1. Taiwan is an emerging market with a services-oriented economy, advanced industry, and stable financial system. The economy is healthy with low inflation, low unemployment, and trade surplus.
2. Taiwanese equities are underperforming due to multiple contraction, not loss of earnings.
3. Multiple contraction may be explained by the following risks:
• Political Risk: DPP is expected to take power from KMT in upcoming January elections.
• Core Industry Risk: Investors perceive Taiwanese tech industry as obsolete.
• Infrastructure Risk: Power shortage is a headwind for industry.
• Macro Risk: Chinese economic slow down, rising US dollar, and Fed rate hikes scare investors from EM equities.
4. Political risk is overstated: DPP will not reverse Taiwan’s economic ties with China; DPP-advocated new trade agreements can reaccelerate a slowing IT industry and foreign investment; DPP has a grand plan to diversify Taiwanese industry; government is on track for healthy financials.
5. Core industry risk is overgeneralization: Taiwanese tech industry is alive and well.
6. Infrastructure risk can be mitigated: Low commodity prices and new foreign investment agreements may mitigate this risk.
7. Macro risk is potential opportunity: Taiwan compares well against other EM equity markets and may be a haven for asset reallocation.
8. Overcoming risks may result in multiple expansion and convex returns.

The government of Taiwan formed when the Kuomintang (KMT) government of the Republic of China (ROC) relocated to the island after losing the Chinese Civil War to the Communist Party of China in 1949. Taiwan is recognized as a sovereign state called the “Republic of China” by 21 nations but considered a “rebellious province” by the People’s Republic of China (PRC). This condition has been a continuous headwind for the island state with implications on its standing in global politics and trade. KMT ruled the island as a single-party state until 1986 when the Democratic Progressive Party (DPP) was founded.

In recent years, KMT has favored closer relations with PRC. Some in the party favor reunification in the long-term. In contrast, DPP distrusts PRC, promotes independence, and favors strengthening relations with other countries to the ire of PRC. Some in the DPP argue no declaration of independence is necessary because they believe Taiwan is already an independent sovereign nation. Under President Ma Ying-jeou of KMT, ROC and PRC signed 23 agreements, including the Economic Cooperation Framework Agreement (ECFA) and the recent and controversial Cross-Strait Service Trade Agreement (CSSTA). Cross-strait relations significantly improved under the Ma Administration.

On November 7, 2015, ROC President Ma met PRC President Xi Jinping in Singapore. This marked the first time leaders of the two sides met since Chiang Kai Shek and Mao Zedong met in 1945. The DPP criticized the historic event as an attempt by the PRC to prop up the KMT, PRC’s preferred party, prior to the upcoming elections.

On January 16, 2016, general elections will be held for the 14th President of ROC and the 9th Legislative Yuan. President Ma will be retiring after his maximum two terms and DPP candidate Tsai Ing-wen is widely expected to win the Presidential election by a landslide. Tsai Ing-wen would be Taiwan’s first female president. Polling by Taiwan Brain Trust on November 13-14 indicated 48.4% of respondents support Tsai, 20.4% support Chu (KMT), and 9.3% support Soong (People First Party). Prospects for the KMT are particularly dim as the party changed its candidate in October from the pro-Beijing Hung Hsiu-chu to New Taipei City Mayor Eric Chu. Hung advocated reunification with PRC, an unpopular position, and polled at only 13% prior to her replacement.

In Taiwan, the president does not have veto power over legislation and so the Legislative Yuan does not require the president’s approval to pass laws. The president’s powers center on commander-in-chief of the military and head of state for conducting foreign policy, including negotiating treaties, declaration of war, and making of peace. The president appoints the premier who heads the Executive Yuan that administrates the government. The president also appoints the Council of Grand Justices that head the Judicial Yuan.

Much attention is focused on the presidential election due to foreign policy implications, but the Legislative Yuan elections are equally important for domestic policymaking. KMT is expected to lose control of the Legislative Yuan after DPP won broadly in local elections last November. However, it is not certain if DPP will win an outright majority of seats. Its Pan-Green Coalition may control the Legislative Yuan if friendly party Taiwan Solidarity Union can win seats as well. Controlling both the Presidency and the Legislative Yuan would enable DPP to push its domestic and foreign policy agenda, which may be a game changer for investors.

China: This issue is the largest uncertainty for investors and geopolitics analysts. There are misconceptions of what a DPP takeover will entail because former President Cheng Shui-bian (DPP) was a disaster for cross-strait relations. Tsai does not promote a declaration of independence or breaking away from economic activity with China that was developed during the Ma era. She promises there will be no scaling down on the Chinese tourist policies enacted by Ma. In general, Tsai has stated her cross-strait platform is to maintain the “status quo” and not undo the “accumulated outcomes” of the Ma administration. Tsai does not want to end warming relations with China; rather, she does not want Taiwan to be focused only on China. If this is true, much of the risk priced into Taiwanese equities is unfounded.

Trade / International Relations: DPP favors joining the Trans-Pacific Partnership (TPP) and trade deals in general so that Taiwan has less economic reliance on China. Tsai encourages businesses to invest in Southeast Asia, rather than focus solely on mainland China for their supply chain and downstream business. Tsai proposes a “New Southward Policy” to build partnerships with Association of Southeast Asian Nations (ASEAN) and India. Key to this is cultural and educational research because President Lee’s “Go South” policy of 1993 failed as Taiwanese businesses encountered challenges with Southeast Asia related to different languages, cultures, and religions. See Trade Policy section below for more detail.

Energy: DPP promotes an environmentalist agenda and is strongly against nuclear power, which the island relies on for 14% of its electricity given its lack of natural resources. Tsai proposes a green energy park in the Shalun area of Tainan to serve as a home for clean energy companies. Tsai is a proponent of hydrogen power and advocates a nuclear-free Taiwan by 2025. Monopoly utility Taiwan Power Company (“Taipower”) is a state-owned enterprise. There are currently no power-related companies in MSCI Taiwan, but the issue of power is a crucial one for the Taiwanese economy. See Infrastructure Risk section below for more detail.

Technology: There is a perception that Taiwan’s core industry of technology is languishing due to reliance on mid-2000s trends. Tsai proposes growing in the area of information technology and communications. Specific areas include cybersecurity but also industrial applications in agriculture and marine. Technology comprises the bulk of MSCI Taiwan. See Core Industry Risk section below for more detail.

Defense: Tsai argues for greater investment in Taiwan’s defense, including construction of new naval ships, including submarines, at domestic shipyards in Kaohsiung. CSBC Corp is a publicly traded ship maker that could receive new defense contracts, but it is not in MSCI Taiwan. Defense is an insignificant portion of Taiwan’s GDP. There are currently no defense contractors in MSCI Taiwan so any increase in defense spending would be very long-term or indirect in its effect on MSCI Taiwan.

Biotech: Tsai envisions Taiwan becoming a biomedical research and development center in the Asia Pacific region. She argues that Taiwan has world class medical personnel and facilities to conduct research on and clinical tests of new drugs and medical equipment. Furthermore, the costs of medical R&D in Taiwan is lower than in Japan, Singapore, and Australia. Taiwan has advantages over the West for treating East Asian specific medical conditions. Tsai points to Taiwan’s genetic database for East Asian ethnic groups and better understanding of East Asian lifestyle habits and environments. Tsai proposes cooperation with US, European, and Japanese companies on R&D while continuing to negotiate with China to open the mainland market to Taiwanese medical products. Currently, pharmaceuticals and biomedical devices are an insignificant portion of Taiwan’s GDP and no companies listed in MSCI Taiwan are pharmaceutical, biotech, or biomedical device companies. Government incentives to promote biotech would be very long-term or indirect in their effect on MSCI Taiwan.

On November 16, 2015, the Legislative Yuan passed a revision to income tax laws that abolished a proposed capital gains tax. The Taiex index rose 1.5% that day. Longer-term, this may be an indication that Taiwanese lawmakers are amiable towards investors.

The Taiwanese government’s “Sound Finance Program” has been successful at cutting the government budget deficit. The deficit has fallen from 2.4% of GDP in 2012 to 0.8% of GDP in 2014. The 2016 budget forecasts revenue growth of 3.8% and expenditure growth of 3.3%. Government debt fell to 44.7% of GDP in 2014. Moody’s and Fitch do not believe Tsai’s government policies would stray from these trends.

Taiwan is suffering a serious electrical power problem. In summer 2015, reserve margins fell below 5%—a margin of 15% is typically regarded as a minimum standard. The risk of a power shortage is a considerable operating risk for industry, especially for firms like TSMC in which a millisecond of power loss would render its semiconductors in production as unusable. The country could, in the future, suffer rolling blackouts and higher power costs.

Industry consumes 53% of the electrical power on the island. The power problem may hinder economic growth as tech manufacturing must move overseas for adequate power supplies. Taiwan currently enjoys low electrical tariffs compared to other Asian countries and these tariffs will likely rise to finance new power production. This will reduce profitability for industry on the island. However, this is an ongoing problem that is likely priced into MSCI Taiwan already in the form of multiple contraction.

The problem is rooted in continuously growing power demand from economic growth in face of a decrease in supply. Taipower had been transitioning its coal-generated electrical production to nuclear power. However, recent protests by anti-nuclear environmentalists have prevented the state-owned utility from turning on the new 2.7GW nuclear plant that was intended to replace the coal plants it has been shutting down. Furthermore, DPP vows to shutdown all of Taiwan’s six currently operating nuclear reactors by 2025, which are responsible for 5.1GW of production. Currently, Taipower produces electricity from nuclear plants at NT$960/MW-hr while electricity from its other sources cost NT$2470/MW-hr.

Taipower is already struggling financially. The utility is heavily invested in the new 2.7GW nuclear plant and will have difficulty raising additional debt to fund new projects. It will also take years to construct new coal or gas plants to replace the lost capacity. Importing coal and natural gas to Taiwan is relatively expensive, but it is currently cheaper than it was over the past decade due to the downturn in global commodity markets. Taiwan’s laws allow 20% of power be supplied by independent power providers and these projects are often financed by foreign investors. However, recent disputes between the government and foreign investors have deterred new capital. International arbitration like that proposed in the TPP could ease foreign investors back into Taiwanese power generation.

Taiwan lacks land and is too rainy for solar to be effective. Environmentalists oppose wind turbine placements. Tsai prefers hydrogen power but such technology is not yet available at utility scale. Given the choices, it is uncertain if the environmentalist DPP would prefer Taipower to pursue additional fossil fuel generated electricity to replace nuclear. It may be that given the choices of investing in coal/gas vs turning on the nuclear plant vs electrical power crisis, DPP chooses to turn on the new nuclear plant.

The economic slowdown in China is affecting MSCI Taiwan as expected. The equity of maritime shipping companies and cement manufacturers have sold off significantly. However, Exhibit 2 indicated that MSCI Taiwan earnings growth has been somewhat resilient while Shanghai Composite earnings growth has turned negative.

Taiwanese corporations are not affected by a slowdown as much as one would expect. Although 40% of Taiwanese exports are to China, much of these exports are parts for assembly that are then exported elsewhere and therefore not dependent on China for final demand. Two-thirds of Taiwan’s exports to China are re-exported to US or Europe.

There are 12 banks and investment banks in MSCI Taiwan and combined represent approximately 11% of the index. Fitch estimates that 8% of Taiwan’s banking assets are exposed to mainland China—this compares well to neighbors as 32% of Hong Kong’s banking assets, 21% of Macao’s banking assets, and 12% of Singapore’s banking assets are exposed to mainland China. Non-performing loan ratio was 0.25% at the end of Q1Y2015 and capital adequacy ratios were at 12.5% at the end of Q2Y2015, well above the 8.0% regulatory minimum. Moody’s describes Taiwanese banks as having a “solid financial base” due to “strong liquidity profiles, favorable asset quality, adequate capital adequacy, and improving profitability.” The credit rating firm’s weighted-average BCA for the top ten banks is baa2.

It appears many investors realize this. Taiwanese equities faired relatively well in the August-September sell-off compared to those of neighboring countries. Global funds reportedly reduced holdings of securities in India, Indonesia, South Korea, and Thailand and increased holdings of equities in Taiwan in the wake of the China-related sell off. The same was true in 1997-1999, when Taiwan fared better than its neighbors in the Asian Financial Crisis. For asset allocators, Taiwan offers asset managers emerging market exposure that is not tied to falling commodity prices and exports of basic materials to China.

The upcoming Fed rate hikes and strengthening US dollar have been detrimental to EM equities and currencies. 75% of firms listed on the Taiwan Stock Exchange have revenue denominated in US dollars so a strong dollar helps their earnings in New Taiwan Dollar (TWD) terms. Taiwan’s financial system is relatively stable compared to other Asian EM economies as its sovereign bonds are 99% domestically held, entirely denominated in TWD, and yields are the lowest in Asia ex-Japan, with the Taiwan 10-year at 1.16%. The implied volatility of the TWD currency is currently 6.78% while historic volatility is 9.19%. Investments in Taiwan should react well to a strengthening US dollar and rising US rates compared to other Asian EM investments that are more at risk of foreign investor outflows.