Market Overview
Equity markets worldwide rose modestly in July, as investors grappled with a potentially significant shift in the global monetary landscape.
Speculation about the interest rate-policy paths of key central banks hung over markets during the month, with the focus squarely on the Federal Reserve (Fed). As expected, the world’s most influential central bank held interest rates steady in July, leaving them at their highest level in nearly 23 years for the eighth consecutive policy meeting. More importantly for investors, the Fed signaled that a rate cut in September “was on the table” if the data supported such an action. However, amid data suggesting that the U.S. labour market was cooling, coupled with the latest reading from a closely watched gauge of domestic inflation that indicated that price growth had resumed its slowdown after a discouraging start to the year, investors were growing increasingly confident that a cut in U.S. interest rates was imminent. Indeed, by the end of the month, traders in the federal-funds futures market were pricing in a 100% probability that the Fed would lower its main interest rate in September, according to data from CME Group. The yield on the benchmark 10-year U.S. Treasury note ended July at 4.04%, 36 basis points (bps) lower than a month earlier.
Mounting expectations that a U.S. rate cut was forthcoming rippled across the U.S. stock market during the month, resulting in a rotation away from high-flying, index heavyweight mega-cap technology stocks toward previously overlooked areas of the market such as small-cap stocks, which are more susceptible to the ebb and flow of the domestic economy, and companies whose profits have been undercut by the weight of high interest rates. Notably, the Russell 2000 Index—the bellwether of the U.S. small-cap equity market—outpaced the S&P 500 Index by a wide margin in July, recording its best monthly performance of 2024 thus far.
In another closely watched central bank decision, the Bank of Japan (BOJ) lifted interest rates for the second time this year and hinted at more hikes to follow, citing the yen’s weakness as one of the main factors for the latest move. A weak yen has raised the costs of key imports like food and fuel and has hurt consumer spending, which accounts for half of Japan’s economic activity. The hike in interest rates to 0.25% from 0%–0.1% came as inflation in Japan has been above the BOJ’s 2% target for some time, and amid data indicating that the country’s economy had contracted in two of the past three quarters. By raising rates, the BOJ aims to boost sluggish consumption in Japan by strengthening the yen and easing the price of imports. In July, the yen appreciated 7.3% against the U.S. dollar.
Events in Europe were also closely monitored. A month after lowering interest rates for the first time in nearly five years with a 25-bp cut, the European Central Bank (ECB) held borrowing costs steady in July and reiterated that it would maintain a cautious monetary policy posture amid expectations that inflation in the eurozone would fluctuate around current levels for the remainder of the year. Meanwhile, the political risks that weighed on European stock markets last month eased in July, as France’s populist far-right National Rally party was unexpectedly denied a decisive majority in the country’s snap legislative election. The ensuing gridlock in the French government due to the inability of any political party to establish a working majority was a relief to investors, who feared a decisive win by the National Rally party could lead to policies that could trigger a financial crisis in France by hindering the ability of the already heavily indebted country to pay its debts. In July, the yield on the 10-year German Bund, Europe’s principal safe-haven asset, fell 19 bps, ending the month at 2.31%.
The start of the new earnings season painted a mixed picture of how interest-rate headwinds have impacted company profits. In the U.S., 79% of the companies in the S&P 500 Index that reported results topped consensus estimates, which was above the long-term average of 66%. The second-quarter earnings growth rate is estimated to have increased 10.9% from a year earlier. In Europe, 52% of the companies in the STOXX 600 Index that reported results posted better-than-expected earnings, below the 54% that do so in a typical quarter. The year-over-year second-quarter earnings growth rate is expected to have contracted 12.2%. In Japan, 61% of the companies in the TOPIX reported positive earnings surprises, which surpassed the 58% beat rate over the past four quarters. The second-quarter earnings growth rate is estimated to have increased 0.5% from a year earlier. In Hong Kong, 33% of the companies in the Hang Seng Index registered better-than-expected earnings, lagging the 49% beat rate over the past four quarters. The second-quarter earnings growth rate increased 3.9% from a year earlier.
Against this backdrop, equity markets in the developed and developing worlds gained in July, with the former outperforming the latter. In the U.S., the S&P 500 gained but underperformed, as investors rotated away from mega-cap technology stocks toward previously downtrodden parts of the U.S. stock market in anticipation of a rate cut by the Fed. Across the Atlantic, the pan-European STOXX 600 outperformed on abating political risk after France’s populist far-right National Rally party was unable to secure a working majority in the country’s legislative election. In Japan, the TOPIX recorded a solid gain, as news of the BOJ’s rate hike fueled hopes that it would strengthen the yen and boost the country’s consumer spending. Elsewhere in Asia, the Hong Kong-based Hang Seng Index, which is comprised mostly of companies from mainland China and serves as a gateway for foreign investors wanting to invest there, retreated on concerns that China’s Politburo meeting did not result in any additional forceful stimulus measures to support the country’s faltering economy and beleaguered real estate sector. News at the end of the month that China’s central bank was lowering a key interest rate allayed some of the investor anxiety.
In anticipation of an imminent U.S. rate cut, previously overlooked stocks such as real estate thrived, making the sector the best-performing one in July. Conversely, traders sold off shares of mega-cap technology stocks in the communication services sector, making it the worst-performing sector in the month.
Outlook
While much of the last few months could be characterized as a series of false starts to a monetary policy pivot, in our view, each month represents yet another tick forward towards deciphering the prevailing macroeconomic conditions that will underpin both the pace of economic easing as well as deceleration in inflation and eventual easing of monetary policy. Collectively, the last several months’ performance serves as an important reminder to take short-term reactions to changes in interest rate expectations in stride.
We maintain our investment outlook and believe the portfolio is designed to take advantage of compelling opportunities that span a wide range - from a budding resurgence of interest in defensive utilities that will power an electrified future, to the key enablers, including materials, services, and technologies that will both facilitate and benefit from increased investment in infrastructure. We remain highly confident and enthusiastic about our investment strategy and positioning for the long-term.
Moreover, while performance of infrastructure as an asset class, with its above average sensitivity to interest rates, has recently had a tough time keeping up with broad-based growth equity indices, the combination of defensive business models, highly predictable revenues and cash flows, and strong inflation pass-through characteristics has demonstrated commendable resilience and we find the investment category trading at considerably more attractive valuations vis a vis broad market indices.
We believe this leaves publicly-listed infrastructure equities well positioned to benefit from a continued brisk pace of investment, with plenty of runway ahead, and an end to the rate-hiking cycle, when we expect eventual lower interest rates will be used to discount cash flows that have been adjusted higher either for regulatory or contractual inflation-adjustment, or the indirect benefit of inflation adjustment that tends to stem from owning and operating high fixed cost, long life assets.
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Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries.
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Published on August 19, 2024.