few changes to the portfolio’s positioning based on pure tariff considerations, not least because we have never been keen on low margin labour cost arbitrage business models which will be most disrupted by tariffs. Our focus has, and will remain upon, value-added players in what are complex supply chains that are unlikely to be easily substitutable, particularly in the US where labour constraints and skills shortages are becoming increasingly apparent.

Of greater concern are the prospects or otherwise for a smooth transition to a lower, but more sustainable, growth model for China. Our central view remains that the authorities can manage a soft landing consistent with their desire for a less credit-intensive growth model. Attacks from Washington are certainly not making the process any easier. However, it is also being made more complicated by less favourable country-specific factors including marked erosion in the current account surplus, elevated levels of domestic credit, and increasing vulnerability to capital leaving the country. Combinations of expanding the money supply, a modest rise in government spending and a gradual depreciation of the Renminbi accompanied by discouragement of capital outflows may still do the trick, but in our opinion scope for a more marked stimulus package looks limited.

Having said all that, regional markets are within a few per cent of the valuation lows seen in late 2015/early 2016, suggesting that investor caution is already elevated. A destabilising event in China remains a possibility rather than an imminent likelihood, and some progress on US/China relations is not out of the question. Consequently, the Company remains very modestly geared, and we also take comfort from the fact that, at least across the companies held in the portfolio, we consider that cash flows are robust and balance sheets generally in good shape.”

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