Perspectives

The year-end 2023 rally continued into the first quarter, but in a more muted manner. A resilient US economy, bullish Japanese markets, potential bottoming in Europe, and strong fourth-quarter earnings reports all provided support for continued global equity market gains. The large cap, MSCI World ex-USA (+5.6%), and small cap, MSCI World ex-USA Small Cap (+2.6%) both had respectable performance despite a resumption in US Dollar (+3.1%) strength. However, as was the case throughout last year, large caps continue to outperform small caps which have yet to reach their 2021 highs.

Asia

Japanese stocks delivered a solid rally as labor negotiations ended with the highest wage increase in 33 years, a key sign that deflation is coming to an end. The Bank of Japan also ended negative interest rates with a well forecasted 10 basis point rate hike, but their tone remained dovish, sending the yen spot rate to a 34-year low relative to the US Dollar Index. As a result, the USD return for the MSCI Japan Small Cap Index was 5.0% versus 12.8% in local currency. Results were mixed in Europe as investors took note of diverging economic growth rates across the continent. Spain, Italy, and Denmark were among the top performers, reflecting their strong economic results relative to European average, while Germany declined early in the quarter on weak industrial output and emerging concerns about the financial industry’s exposure to commercial real estate. Hawkish Bank of England comments capped gains in the UK, but the economy did show signs of a nascent turnaround. Top performing sectors included Financials, led by banks and insurance providers, Energy, supported by higher oil and gas prices, and Industrials, with aerospace and defense, machinery, and electrical equipment key contributors. Real Estate declined on concerns regarding office properties. Health Care and Utilities were also down during the period.

In the course of the quarter, the Nikkei surpassed the 1989 high of 38,915 on its way to a new high of 40,888 by quarter’s end. As has been highlighted here several times in the past few years, we remain bullish on Japanese equities. Given it took 30-plus years to get back to this point we feel comfortable in the durability of the potential bull market although we fully expect periodic corrections. On a side note, years of deflation and a weak currency have made Japan a low-cost destination (hotels noticeably excepted) for both companies and tourists — schedule your visit while you can!

Outlook

Our outlook on global equities remains positive. Many of our previously contrarian views have become worrisomely consensus, but sentiment in our markets seems far from extremes. We have likely passed through the trough of low expectations but are still in the early stages of a global cyclical recovery. In discussions with company managements, we see signs of improvement and a potential cyclical bottoming in continental Europe and industrial China. The new “globalized localization,” driven by the break-up of Chinacentric production bases and government subsidized tech capex, is a tailwind for a classic business investment spending driven expansion. Japan has somehow become a low-cost yet high-quality supplier and remains our single favorite market. Further, its rally has been driven by strong fundamentals, reasonable starting valuations, and, we would argue for the first time, better run companies than you will find in other major markets, including the US. In Europe we are finding opportunities in the UK and periphery countries for the first time in years. Similarly, on a sector basis, much of our recent work has revolved around attractive opportunities in Financials and Real Estate, areas we have long been underweight.

The list of potential risks remains long and varied. Markets are normally driven by sentiment and flows in the short term, so our focus on fundamentals can, at times, be out of sync. However, our core investment philosophy is that long-term performance is linked closely to underlying business fundamentals and this is what will matter over the long term. As such, we continue to recommend a well-diversified portfolio of attractive businesses with a holding period long enough to convert the short-term volatility into long-term performance.

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

With contributions from members of our Global Equities Team