For the quarter ending March 31, 2017, the Matthews Japan Fund (Trades, Portfolio) returned 7.38% (Investor Class), outperforming its benchmark, the MSCI Japan Index, which returned 4.64%.
Market Environment:
Japan’s equity markets advanced modestly on a U.S. dollar basis during the first quarter, due to a strengthening yen. Markets seem to have tempered somewhat lofty expectations of the Trump administration’s ability to enact new economic policies. The yen strengthened by 5.03% against the greenback during the quarter despite a rate hike by the U.S. Federal Reserve. This reflects lower inflation expectations in the U.S. and resulted in profit taking activity, particularly in sectors like financials.
Meanwhile, Japan’s economy is chugging along. Purchasing manager indices globally have been improving since the middle of 2016, and global trade volume has been picking up. Japan has reported stronger-than-expected export figures in recent months, resulting in upward revisions for 2017 GDP growth estimates. Japan’s labor market conditions have grown even tighter, with unemployment at 2.8% in March—its lowest level in 23 years. This is leading to stronger wage growth for part-time workers, particularly in urban areas.
Performance Contributors and Detractors:
During the quarter, the Fund managed to make up for its underperformance versus the benchmark in 2016 thanks to stock selection in the industrials and consumer discretionary sectors. Suzuki Motor (TSE:7269, Financial) was the top contributor to returns as investors shifted toward auto makers with less exposure to the saturated U.S. markets. Suzuki derives the vast majority of its profits from India where automobile sales remain robust. Technical staffing company TechnoPro also advanced, supported by solid growth in its stable of professional engineers. Utilization of its electrical and mechanical engineers remains high due to strong demand from Japanese manufacturers.
On the other hand, our holdings in the materials sector performed poorly. W-Scope (TSE:6629, Financial), a leading producer of separator films used for lithium-ion batteries has corrected due to fears of potential oversupply from Chinese manufacturers. Additionally, newly added SoftBank (TSE:9984, Financial), a telecom sector holding, saw profit-taking as investors appear to be waiting for the formal announcement that it has closed the first round of investment in its US$100 billion investment fund, the Softbank Vision Fund.
Notable Portfolio Changes:
During the first quarter of the year, we re-initiated a position in Shin-Etsu Chemical (TSE:4063, Financial), a specialty chemical company that holds leading market share in silicon wafers and PVC resins. Semiconductor output is steadily climbing and poised to further accelerate as China expands its own chip-making capacity. At the same time, the supply of high-end silicon wafers has been limited, raising the prospect of price hikes. We also added Oracle Corp. of Japan, the local listed subsidiary of U.S. based Oracle. The firm’s cloud-based services are poised for accelerated growth as it furthers its partnership with local system integrators.
To fund these new positions, we eliminated our holdings in Toyota Motor and Mitsubishi Heavy Industries. Toyota is facing more stress as U.S. automobile sales are believed to have peaked while markets like the Middle East and Southeast Asia, where the company has a dominant presence, remain weak. Additionally, falling used car prices weigh on the residual values of its finance business. Mitsubishi Heavy Industries has conducted some restructuring of its massive business portfolio, but the results have been underwhelming as the shipbuilding business continues to weigh heavily on earnings. Commercial aircraft development has also been saddled with numerous delays.
Outlook:
We remain upbeat on the outlook for Japanese equities. Though share price performance year to date has been somewhat lacking, we believe economic fundamentals are headed in the right direction. Absent any sharp moves in currency rates, we believe corporate earnings in Japan will see solid growth this year. Japan’s tight labor market is setting up nicely for potential accelerated wage growth. Within that backdrop, our focus remains on finding unique Japanese companies based on a bottom-up fundamental approach.
The views and opinions in this commentary were current as of March 31, 2017. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the Fund’s future investment intent.
Statements of fact are from sources considered reliable, but neither the Funds nor the Investment Advisor makes any representation or guarantee as to their completeness or accuracy.
As of 3/31/2017, the securities mentioned comprised the Matthews Japan Fund (Trades, Portfolio) in the following percentages: Suzuki Motor Corp. 2.7%, TechnoPro Holdings, Inc. 2.3%, W-Scope Corp. 1.1%, SoftBank Group Corp. 2.0%, Shin-Etsu Chemical Co., Ltd. 2.0% and Oracle Corp. Japan 1.4%.The Fund held no positions in Toyota Motor Corp. or Mitsubishi Heavy Industries, Ltd. Current and future portfolio holdings are subject to risk.
