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Commentary and Review by portfolio manager Edmund Harriss

August 2011

Asia

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Despite recent market volatility, some of the peripheral Asian markets have per-

formed relatively well. There are parallels between the 1997-98 Asian crisis and

current events in the Eurozone, where peripheral nations have become over-levered

with foreign capital as a result of fixed exchange rates. Thailand, which was the epi-

center of the 1997-98 Asian crisis, has survived this process and is now prospering

as one of the most attractive markets for equity investors in Asia. Good economic

data and a recent election offering a clear win for the opposition bring hope of a

new beginning for Thailand.

Highlights

Market Review

Market Outlook

China Economic Monitor

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ASIA BRIEF 2

Highlights

Amidst the volatility of recent weeks in equity markets, some of the smaller markets, such as Thai-land, Indonesia and the Philippines have been surprising outperformers. These markets are seen as marginal by a lot of equity investors, and they have very low weightings in the regional equi-ty benchmarks. At the end of July these three nations only accounted for 9.22% of the MSCI Far East ex Japan index, which is used by many investors to measure their exposure to the Asian re-gion. Thailand accounts for less than half of the weight of the three, but it is arguably one of the most interesting markets in the region. Thailand is a microcosm for just how far Asia has come since the crisis of 1997-98, and its political outlook looks better than it has for some years, with a peace-ful transition of power to the Puea Thai party after their election victory earlier this year. Its eco-nomic outlook is also sound, with the country having clawed its way back from the brink in 1997.

During the Asian crisis of 1997-98 Thailand was in a similar position to the marginal Eurozone nations of today, such as Greece, Ireland and Portugal. It was at the end of a relatively long pe-riod of expansion in its output, and it was suffering the painful consequences of financial adjust-ment. One of catalysts for its situation was its fixed currency regime, where its currency, the Thai Baht, was pegged to the US Dollar. This had given foreign investors the confidence to invest their money in a relatively small country, with the knowledge that the value should be some-what “protected” by reference to the US Dollar. Against a background of strong economic growth, foreign investors were only too happy to lend their money to growing companies in Thailand.

However, this situation encouraged an unhealthy dependence on foreign capital in Thailand in the mid-1990s, and foreign liabilities reached an unsustainable level relative to economic activity in Thailand and Thai ownership of foreign assets. In addition, a maturity mismatch developed between the funds being advanced and the projects being financed with that money. In Thailand’s case, there was too much short-term money being used to finance investments that would have a long-term payoff, such as capacity expansion by firms, property and infrastructure spending. The Thai Baht depegged from the US Dollar on July 2, 1997, and this helped to precipitate a financial crisis in Thai-land, which then spread around the region as confidence fell in the emerging Asian growth story. In order to slow the outflow of capital from Thailand, interest rates were increased to keep capital onshore, but this served to further increase investor concerns about future economic growth, and added fuel to the fire. With excess foreign liabilities, slowing economic growth and financial volatil-ity, the country and its banking sector were forced to restructure and recapitalize. 1998 was a painful year for Thailand, and its GDP (Gross Domestic Product) contracted by 10.50% in real terms that year.

Fast forward to today, and the outlook for Thailand is better than it has been for some years. It re-corded positive real economic growth every year between 1998 and 2009. The nation deleveraged sharply over the last 14 years, allowing its exchange rate to float and building its foreign currency reserves to avoid over-dependence on foreign capital. Thailand has some natural advantages over its peers in Asia, with decent reserves of natural resources, such as gas, and a good baseline of food supply, with a decent rice surplus, making it one of the world’s leading rice exporters. Thailand has also been able to move up the value chain in electronics, autos and industrial goods, and has been a favored location for both Japanese and Taiwanese firms looking for exposure to South East Asia.

Thailand grew its GDP at a rate of 7.80% in 2010, which was extraordinary following the financial dislocation of 2008-09. This highlighted the extent to which Thailand had managed to separate its growth from the developed world and to reorient itself towards China and the rest of Asia. 2011 is shaping up to be a slower growth year, but the country still managed 3.00% real annualized GDP growth in the first quarter of the year. The banking sector is now relatively well capitalized, unem-ployment is low, and the trade balance is healthy at $1.88 billion as at the end of June. The country also has foreign currency reserves of $187.64 billion at the end of July, which is substantial com-pared to 2010’s GDP of $318.85 billion. Thailand is also benefiting from the middle-class growth story seen elsewhere in the region, where improving economic conditions help to spur consumption growth. Retail sales growth has been in double digits every month this year against the same month of last year, while car sales were also reasonably strong at 72,902 units in July.

From a foreign investor’s point of view, probably the biggest fear about Thailand relates to political uncertainty. June’s elections passed by without violence, and there was a clear result in favor of Puea Thai, which allowed a new government to be formed quickly. However, there is still uncertainty over how populist the new government will be and whether there will be policies to transfer wealth to the rural poor and farmers that form the core of Puea Thai’s support. The early indications are that the government is mindful of upsetting the equity markets, although it faces early challenges, particu-larly in gasoline subsidies and in infrastructure spending. The policies mooted so far include cutting corporate tax rates from 30% to 23% and kick-starting infrastructure spending with 10 new metro lines and a 250km rail link. As always, execution is key, and as investors we will be looking for real signs of progress on these projects. There is also the possibility of further political instability, given Puea Thai is the party of the ousted former Prime Minister, Thaksin Shinawatra, and it is fronted by his sister, Yingluck. Thaksin is yet to be rehabilitated into Thai society, and his reappearance in Bang-kok could yet arouse the ire of the royalist yellow shirt movement.

August 2011

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ASIA BRIEF 4

Market Review

July was a mixed month for Asian equities with the MSCI Far East ex Japan up 1.62%, although this masks a wide range of performances across the region. The performances were exaggerated by cur-rency moves, as investors began to look for what they perceived as safe assets, such as economies driven by commodity exports, or countries with little sovereign default risk.

The top performing markets in July were Thailand (+11.65%), Indonesia (+7.30%) and the Philip-pines (+7.01%). It is perhaps surprising that in markets where investors are becoming more con-cerned about macro economic risk, that these smaller, more peripheral markets would be the best performers.

Indonesia performed well on the back of good GDP figures of 6.5% real annualized growth in the second quarter. Much of the growth was focused on non-tradable sectors, such as transport and communication, which suggests that the fruits of Indonesia’s growth in commodity exports are be-ginning to drive domestic growth. The Philippines has also been enjoying decent rates of economic growth this year, and this has helped to support equity markets in July.

The worst performing markets in July were Australia, China and Malaysia. This is something of a surprise, given that Australia has been attracting capital from overseas as a result of its strong posi-tion in minerals exports. China has been under pressure for some time, and July continues the run of weak performance in its equities, which has continued for much of the year. Year to date, it is the second worst performing market in our universe, and the only market, apart from Taiwan, which is still in negative territory this year. The underperformance in the Chinese benchmark is partly driven by negative sentiment towards some of the larger capitalized stocks, in particular the Banks, which have been forced to set aside more and more capital to hold as reserves at the Chinese central bank. This has directly affected their profitability, and has kept the benchmark’s performance subdued.

Market Performance Ending July 31st, 2011 July

2011 2011 YTD

2010 2009 2008 2007

Australia -2.19% 1.66% 14.69% 73.87% -49.47% 29.38% China -0.99% -0.17% 4.59% 62.06% -50.43% 66.01% Hong Kong 2.03% 0.79% 23.28% 60.48% -50.46% 42.46% Indonesia 7.30% 20.77% 35.47% 136.12% -57.87% 55.34% Korea 1.72% 8.68% 25.84% 74.44% -56.36% 32.14% Malaysia -0.19% 7.64% 37.67% 51.26% -41.15% 46.56% New Zealand 5.92% 23.21% 8.73% 49.89% -53.54% 8.95% Philippines 7.01% 7.18% 35.24% 67.34% -52.02% 41.60% Singapore 4.88% 6.47% 22.03% 73.18% -47.21% 28.52% Taiwan 1.47% -1.64% 23.14% 80.23% -46.04% 9.15% Thailand 11.65% 13.99% 56.67% 76.59% -48.21% 46.29% MSCI AC Far East Free ex Japan

1.62% 3.90% 19.41% 68.56% -50.34% 36.82%

MSCI AC Pacific ex Japan *

0.57% 3.30% 17.95% 71.51% -50.00% 34.96

*MSCI AC Pacific includes Australia & New Zealand (MSCI Indices were used for regional & individual market performance)

August 2011

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ASIA BRIEF 5

Market Outlook

This is a period of higher volatility for global equities, partly due to the uncertainty surround-ing the extension of the US Federal borrowing ceiling, and partly due to the ongoing process of sovereign deleveraging in the Eurozone. This is clearly a worrying time for equity inves-tors, and typically emerging markets can be hurt worse than developed world equities.

However, we view this period as part of the same event as 2008, rather than as a new phe-nomenon. Dealing with the excess leverage in the Eurozone and in the US is a slow, and sometimes painful, process, and one that is causing social, political as well as economic dis-ruption. Whether the world is likely to enter another recession or not, it is clear that economic growth has not been reasonable in the developed world since 2008, and the data there sug-gest bottoming, rather than a clear recovery in output.

In our view, the fundamental problems which have caused economic distress in the Euro-zone and in the US are, broadly speaking, not present in Asia. These are the creditor nations, which sit on the other side of the fence, having lent back their trade surpluses to the devel-oped world. There have been some concerns about local government financing vehicles in China, but these have been thoroughly examined by three parts of the Chinese central gov-ernment, and while some banks may need additional capital, in the most likely scenario, this issue does not seem likely to cause a drastic recapitalization of the Chinese banking sector. Given that the data suggest that economic activity across Asia remains robust, we think that the theme of domestic-led growth driven by the rise of the Asian middle-class consumer remains in place.

This helps to explain the wide divergence in equity performance between Asia ex Japan, the US and the Eurozone over the past five years. Our concern is in translating this more positive macroeconomic picture for Asia into better equity returns. Looking at the falling confidence in the developed world suggests that domestic Asian demand-related stocks are most likely to see corporate earnings growth this year and next. The recent interim corporate earnings season suggested that 2011 will be a reasonable year for Asian earnings, and corporate fun-damentals remain good.

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ASIA BRIEF 6

China Economic Monitor

Chinese growth seems to still be on track with 9.50% annualized real economic growth in the second quarter, suggesting activity remains strong. Monetary policy remains the central issue for Chinese economic policymakers at present, and there are clear signs that the tightening policies are having an impact on the real economy. Money supply growth, as measured by M2, picked up slightly in June at 15.9%, from 15.1% in May. However, new loans remained relatively subdued in June, at Renminbi 634 billion. On balance, this is good news, but there are reports that credit is now relatively tight for smaller enterprises and that there is some pressure on trade credit. In our view, this is a function of the structure of the Chinese fixed income markets more than a sign of distress, given it is possible to borrow money with ten or up to one year, or over five years, but it is very difficult to raise 1 to 3 year funds. This means that funds used for medium-term financing often must be refinanced annually, leading to some pressure on one year credit when monetary policy is tightened.

Source: Bloomberg

China M2 Money Supply (% Chg YoY) and Monthly New Loans Extended (RMB bn)

0%

5%

10%

15%

20%

25%

30%

35%

Jul-9

9

Jan-0

0Ju

l-00

Jan-0

1Ju

l-01

Jan-0

2Ju

l-02

Jan-0

3Ju

l-03

Jan-0

4Ju

l-04

Jan-0

5Ju

l-05

Jan-0

6Ju

l-06

Jan-0

7Ju

l-07

Jan-0

8Ju

l-08

Jan-0

9Ju

l-09

Jan-1

0Ju

l-10

Jan-1

1

% C

hang

e Yo

Y

-500

0

500

1,000

1,500

2,000

RMB

bn

New Loans (RMB bn) (RHS)

M2 Money Supply Growth (LHS)

Source: The People’s Bank of China

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ASIA BRIEF 7

The consumer price index (CPI) figures are being closely scrutinized by investors at present, and July’s figure was a minor disappointment, at 6.5% growth year on year. This was slightly higher than June’s figure of 6.4%, and many investors had hoped that that would mark the peak for CPI. However, there are grounds for optimism, in that the elements of CPI in July suggested that the focus of inflation remains in food, and particularly in pork prices. Pork prices have been driven higher in recent months by an extension of the current hog cycle, due to improving demand for pork as incomes and diet improve and due to supply-side is-sues, such as higher feed costs and farmers not returning to the market after volatility in 2008. In our view, this is likely to be a temporary issue, and it is clear than monetary policy cannot accelerate the life cycle of hogs.

It is also becoming clear that there are concerns over growth in the developed world, and this may help to bring down the price of some of the imported commodities which have helped to drive up inflation in China. Energy is the key commodity in this regard, and if oil prices fall over the coming months, this should also help to take the pressure off inflation.

China: Consumer Price and Core Inflation - % change YoY

-5-30358

101315182023252830

Jan-9

4

Jan-9

5

Jan-9

6

Jan-9

7

Jan-9

8

Jan-9

9

Jan-0

0

Jan-0

1

Jan-0

2

Jan-0

3

Jan-0

4

Jan-0

5

Jan-0

6

Jan-0

7

Jan-0

8

Jan-0

9

Jan-1

0

Jan-1

1

% C

hang

e Y

oY CPI

Non-Food CPI

Source: Bloomberg, China Economic Information Net.

Coal imports have staged an impressive recovery from the lows of the first quarter of this year, and are now around their medium term trend level of 15 million tons a month. The supply disruption in Queensland seems to have been substantially resolved, and imports have recovered sharply in the last three months. Iron ore imports have also been relatively firm, with much of the volume growth in the last three months also coming from Australia. Overall, steel production remains strong but was slightly down from May’s figure, which was an all-time-high. There were concerns earlier this year that a shortage of water hurt hydropower production, thus reducing electricity generation and slow-ing heavy industrial production, but this has so far not been the case. Indeed, electricity generation hit an all-time high in July.

Chinese imports of industrial metals have moderated over the last 12 months, with Copper particu-larly weak in recent months. This is something of a surprise, given the continuing strong growth in economic output in China in the recent quarters. However, there are early signs of a turnaround, with a pick-up in copper imports in June and a fall in inventories of copper at the Shanghai Futures Ex-change, suggesting an increase in apparent copper consumption. Both Zinc and Nickel imports were mixed in June, and we would hope to see these recover in the coming months, particularly if Chinese output continues to grow as it has been doing.

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ASIA BRIEF 8

China's Monthly Steel Production and Imports of Iron Ore and Coal (tonnes)

-

10,000,000

20,000,000

30,000,000

40,000,000

50,000,000

60,000,000

70,000,000

80,000,000

Jan-

99Ja

n-00

Jan-

01Ja

n-02

Jan-

03Ja

n-04

Jan-

05Ja

n-06

Jan-

07Ja

n-08

Jan-

09Ja

n-10

Jan-

110

3,000,000

6,000,000

9,000,000

12,000,000

15,000,000

18,000,000

21,000,000

Steel Production (LHS)Iron Ore (LHS)

Coal (RHS)

Sources: National Bureau of Statistics, China Customs General Administration

In line with the decent economic growth in the second quarter, it seems that the Chinese consumer should continue to grow spending. We take this as a positive sign, in light of the monetary tighten-ing which has so far taken place, and in the face of rising inflation, which in effect acts as a tax on consumption. Passenger car sales for June remained above 1 million units, while retail sales growth has now accelerated for four straight months, and in July was 17.4% up on the same month of 2010.

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China's Monthly Imports of Zinc, Nickel and Copper (tonnes)

-

25,000

50,000

75,000

100,000

125,000

150,000

175,000

200,000

Jan-

04Ju

l-04

Jan-

05Ju

l-05

Jan-

06Ju

l-06

Jan-

07Ju

l-07

Jan-

08Ju

l-08

Jan-

09Ju

l-09

Jan-

10Ju

l-10

Jan-

11

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

Zinc (LHS)Nickel (LHS)

Copper (RHS)

Source: China Customs General Administration

China Retail Sales Growth (3 Month Moving Avg YoY change) and Monthly Passenger Car Sales (Number of Vehicles)

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

Jan-9

9

Jan-0

0

Jan-0

1

Jan-0

2

Jan-0

3

Jan-0

4

Jan-0

5

Jan-0

6

Jan-0

7

Jan-0

8

Jan-0

9

Jan-1

0

Jan-1

10

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1,800,000

Passenger Car Sales (RHS)

Retail Sales (LHS)

Sources: China National Bureau of Statistics, China Automotive Information Network

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Commentary for our views on Alternative Energy and Energy markets is available on our website.

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Performance data quoted represents past performance and does not guarantee future results. Index performance is not illustrative of Guinness Atkinson fund performance and an investment cannot be made in an index. For Guinness Atkinson Fund performance, visit gafunds.com.

Mutual fund investing involves risk and loss of principal is possible. Investments in foreign securities involve greater volatility, political, economic and currency risks and differences in accounting methods. Non-diversified funds concentrate assets in fewer holdings than diver-sified funds. Therefore, non-diversified funds are more exposed to individual stock volatility than diversified funds. Investments in smaller companies involve additional risks such as lim-ited liquidity and greater volatility. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. The funds may invest in derivatives which involve risks different from, and in certain cases, greater than the risks presented by traditional investments.

The MSCI All Country Far East Free ex-Japan Index (MSCI AC Far East free ex-Japan Index) is a free float-adjusted, capitalization-weighted index that is designed to measure equity market perfor-mance in the Asia region excluding Japan. The Index is made up of the stock markets of China, Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan and Thailand.

The MSCI All Country Pacific Free ex-Japan Index (MSCI AC Pacific Index) is a free float-adjusted, capitalization-weighted index that is designed to measure equity market performance in the Pacific region. The Index is made up of the stock markets of Australia, China, Hong Kong, Indonesia, Korea, Malaysia, New Zealand, Philippines, Singapore, Taiwan and Thailand.

The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general.

The Dow Jones STOXX 50 Index is a capitalization-weighted index of 50 European blue-chip stocks using free float shares in the index calculation.

One cannot invest directly in an index.

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