Perspectives

Global equity markets spent the quarter moving around but going nowhere. An April selloff led to a May rally only to end June slightly lower but off the worst levels. The large cap MSCI World ex-USA (-0.6%) and small cap MSCI World ex-USA Small Cap (-1.6%) both declined in USD terms. However, markets continue to do better in their local currencies as the US Dollar Index outperformed again (+1.3%). Dollar strength is broad based, but particularly noticeable versus the Japanese yen (-5.9%), which is now at multidecade lows.

Asia

Most likely related, the Japanese equity market, as represented by the TOPIX, proceeded to hit 34-year highs. Yet, companies in Japan are starting to mumble about the currency being too weak, with the average company using 143 yen to the dollar versus the current spot price of 161 in their earnings forecasts. Generally speaking, a weak yen is positive for exporting companies and negative for those serving domestic demand. However, despite popular perception, the makeup of Japan’s economy is primarily consumption driven, similar to the US. The concern is that yen weakness is now driving a decline in purchasing power, which could become counterproductive if it hurts consumer sentiment. The interactions between weak currency, inflation, pricing power, and wage increases are complicating the analysis.

Foreign investor excitement towards the Japanese market faded a bit during the quarter despite strong business fundamentals and improvements in shareholder returns. The unwinding of cross shareholdings, in particular, picked up momentum, and while it can serve as a headwind in the short-term (e.g., companies selling each other’s stock), it should be a long-term positive as business returns improve, managements focus on core competencies, and shareholder concerns take precedence. This will be a long process, but we continue to see Japan as the most attractive equity market.

Europe

Parliamentary elections in the EU went as we expected, but led to a surprise French general election, which has worried the financial markets as the far right and left parties are likely to make significant headway. Fiscal spending issues have long plagued France, especially when compared to its peer Germany, but the election has brought the concerns to the fore. How the European Central Bank (ECB) manages a policy that is appropriate for both the German and French economies at the same time is a real head scratcher and a potential fault line in Europe. Labor’s strong victory in the UK election is exactly as we expected, and we continue to expect a majority, center left government to be seen as a sign of stability, making the UK more attractive for investment. The UK and EU periphery remain some of our preferred markets.

Moving to interest rates, Europe kicked off the global developed market rate cutting cycle first with the Swedish Riksbank and then the ECB and Swiss National Bank all cutting rates by 25 bps. This despite the EU GDP surprising to the upside while inflation appears to be returning to targets. Clearly there is a bias towards cutting everywhere except Japan and Australia, but these moves have little impact on how we are currently investing.

Outlook

When focused solely on economic and business fundamentals, we continue to find much to like in global markets; however, we think that some geopolitical risks remain underpriced. Events with low likelihood, but potentially large impacts are seldom priced accurately. Investors, for example, seemed to have already forgotten about the Iranian missile attack on Israel and are paying little attention to the growing conflict in the South China Sea. There is little we can do about this directly except to maintain appropriate diversification and avoid those areas which may be most exposed.

At the micro level we found the recent earnings season to be decidedly mediocre. Inventory destocking continues while accumulated inflation and falling savings have weakened end demand. Pricing power, with the notable exception of Japan, is becoming a concern. New growth areas related to AI and the electrification of industry are booming, while formerly hot EVs, batteries, and green energy pull back. Overall, we think this variability within markets should help our ability to differentiate the winners and we are quite bullish on our prospects.

Read GW&K’s full Quarterly Investment Review for the second quarter here.

With contributions from members of our Global Equities Team