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Market Commentary

An Asia-Pacific Equity Portfolio Tilt
December 10, 2012  Bill Witherell, Chief Global Economist and Portfolio Manager

Last summer the Obama administration announced a “tilt” towards Asia, that is, a strategic rebalancing of US military forces to the Asia-Pacific region. Meanwhile, at Cumberland Advisors we have recently rebalanced our international and global equity ETF portfolios toward the Asia-Pacific region (with the exception of Japan). We discuss this shift and its rationale below.

The global economy is expected to grow at a somewhat more rapid annual rate of 3.5% next year, as compared with 3.3% in 2012. The emerging-market and developing countries of the Asia-Pacific region will likely be the global growth leaders. The World Bank projects 7.6% economic growth for “East Asia and Pacific,” centered on a return of China’s growth to above 8%. The advanced economies in the region, on the other hand, will register growth rates at or below the global average (Singapore 3.5%, Hong Kong 3%, Australia 2.6%, New Zealand 2.5%, and the one significant weak spot, Japan, at 0.7%.). Asia-Pacific equity markets should also benefit from benign inflation, improved earnings, and generally attractive valuations.

We closely monitor 42 economies in order to develop our global investment strategies. In addition to economic growth, we give considerable weight to the quality of governance and to factors affecting the international competitiveness of these economies. We are developing a ranking of these countries that seeks to bring all these elements together. While this is still a work in progress, it is noteworthy that in our preliminary ranking, eight of the twelve top positions are economies in the Asia-Pacific region: Korea, Taiwan, Malaysia, Australia, China, Thailand, Singapore, and Indonesia. These are countries that over the medium to long term appear to be attractive places in which to invest. The other four in our preliminary top 12 are the United States, the United Kingdom, Canada, and India. Japan is ranked 15th, the Philippines 17th, and Hong Kong 24th.

The mounting evidence that the Chinese economy has indeed turned the corner, including the rise in the November PMI index, is central to the improved outlook for the region. China, which has the world’s second largest economy, accounts for 45% of the region’s exports. While those exports have been hurt by the recession in Europe, they have been sustained by continued demand in the United States and within the Asia-Pacific region. The November export orders index rose to a six-month high. Within China, domestic orders, retail sales, and fixed-asset investment have all strengthened and profits have improved. International investor sentiment toward China is getting better. The new leaders of the Chinese government have shown promising signs that they will pursue responsible policies that will be conducive to a sustained revival of the economy and reforms that will improve the quality of growth.

Following several years of underperformance, Chinese equities – or to be more precise, the shares that are investible by foreigners, mainly the so-called H-shares listed in Hong Kong – have risen by some 18% over the past three months. We expect this outperformance to continue in 2013, not only because of a quickening pace of economic activity but also because Chinese shares are at a 20% discount to the emerging-markets benchmark.

The US-based ETF investor is fortunate to have a wide range of alternative ways to gain access to the Chinese market. Setting aside the leveraged and inverse ETFs, which we do not use, there are currently 19 Chinese equity ETFs on the US market and one ETN. A number of these are rather new and/or have limited liquidity. Our favorite continues to be the SPDR S&P China ETF, GXC, which provides the broadest diversification across all investible Chinese shares and is highly liquid, with a market capitalization of $960 million. We also use the largest China ETF ($7 billion market capitalization), the iShares FTSI China 25, FXI, which holds shares in 25 of the largest and most liquid Chinese companies listed on the Hong Kong Stock Exchange. Financial firms account for almost 60% of FXI’s holdings, as compared to 32% in the case of GXC. The very dynamic small-cap sector in China can be accessed with the Guggenheim China Small Cap ETF, HAO, (market capitalization of $264 million), which invests in companies with a market capitalization of less than $1.5 billion. Also of possible interest is the Global X China Consumer ETF, CHIQ, with a market capitalization of $150 million.

Many economies, particularly those in the Asia-Pacific, have become dependent on developments in the Chinese economy. They are now benefitting, and will continue to benefit from in 2013, the rebound in the Chinese economy. Korea, where exports have recently begun to strengthen, is a case in point. Domestically, we expect Korean business capital investment to pick up as the external outlook improves. Korea’s economic growth should return to the 3.5-4% range in 2013. The iShares MSCI South Korea ETF, EWY, is up 15.7% so far this year, 2.8% in the last 4 weeks. It is important to note that in this ETF one company, Samsung, accounts for 22.6% of the holdings.

Economic growth in Taiwan also should return to the 3.5-4% range next year. Recently, the Taiwanese stock market has been bolstered by a government statement that it will undertake measures to bolster equity prices. The iShares MSCI Taiwan ETF is up 16.8% year-to-date and 6.1% in the last four weeks alone. Information technology firms account for about 55% of this ETF’s holdings, and thus its performance is significantly affected by the US technology market.

There are two markets in the region that have performed very strongly this year and were doing so well before China’s economy started to rebound: the equity markets of Thailand and the Philippines. Both of these economies appear likely to register economic growth rates of better than 5% this year. We expect the Philippines to continue to grow at a similar rate next year, while the Thai economy appears to be slowing somewhat. The iShares MSCI Thailand Investible Market ETF, THD, is up an impressive 30.6% year-to-date and 3.6% over the past four weeks. The iShares Philippines Investible Market ETF, EPHE, has surged by 45.4% year-to-date, including a 6% advance during the last four weeks. In both cases a pause in these advances would not be surprising, but their medium-term prospects remain attractive.

In contrast to the above two economies, there are two others in the region whose equity markets are laggards: Indonesia and Malaysia. This is despite both countries having strong economic growth prospects for 2013 – 6.3% for Indonesia and 5% for Malaysia. Indonesia has fared the worst. The Market Vectors Indonesia ETF, IDX, is essentially unchanged for the year to date, at +0.25%, and declined over the past month by 2.5%. The other Indonesian ETF, the iShares MSCI Indonesia Investable Market Index Fund, EIDO, has registered a modest year-to-date increase of 2.4%, but it has also declined over the past four weeks, by 2.9%. These recent declines occurred despite the better news out of China. Indonesia is experiencing weakness in its exports and unfavorable terms of trade, and its declining equity market could well trigger a reversal of international portfolio flows. Malaysia’s equity market has done a little better. The iShares MSCI Malaysia ETF, EWM, is up 9.9% for the year to date, while off 1.9% over the past four weeks. It has been trending upward since November 27th, which suggests it is somewhat more sensitive to developments in China.

Turning to the advanced markets in the region, with the exception of Japan we are attracted to their sound economic policies and the quality of their governance. Australia, New Zealand, Singapore, and Hong Kong are all equity markets in which we would tend to maintain investment positions over the long term. Of the four, only Australia looks likely to have somewhat slower economic growth in 2013, although this prospect could well improve with more rapid growth in China. The iShares MSCI Australia ETF, EWA, is up 17.4% so far this year and up 1.9% over the past four weeks. The small equity market of New Zealand has had a good year so far. The iShares MSCI New Zealand ETF, ENZL, is up 27.7% year-to-date, with a 2% advance in the past four weeks.

The Singapore economy declined in the third quarter, with electronics and financial services looking particularly weak. We expect the economy to bounce back in the coming months. The iShares Singapore ETF, EWS, has registered a solid 25% gain so far this year, including a 2% gain in the past month. Hong Kong is now part of China, of course, but its equity market remains somewhat separated from the mainland China markets. The Hong Kong equity market is strongly influenced by developments in China and also by its high-flying real estate market. The iShares MSCI Hong Kong ETF, EWH, has advanced by 24.4% year-to-date, but has been flat in the last month, eking out only a 0.2% gain.

Finally, for the Asia-Pacific, we have the third largest economy in the world, Japan, with the region’s largest equity market. Japan, still not out of a twenty-year slump and burdened by ineffective governance and ineffective central bank policies that have led to an inappropriately strong currency, together with adverse demographics and natural disasters, has not been able to engineer a sustained economic recovery. There are hopes that a new government – a likely outcome from the forthcoming election – will be able to get the economy and financial markets operating at a healthier pace, with a significantly weaker currency. Indeed, it is the future rate of the yen that will largely determine the level of Japanese equity prices. We will stay on the sidelines until there is some convincing evidence of real progress. Our current projections are for economic growth rates of less than 1% next year and in 2014 as well.

The $4.5 billion iShares Japan ETF, EWJ, has recently picked up along with the hopes for a new government and weaker yen in the coming year, advancing 2.7% in the past four weeks. That is about the same as its year-to-date gain of 2.6%. US-based investors have several other reasonably liquid Japanese ETFs to consider. The Precidian MAXIS Nikkei 225 ETF, NKY, is up 6.4% year-to-date and 2.7% in the last month. The WisdomTree Japan SmallCap ETF, DFJ, advanced 3.4% year-to-date and 1.9% in the last month. An interesting alternative to the above three is the WisdomTree Japan Hedged Equity Fund ETF, DXJ, which provides access to the Japanese market while hedging exposure to fluctuations between the value of the US dollar and Japanese yen. This ETF has achieved a 7.5% advance year-to-date and 4.8% in the last month.

Bill Witherell, Chief Global Economist and Portfolio Manager

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