Equities Play a Waiting Game

The waiting game continues for the U.S. Federal Reserve (Fed) and other major central banks to cut interest rates this year. In the meantime, however, global equities have performed well. As discussed at the beginning of the year, the economic distortions from the pandemic have normalized, and 2024 is shaping up to be a “normal” expansionary year—that is, one with healthy levels of economic growth and inflation.

The Waiting Game Continues

Consumption continued to drive growth in the first quarter. In the United States, fourth-quarter annualized gross domestic product (GDP), adjusted for inflation, grew to more than 3%. Unemployment remained below its long-term average. And purchasing managers indices (PMIs) indicated expansion in both services and manufacturing.

We expect a continuation of broad growth, particularly in the United States. We should see a bit less in Europe and accelerated strength in Japan. Our views on this have not changed. All in, we believe developed markets should continue to grow by 2%-plus on a sustainable basis.

As mentioned in previous quarters, while we believe inflation is largely in the rear-view mirror and should continue to moderate in both the United States and the euro area, it will likely remain above the historically low levels experienced during the last decade. We expect developed-market inflation of 2% to 2.5%, allowing central banks to ease monetary policy accordingly.

We believe the Fed is likely to lower nominal policy rates as early as the second quarter.

In fact, in March Fed policymakers maintained the forecast of three interest rate cuts this year (leading U.S. stocks to rally to all-time highs). We believe the Fed is likely to lower nominal policy rates as early as the second quarter, even as domestic economic growth remains resilient.

The same is true of the European Central Bank. The Bank of England has also held rates constant, edging toward three cuts as well, while the Swiss National Bank announced a surprise rate cut of 25 basis points, making it the first major central bank to start easing monetary policy.

Global Equities End the Quarter Strong

Strength in global equities continued through the first quarter on earnings results that were largely better than expected. Technology and communication services once again led, but sector performance within the MSCI ACWI Investible Market Index (IMI) Index was broadly positive, with energy, industrials, and financials also posting strong returns.

Has the United States Achieved a Soft Landing?

The United States appears to have achieved a soft landing, with corporate earnings generally better than expected in the first quarter.

The S&P 500 Index hit all-time highs, rising above 5,000 for the first time in February. The “Magnificent 7” stocks (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms, and Tesla) remained among the top performers, but nearly 75% of S&P 500 Index constituents reported earnings above expectations.

Notably, we expect the growth differential between the Magnificent 7 and the rest of the S&P 500 Index to moderate in the coming quarters as sector outperformance broadens.

Europe Shows Economic Resilience

We also saw economic resilience in Europe, in part due to easing inflationary pressures. Sharply declining energy prices buoyed real incomes and consumption growth.

Growth in Europe appears to have bottomed at the end of 2023, and we expect improvement in the coming quarters. Earnings have outpaced expectations, and manufacturing PMIs have trended higher.

Japan—One of the Strongest Markets

Japan was one of the stronger markets during the first quarter, with investors optimistic about its macroeconomic outlook and structural tailwinds.

On the macro front, Japan is finally experiencing positive inflation that appears sustainable. One of the key data points to come out of Japan in the recent weeks was the result of the shunto wage negotiations. These negotiations resulted in the largest wage increase in Japan since 1991, at approximately 5.3%. We expect real wage increases to drive consumption growth, similar to what we have already seen play out in the United States and Europe.

A change to Japan’s corporate governance code should lead to better capital allocation decisions and, we believe, improving returns.

In terms of structural tailwinds, we are continuing to monitor a number of changes driving improvement in corporate performance. The Tokyo Stock Exchange has instituted a program targeting listed companies with low price-to-book ratios and low returns on equity. These companies are being challenged to devise a plan to improve their efficiency or potentially face delisting from the exchange. This should lead to companies focusing on profitability and business lines where they have competitive advantages and may lead to increased M&A activity.

Lastly, Japan has historically scored poorly on corporate governance metrics, but a change to the corporate governance code aims to address things such as board independence and board diversity, which should lead to better capital allocation decisions and, we believe, improving returns. It remains an area of research focus for our team.

China Challenged

China’s near-term outlook remains challenged despite recent monetary stimulus initiatives. We believe market performance in 2024 will depend largely on an economic recovery in which consumer confidence increases, the property market stabilizes, and youth unemployment improves.

Geopolitical risks are also likely to remain an overhang to equity valuations. While tensions have eased in recent months, as the 2024 U.S. election cycle turns to the general election, we expect increased rhetoric and policy proclamations to accelerate.

More than ever, we believe in the importance of active management within Chinese equites.

Against this backdrop, we believe valuations of Chinese equities remain quite attractive relative to their own long-term averages and emerging market valuations more broadly. China is currently trading at about a 20% discount to emerging markets, versus a long-term average discount of 4.5%.

More than ever, we believe in the importance of active management within Chinese equities.

Broader Distribution of Growth Likely

We continue to believe that the normalization of the post-pandemic global economy will result in broader distribution of growth.

This is also consistent with what we would expect during an economic expansion, when performance is driven by earnings growth, rather than valuations, and we expect a relatively strong breadth of profit growth.

The flight to safety has given way to the search for growth, and thus is likely to result in a shift of leadership from some of the more recent obvious mega-cap winners. Recent performance of the industrial and energy sectors is evidence of this.

Ken McAtamney, partner, is a portfolio manager on William Blair’s global equity team.