Asia Insight

April 2008

Sound and Fury

Andrew Foster
Acting Chief Investment Officer and Portfolio Manager
Matthews International Capital Management, LLC

Liquidity has been in short supply in American capital markets, with disastrous consequences for some banks, borrowers, lenders and investors. Yet even as liquidity has been scarce, there has been a corresponding abundance of speculation as to “what all of this means” for the future. Pundits have emerged from every corner, keen to establish their views on the root cause of the damage, its extent and its impact on growth. Some suggest the domestic economy is poised for a deflation-driven recession; others see stagflation on the horizon; and many more predict the further demise of the U.S. dollar. A few market veterans have declared that current conditions constitute the worst financial crisis in six or seven decades.

I have no intention to dispute such arguments, or to present a rosy case for investment. Indeed, the evidence from the U.S. housing market is bleak, and it is reasonable to expect that such conditions will persist some while longer. It is also possible that any number of dire predictions may come to pass. Nevertheless, I believe that during times of distress such as the present, it is critical that investors do their utmost to separate fact from speculation, and evidence from estimation. Though some prevailing commentary comes from astute sources, the aggregate chatter has nonetheless risen to a deafening level. As investors, we all struggle to make sense of the marketplace—none of us wishes to be caught flat-footed, outside those “in the know.” But what does anyone really know at this juncture?

How will the housing sector impact the broader economy? Are we headed into recession? Have we already entered one? Can growth in other segments of the U.S. economy offset weakness in housing? What are the ramifications for global growth or for Asia’s “decoupling?” It is important to strive to answer such questions, but to also recognize that no one possesses factual answers—at least for the moment. It is tempting to form views based on the speculation of others; however, the complexity of the modern economy makes consistent prediction about it’s future beyond any individual’s foresight, no matter the caliber of the forecaster. At best, the most talented minds in the world might comprehend only a few aspects of the multifaceted U.S. economy. Meanwhile, the danger is that the cacophony of perspectives may grow to such a crescendo that it deters investors from otherwise practicing a disciplined approach toward longterm investment.

During times such as these, I find it useful to remind myself of what I do know, based on evidence and personal experience, versus what I may have envisioned, based on conjecture or extrapolation. By returning to such “fundamentals,” I often achieve greater clarity. In this vein, I would offer some of my own experience for contemplation. I have lived and worked in Asia. I have lived and studied in Europe; and I was raised and now work in the U.S. Having done so, I can state that in my experience there is no large economy on earth that is more flexible and adaptive than that of the United States.

Given where I work, it is obvious that I hold the Asian economies in high regard. Nevertheless, based on my own experience, the U.S. economy’s ability to adapt is one of its singular strengths. I have not witnessed an Asian or European economy that is its match in this regard. Further, it is my experience that America’s flexibility will serve it well, particularly in times of distress, provided that it is not hamstrung by excessive government intervention. The facts have already begun to bear out my anecdotal experience. Even as the dollar has declined on the back of housing-related woes, the U.S. export sector has accelerated. The trade deficit, which was considered by many commentators to be a disastrous imbalance and the country’s Achilles heel, has subsequently improved¹. The U.S. economy has demonstrated it is not a “one trick pony,” even as some are keen to suggest that the housing market comprises a new source of doom.

Historical perspective offers a second basic insight: Though the market’s current mood may feel new and ominous, we are (unfortunately) in familiar territory. That is to say that the U.S. economy is currently traversing the downside of a credit cycle. The causes and the culprits and even the acronyms are different this time around; but at the end of the day, we are watching a credit cycle unravel. In this sense, there is nothing particularly new about the market’s behavior—we have, for better or worse, been here before. Some try to drum up intrigue (and book sales) by declaring “what it all means;” but for those that would rather look to the facts, there are plenty of lessons to be drawn from recent credit contractions, including the savings and loan crisis of the 1980s, Japan’s bust in 1989, or the Asian financial crisis of 1997.

A simple reading of the latter two episodes offers an important lesson for the present. That is that when markets contract near the end of a credit cycle, it is far better to allow them to clear, even if that should mean sharp volatility, rather then to support them in an artificial fashion. To be sure, Japan and Asia’s credit cycles were very different from one another, as well as from the current U.S. cycle. Still, all three cases share in common a point of market inflection, during which prices needed to drop in order to clear. In Japan’s case, banks faced massive losses on overextended loan portfolios; in Asia, currencies were the crux of the dislocation.

When Japan’s banks faced their moment of inflection, they flinched, refusing to incur large-scale credit write-offs. Local regulators abetted, allowing the banks to limp along, hobbled with too little capital to be solvent, and with balance sheets too stretched to finance the country’s growth. The economy weakened as a result and deflation ensued. Because the markets had not cleared, and the mechanism for credit transmission was broken, little helped to lift the economy out of its persistent stagnation—not even interest rates set at zero by the Bank of Japan.

Asia followed a very different path. As crisis struck, regional leaders found themselves under immense pressure to keep their currencies floating, and to accept the austerity that would follow severe currency weakness. While it is debatable whether this course of action was the only viable one, the region had little choice. It generally lacked the financial resources to follow any other path. Asia’s currencies suffered sharp declines, and domestic economies contracted as excess consumption was wiped out. I lived in the region during this time, and it was a very painful period. However, there was one important consequence of this pain: because the market was able to clear, the region was growing again about 18 months later. This came despite predictions of many pundits who consigned Asia to a decade of recession. As we know, the region has since gone on to produce higher standards of living and greater economic progress.

In my view, there is no simple prescription for the U.S. credit cycle, except to allow markets to work. If growth falters along the way, the flexibility of our economy should prove its greatest asset. However, if markets are prevented from clearing, history would suggest that the economy may be slow to recover. In this context, the Fed’s partial rescue of Bear Stearns² is an ambiguous event—shareholders have lost a great deal, but most creditors have been bailed out. Investors must determine whether the Fed’s actions have encouraged markets to resume their proper function, or whether the Fed has only sustained the unsustainable. Evidence from Japan indicates that even very low interest rates are not enough if markets do not clear. Yet for investors with a long-term focus, there is one “bright side” to the current market that is rooted in mathematical fact: it is always far better to buy stocks at lower prices than higher ones.

¹ The changes in exports and the trade deficit noted above have been measured on a seasonally adjusted rolling 12-month basis. Source: U.S. Census Bureau.

² Matthews Asian Funds hold no positions in Bear Stearns.

April 7, 2008

The view and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investments vehicles.