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Q2 Commentary: As of 30th June 2018

Market summary

Global trade concerns led to increased risk aversion over the quarter. However, Pacific ex Japan equities gained in sterling terms, but underperformed the broader MSCI World index.

The best performing index countries were New Zealand and Australia. The latter was boosted in part by an acceleration in GDP growth to 3.1% for the first quarter compared to 2.4% in the final quarter of 2017. The boost was driven largely by exports of mining commodities, the price of which also added further market support over the quarter.

Hong Kong and China also outperformed. In China the central bank cut the reserve ratio requirement for banks by a total of 1.25% to encourage lending and support growth. However, a combination of slowing domestic growth momentum and global trade uncertainty contributed to weakness later in the quarter.

ASEAN markets were among the weakest index countries while Korea also fell sharply. This was despite positive developments with regards to peace on the Korean peninsula; an Inter-Korea Summit in April saw leaders from the South and North pledge to agree a formal end to the war between the two sides. US President Trump subsequently met with North Korean leader Kim Jong-un in Singapore in June. In Malaysia, the market declined after the unexpected election victory of Mahathir Mohamad’s Harapan alliance ended the ruling coalition’s 60 years in power.

[1] The Association of Southeast Asian Nations (ASEAN) is a regional grouping that promotes economic, political, and security cooperation among its ten members: Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam.

Investment outlook

Following an extended period of low interest rates, the US Federal Reserve continues to maintain a hawkish stance, with further tightening of monetary policy. Rising bond yields and a strengthening US dollar remain potential headwinds for equity markets in the near term in a move towards normalisation. In contrast to previous “taper tantrums”, however, Asian emerging markets generally look better-placed today from a macro perspective. Current account deficits have reduced, with most Asian countries running a surplus. Currencies have already weakened in recent years and inflationary pressures in the region remain benign outside of India and the Philippines. While we may still see “risk-off”-driven selling of assets and foreign exchange [FX] FX in some countries in response to any sharp US dollar moves, we do not expect this to escalate to cause any systemic problems on the ground in Asia.

More recently however, politics and protectionism with escalating trade tensions between US and China have taken centre stage as key drivers of markets and investor sentiment amid a sense of heightened uncertainty. Even with the first set of tariffs having taken effect, our base case remains that a wide ranging, very destructive trade war is not in anyone’s interest, and that the risk from increased tariffs will ultimately prove manageable in the context of overall Asian earnings.

Dividend investing remains relevant, especially in view of heighted uncertainties and risk aversion, given its strong quality bias and some defensive qualities. In Asia, dividends have scope to increase as profitability and free cash flows rise. Structural improvements to corporate governance, aided by regulatory changes in some markets, further underpin longer term rises in dividend payouts.

In terms of portfolio strategy, we continue to be invested across a well-diversified portfolio. We maintain a bottom-up investment approach and we continue to look for good companies where we can see a strong income case and potential for capital growth.

2017 proved a remarkable year for Asian equities, with total returns for regional markets of c.40% in US dollar terms. These have been the strongest returns since 2009 and among the best five calendar-year returns we have seen in the last 30 years. Even more remarkable is that a year ago we were faced with huge political and economic uncertainties. President Trump had been elected unexpectedly in the US, huge uncertainty was created by Brexit and the future integrity of the European Union (EU) was in doubt amid a widespread rise in populist parties. A rallying US dollar, traditionally a headwind for Asian markets, and concerns over North Korea capped off the host of worries.

Given the ‘mixed’ medium term backdrop and aggregate valuations for markets that are above historic average levels, we continue to focus on bottom-up stock selection and picking longer term structural winners, rather than chasing the shorter term momentum in the more cyclical parts of the market. Rapidly shifting business models and trade patterns means that it is more important than ever to look forward at the potential growth opportunities of tomorrow rather than remain anchored in today’s incumbent market heavyweights. We believe there maybe attractive long term growth opportunities in the technology sectors – both hardware and ecommerce – and some of the more domestically-focused service sectors and financials across the region that are benefitting from rising income levels and evolving consumption patterns.

Asia is also home to world class exporters across many other sectors that are benefitting from growth in attractive market niches and, in China’s case in particular, a more competitive renminbi (RMB) exchange rate recently. Although aggregate valuations have risen in recent months as markets have rallied, multiples are not yet at worrying levels and our outlook is that we see long term opportunities in our favoured areas of the markets.

Quarterly overview

The fund (NAV) underperformed the benchmark over the second quarter of 2018.

On a country basis, the main detractor from returns was stock selection in Singapore. Stock selection in Australia and to a lesser extent Taiwan also detracted from performance. Meanwhile, stock selection in China, Thailand and Korea was positive.

Looking at sectors, the main drag on returns came from our stockpicking in information technology. Positive stock selection in real estate, consumer discretionary and industrials failed to offset this.

[1] The Association of Southeast Asian Nations (ASEAN) is a regional grouping that promotes economic, political, and security cooperation among its ten members: Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam.

Discrete yearly performance (%)

	Q2/2017 - Q2/2018	Q2/2016 - Q2/2017	Q2/2015 - Q2/2016	Q2/2014 - Q2/2015	Q2/2013 - Q2/2014
Share price	0.5	26.7	10.3	8.6	0.4
Net Asset Value	4.9	23.8	13.4	8.6	-1.1
MSCI AC Pacific ex-Japan Net TR GBP	8.1	29.3	5.2	7.6	3.7

What are the risks?

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.

Investors in the emerging markets and the Far East should be aware that this involves a high degree of risk and should be seen as long term in nature. Less developed markets are generally less well regulated than the UK, they may be less liquid and may have less reliable arrangements for trading and settlement of the underlying holdings.

The Company invests in smaller companies that may be less liquid than in larger companies and price swings may therefore be greater than investment trusts, companies and funds that invest in larger companies.

The Company holds investments denominated in currencies other than sterling, investors should note that exchange rates may cause the value of these investments, and the income from them, to rise or fall.

The Company may borrow money to invest in further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase in value by more than the cost of borrowing, or reduce returns if they fail to do so.

Investment in warrants, participation certificates, guaranteed bonds, etc will expose the fund to the risk of the issuer of these instruments defaulting. Deducting charges from capital can result in the income paid by the company being higher than would otherwise be the case and the growth in the capital sum being eroded.

As a result of the fees being charged partially to capital, the distributable income of the Company may be higher, but the capital value of the Company may be eroded.

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Schroder Oriental Income Fund Limited

"While by no means universal, many Asian companies are increasingly focused on dividends as a substantial contributor to shareholder returns."

Matthew Dobbs

Asian Equities Fund Manager and Head of Global Small Cap

Q2 Commentary: As of 30th June 2018

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Quarterly overview

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