Market Overview
World equities rose in September, as a seismic shift in the global monetary landscape reverberated across markets.
The month was marked by the Federal Reserve (Fed) taking the first steps in its widely expected retreat from its restrictive monetary policy stance. The world’s most influential central bank lowered its benchmark interest rate by a larger-than-expected 50 basis points (bps) at its policy meeting in mid-September, its first and largest rate cut since March 2020 when the U.S. economy was grappling with the fallout from the coronavirus pandemic. With data continuing to suggest that domestic inflation was heading sustainably toward the Fed’s 2% target after an aggressive rate-hiking campaign that raised borrowing costs to their highest level in 23 years, the U.S. central bank stated that it would focus more on the labour market and the overall economy. The Fed also forecasted two 25-bp cuts through the end of the year and a series of cuts next year totaling 100 bps. Investors, who had worried that the U.S. economy was at risk of tipping into a recession because the Fed had kept interest rates too high for too long in its aggressive campaign to quell high inflation, cheered the brightening outlook for interest rates in the U.S., sparking a strong rally in stock markets around the world. The yield on the benchmark 10-year U.S. Treasury note ended September at 3.79%, 12 bps lower than a month earlier.
The Fed was not the only major central bank to make news in September. In a widely expected move, the European Central Bank (ECB) cut interest rates 25 bps, marking the second time it had done so in the past three months. The ECB’s latest move came amid data suggesting that inflation in the eurozone was hovering near the central bank’s 2% target and economic growth in the common currency bloc was weakening. Despite this climate, the ECB reiterated that it was adopting a cautious, data-driven approach to its monetary policy and was not “pre-committing to a particular rate path,” though expectations were growing that the ECB will cut rates again in December. In the U.K., the Bank of England held interest rates steady but signaled a commitment to a more accommodative monetary policy posture amid cooling domestic inflation and a struggling British economy. Elsewhere in Europe, Norway’s central bank held interest rates at a 16-year high but indicated that it may lower them next year while central banks in Sweden and Switzerland cut their benchmark interest rates 25 bps. In September, the yield on the 10-year German Bund, Europe’s principal safe-haven asset, fell 17 bps, ending the month at 2.13%.
Meanwhile, in Japan, the country’s central bank held interest rates steady in September and reiterated that it would take a cautious approach to raising borrowing costs, dampening speculation of another rate hike in October. However, the elevation late in the month of Shigeru Ishiba, a former defence minister who had been a critic of the Bank of Japan’s (BOJ) earlier ultra-low interest rate policy stance, as Japan’s next Prime Minister raised expectations of further rate hikes. Investors speculated that with Ishiba as Prime Minister, the BOJ will have a freer hand to raise rates without much political pushback. Elsewhere in Asia, China’s central bank unveiled an array of stimulus measures designed to encourage consumption and revive the country’s ailing economy, including reducing by a record amount the interest rate charged on its one-year policy loans and instructing banks to lower mortgage rates for existing home loans before the end of October.
The conclusion of the second-quarter earnings season provided investors with the latest update on how interest-rate headwinds have impacted company profits. In the U.S., 79% of the companies in the S&P 500 Index topped consensus estimates, which was above the long-term average of 66%. The second-quarter earnings growth rate increased 11.3% from a year earlier. In Europe, 49% of the companies in the STOXX 600 Index posted better-than-expected earnings, below the 54% that do so in a typical quarter. The year-over-year second-quarter earnings growth rate contracted 10.2%. In Japan, 63% 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 increased 5.4% from a year earlier. In Hong Kong, 52% of the companies in the Hang Seng Index registered better-than-expected earnings, surpassing the 49% beat rate over the past four quarters. The second-quarter earnings growth rate increased 7.8% from a year earlier.
Against this backdrop, equity markets in the developed and developing worlds both gained in September, with the latter outperforming the former. In the U.S., the S&P 500 recorded its fifth consecutive month of gains and climbed to an all-time high, as the Fed’s outsized rate cut in September stoked optimism that the U.S. economy will achieve a “soft landing.” Across the Atlantic, the pan-European STOXX 600 eked out a modest gain but underperformed, as positive sentiment about rate cuts from key central banks on the Continent was tempered by concerns about the economic outlook for the eurozone. In Japan, the TOPIX inched upward but lagged the broader global market index, as the election of Shigeru Ishiba as the country’s next Prime Minister raised expectations for more rate hikes from the BOJ. Elsewhere in Asia, the CSI 300 index of large Chinese companies traded in Shanghai or Shenzhen, and the Hong Kong-based Hang Seng Index both soared after China’s central bank unveiled its largest stimulus package since the pandemic in its latest effort to address the country’s mounting economic woes.
Consumer discretionary was the best-performing sector in September, as the start of the global rate-cutting cycle fueled hopes that consumers will increase their spending on non-essential goods and services. Energy was the worst-performing sector, as shares of oil producers fell in sympathy with the drop in crude oil prices. Despite an escalating conflict in the Middle East that could curtail oil supply, the global benchmark tumbled 9% in September, its largest monthly decline since November 2022, due to concerns about demand.
Outlook
The long-awaited start to the U.S. Fed rate cutting cycle finally began in September, and as expected, prospects for lower interest rates and a soft-landing for the economy had a favourable effect on portfolio performance.
Utilities have been a key contributor to performance in recent months—likely a reflection of the growing appreciation for the importance of powering the energy transition, as well as a defensive play should the economy begin to decelerate more quickly than anticipated. Valuation has now re-rated substantially higher among Utilities in the U.S. while, internationally, sector valuations remain considerably lower, particularly in Europe.
Outside of the utilities sector, midstream energy, namely oil & gas storage and transportation, looks to be taking a break after the strong positive performance the sector has mostly contributed to the portfolio year to date. This is likely partly in sympathy with the downward pressure on oil & gas prices although the vast majority of the cash flows associated with the portfolio’s holdings are fee-based and enjoy strong support from the volume of energy molecules transported as well as favourable spread differentials at key access points.
Elsewhere within the portfolio, we see positive effects from large-scale investment in transportation infrastructure and renewable energy development, leading to increased demand for materials, capital goods and industrial equipment. We believe the portfolio remains well-positioned to take advantage of compelling opportunities in real asset infrastructure businesses as well as key enablers, including materials, services, and technologies, that will both facilitate and benefit from increased investment in infrastructure.
We believe publicly-listed infrastructure remains well-positioned to benefit from a continued brisk pace of investment, with plenty of runway ahead, and an end to the rate-hiking cycle, as eventually lower interest rates are 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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Published on October 18, 2024.