Perspectives

Global equity markets climbed steadily throughout the third quarter, despite a bout of intra-month volatility in August. The large cap, MSCI World ex-USA Index advanced 7.8%, but was finally sur- passed by very strong performance of the MSCI World ex USA Small Cap Index (+10.5%). Non-US markets benefited from a USD selloff, which erased all the year-to-date dollar strength. The US Dollar Index was down -4.8% during the quarter with a particularly large move in the Japanese yen (+12%). Even with this recent pullback, the US Dollar Index remains strong by historical standards, and although it is premature to call an end to the current upcycle, signs are pointing in that direction. This would turn a 15-year headwind into a tailwind for non-US equity market returns.

Central Bank Policies and Market Reactions

Major shifts in central bank interest-rate policies, even though well telegraphed, contributed to the significant market volatility. Continued interest-rate cuts in Europe, the US Fed’s first rate cut, and the Bank of Japan’s (BOJ) second interest-rate increase, combined to shift the global monetary policy landscape. This shift reduced the attractiveness of the Japanese carry trade resulting in sharp and significant moves in currencies and asset prices. The early August selloff was focused on Japanese equity markets, which saw a 20% selloff over three days as the yen appreciated. However, after a violent realignment of positioning, the equity market quickly rebounded and ended the month essentially flat, in US dollar terms. While major changes in FX can sometimes have an impact on business fundamentals, the moves this time were more about investment flows and positioning. It is possible that the easy money, post financial crisis era is finally ending after 15 years. Rather than worry about the impact this might have on asset prices, investors should see this as a return to normalcy.

China’s Economic Policy Shifts

Just prior to quarter end, China finally implemented meaningful policies meant to address increasingly serious signs of weakness in their economy. The government dramatically loosened property curbs and financial conditions, provided funding to prop up equity markets, and increased supply-side industry support. The mainland China and Hong Kong equity markets rallied sharply as a result. Our view is not as positive as the stock market would indicate. After selling off for several years the markets were due for a rebound, and when the Chinese government puts in place policies to jump start the market it should work…for a time. However, the country’s underlying economic issues are not being directly addressed by current policies, although there are some hints that this might occur. The Chinese economy is almost unprecedentedly focused on investment at the expense of consumption. Making a shift towards consumption is easy to say, but harder to do given entrenched vested interest and what seems a personal opposition from President Xi Jinping to most of the obvious fixes. It appears that China is undergoing a balance-sheet recession similar, although not identical, to what occurred in Japan in the 1990s. Trying to use supply-side policies to fix China’s issues is like the proverbial “pushing on a string.” This is not to say the stock market can’t go higher, but we would be quite cautious about long-term investment exposure to the mainland until there are signs the underlying, structural problems are being addressed.

Corporate Earnings: A Mixed Picture

Moving to the company level, earnings reports in the quarter were acceptable, but not exciting. Part of the problem has been a series of significant “one-off” problems occurring repeatedly, such as auto-production issues in Japan and various natural disasters, as well as early signs of consumer spending exhaustion. Offsetting these issues have been continued corporate investment in regional reshoring and technology advancement. Individual companies continue to be extremely profitable, and balance sheets are in good shape. Earnings revisions are generally slowing, although in Japan, which remains a preferred market, they continue to be robust. One potentially important tailwind would be the impact of lower US rates in non-US countries, many of whose central banks have been waiting for cover from Fed cuts to lower their own policy rates. We also think the market may be overestimating how quickly the BOJ will raise rates, even though in hindsight they should have started well before the Fed cut.

Outlook

Overall, the markets seem to be in one of those periods where patience and stock selection are likely to be rewarded, but it might not pay to take significant risks. We remain focused on specific company fundamentals, valuation, and growth outlooks. We believe the best advice during such a volatile period is to maintain diversification and focus on quality businesses at good prices.

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

With contributions from members of our Global Equities Team