Global Markets Regain Their Footing
Global markets regained their footing in the second quarter, thanks to a decisive pivot from the U.S. Federal Reserve (Fed), strong performance in tech and artificial intelligence (AI), and resilience in emerging markets. The recalibration of interest-rate expectations ignited a surge in equities, with standout contributions from the United States, Taiwan, and India. Amid these shifts, India emerged as a beacon of growth, bolstered by robust gross domestic product (GDP) growth and infrastructure investments.
We believe our innovative research insights on profitability help us understand this evolving landscape of growth investing.
Second-Quarter Recap
Global equities ended the quarter in positive territory following sharp declines in April, thanks in part to a hawkish pivot by the Fed, which recalibrated consensus expectations for the number of interest rate cuts this year from three to one .
Sector performance was dominated by information technology and communication services, which was particularly evident in the United States. Not surprisingly, stocks with exposure to artificial intelligence (AI) continued to outperform (Taiwan, one of the top-performing markets globally, in particular).
Emerging markets’ outperformance was bolstered by India’s continued strength and Chinese policymakers’ initiatives to salvage the failing property market, which edged Chinese equities into positive territory.
Regional Outlooks
Following higher-than-expected inflationary data and robust jobs growth in the beginning of the quarter, U.S. economic data showed some signs of cooling as core personal consumption expenditures moderated to 2.6% in May. This should help pave the way for the long-anticipated rate-cut cycle, with an accompanying continuation of the economic expansion.
In Europe, inflationary trends also appear to be moving in the right direction, with the European Central Bank announcing its first rate cut of 25 basis points. Wage growth remains positive in both the United States and Europe, and this should bode well for continuing domestic demand growth. However, we are concerned that the political backdrop in Europe may weigh on intermediate-term growth, as evidenced by the result of the French election leaving the government deadlocked. It is difficult to see the growth differential between Europe and the United States narrowing anytime soon.
In Japan, a weak yen has weighed on the market.
In Japan, a weak yen has weighed on the market. The weakness, largely driven by persistently lower real rates relative to the rest of the world, was causing concern that Japanese inflation may remain above expectations, and is diluting the positive impact from nominal wage growth and the stock-exchange-led structural reforms. The need to import food and energy was further deteriorating consumption while also depressing wage growth in real terms. This changed rather dramatically in late July as the Bank of Japan raised rates, causing the yen to strengthen. This caused elevated levels of volatility in the markets, overshadowing the continued progress of structural corporate reforms, with more focus on efficient capital allocation and improving shareholder returns.
We remain cautious about China against the backdrop of subpar growth, a challenging property market, and the increasingly difficult and unpredictable regulatory environment. Given that real estate represents the largest portion of household wealth for most of the Chinese population, falling property values have produced a negative wealth effect. While policymakers recently announced initiatives to prevent further deterioration of the property market, it likely is not nearly sizable enough to reignite confidence in the household and business sectors. Valuations may reflect much of this pessimism, but our international and global investment strategies will wait for more concrete signs of property and economic stabilization before broadening our China exposure.
Spotlight on India
With a share of global GDP growth approaching 20%, we view India as one of the strongest markets in the emerging world, and its story continues to improve. Inflation has cooled, interest rates are no longer rising, GDP growth is robust, and capital expenditures (capex) in both the public and private sectors appears to be entering an upcycle. The country has surpassed Taiwan and Korea to become the second-largest component of the MSCI Emerging Markets Index.
We have long viewed India as a source of alpha-generating opportunities for our portfolios: India is overrepresented in our quality growth opportunity set, and we have made countless research visits to the country over the past 20 years.
The first leg of India’s multidecade growth story—characterized by an emerging consumer—has evolved to “version 2.0,” centered on building out housing and critical infrastructure.
The first leg of India’s multidecade growth story—characterized by an emerging consumer—has evolved to “version 2.0,” centered on building out housing and critical infrastructure. India’s residential real estate market is booming, and we expect decades of growth given the massive demand and short supply of housing.
The country has announced a $35 billion railway expansion plan, substantial investments in power infrastructure, significant improvements to airport infrastructure, and numerous other initiatives that support our positive stance on the industrials sector.
We also maintain our positive outlook for the Indian financial sector. Since 2005, Indian banks have quietly but significantly outperformed the MSCI AC World Banks Index, and there are reasons for continued optimism, since penetration rates for financial products are trending higher and remain very low relative to the rest of the world on an absolute basis.
Justifiably, the Indian market is trading at a premium to the emerging markets universe, which we believe to be sustainable.
Research Insights
Occasionally, we highlight some innovative research insights from our quantitative research team. One area of recent development that we believe can be a powerful breakthrough is the William Blair improving profitability factor.
Our research in this area stems from analyzing the differences between the investment performance of growth versus value styles. As growth investors, we understand the powerful influence of the valuation factor that drives returns for value-oriented strategies; we acknowledge that we take the risk to actively “bet against” it when we believe future growth to be underappreciated.
It is intuitive and fundamentally based that compared with “value” companies, “growth” companies demonstrate higher levels of profitability, higher investment growth, and lower cost of debt.
We believe we can further reduce the valuation risk inherent in growth investing by better predicting a company’s future cash flow growth and the related level of profitability.
Our longstanding investment focus as growth investors centers on corporate sustainable value creation (SVC), which is our definition of quality (or profitable cash flow growth). Ideally, we would like to improve upon demonstrated SVC and better predict future realized SVC to create an even more powerful investment signal by predicting the levels of future investment growth and future profitability.
Improving profitability’s origin is based on the premise that a stock’s expected return is driven by fundamental characteristics, including current and future investment and future profitability.
Simply put, companies that can invest for growth and do it profitably can generate outsized investment returns. Our improving profitability approach attempts to capture this by identifying the change in a company’s profitability (cash flow return on invested capital, return on equity, free cash flow margin) combined with its investments for growth (research and development, capex).
Adding this approach has been influential since it has many powerful attributes. It strengthens the SVC signal, in both duration and magnitude. It is less volatile than other signals of changing corporate performance, such as earnings revisions. It has low correlation to other factors. And it is effective in all economic regimes.
Thus, we believe we can further reduce the valuation risk inherent in growth investing by better predicting a company’s future cash flow growth and the related level of profitability.
In our opinion, companies that consistently demonstrate superior attributes should continue to outperform. This should prove effective in all market regimes, which is important given our assumption that the economic and market backdrop for investing will be different during this decade than the last, where growth investing at any cost was rewarded.
The return to a more-balanced backdrop should put a premium on the precision of growth investing execution, and we believe we have developed another tool that will be additive to our suite of investment insights.
Ken McAtamney, partner, is the head of the global equity team and a portfolio manager on William Blair’s global equity team.
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The MSCI Emerging Markets Index is a benchmark index that tracks the performance of stocks in emerging market economies. It includes large- and mid-cap companies across 27 emerging market countries, providing a broad measure of equity market performance in these regions. The MSCI AC (All Country) World Banks Index is a benchmark index that tracks the performance of global banking sector stocks.
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