Could Consumers Change Japan's Tide?

This year, investor attention has focused on Japan and its macroeconomic policy with hopes that rising inflation expectations might spur businesses to invest and consumers to spend. Since Prime Minister Shinzo Abe and Japan's ruling Liberal Democratic Party (LDP) regained power late last year and proposed more aggressive monetary policies, including an ambitious inflation target, the yen has weakened more than 20% against the U.S. dollar and more than 15% against the euro. Over just four months, the Tokyo Stock Price Index rallied sharply with significantly increased trading volumes. Foreign institutions were the biggest market participants, and net buying of stocks by such institutions from mid-November 2012 to early March this year was equal to the sum of foreign institutional stock purchases for all of 2010 and 2011 combined. Retail investors have also returned to Japan, marking notable inflows in recent months.

But could this rally be short lived? While sentiment among large Japanese manufacturers improved for the quarter ending March 31, according to a key economic indicator known as the Tankan survey, it recorded a slightly negative reading. That reading suggests that more of the large manufacturers surveyed hold a pessimistic outlook than an optimistic one.

I recall that when the yen weakened against both the U.S. dollar and euro in 2005, investors were similarly optimistic about a rebound. Japan's GDP expanded 1.3% in 2005, 1.7% in 2006 and another 2.2% in 2007. The single-biggest driver for economic growth then was capital expenditure by Japanese manufacturers. Capital expenditure in manufacturing was up 15% in 2005, 5% in 2006 and another 14% in 2007. Japan's large exporters invested in new technologies and expanded production capacity at home to serve strong demand coming from the U.S. and Europe on the back of a cheaper yen.

However, an economic rebound for Japan this time may have just as much to do with rising consumer spending. Many Japanese exporters have seen their global competitiveness slip and high energy prices also have added to an uncertain business environment. Moreover, end consumer demand is shifting from Western countries to Asia's fast-growing Southeast region. This is a region that also offers low-cost labor and resources that may help in the production of Japanese products closer to home.

When I looked at consumption during recent visits to Tokyo, I was encouraged to find that some major restaurants now seem to be expanding rather than restructuring their businesses. Especially noteworthy is the fact that these industry expansion plans include more Japanese-style pubs known as izakaya, which tend to be sensitive to the overall economic environment. In another retail area, I noticed crowds on a recent weekday evening at a large department store in Tokyo's Shinjuku neighborhood that were bigger than I have ever seen in all my visits over the past 15 years (including weekends). Some may argue that department store traffic is merely a reflection of rising wealth among the affluent. But the most encouraging sign of Japan's recovery has been an all-employee base pay increase at several large basic goods retailers for the first time in four years. Clearly they have heeded Abe's urging for local firms with improving fundamentals to raise worker salaries. If wages in other industries also begin to rise, this would underpin a continuously improving consumer outlook.

Matthews International Capital Management, LLC

You should consider the investment objectives, risks, charges and expenses of the Matthews Asia Funds carefully before making an investment decision. This and other information about the Funds is contained in the prospectus, which may also be obtained by calling 800.789.ASIA (2742). Please read the prospectus carefully before you invest or send money as it explains the risks associated with investing in international and emerging markets. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. Fixed income investments are subject to additional risks, including, but not limited to, interest rate, credit and inflation risks. In addition, single-country and sector funds may be subject to a higher degree of market risk than diversified funds because of concentration in a specific industry, sector or geographic location. Investing in small- and mid-size companies is more risky than investing in large companies as they may be more volatile and less liquid than large companies .

The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Matthews does not accept any liability for losses either direct or consequential caused by the use of this information.

Matthews Asia Funds are distributed in the United States by Foreside Funds Distributors LLC

Matthews Asia Funds are distributed in Latin America by HMC Partners

© 2013 Matthews International Capital Management, LLC. Matthews Asia® is a registered trademark of Matthews International Capital Management, LLC.

Matthews International Capital Management, LLC

Four Embarcadero Center, Suite 550

San Francisco, CA 94111

USA

© Matthews Asia

www.matthewsasia.com

© Matthews Asia

Read more commentaries by Matthews Asia