Monday digest

Posted 3 June 2024

Markets Consolidate

Global stocks were slightly down last week, but with no obvious trigger. It felt like consolidation through month-end rebalancing, after many stock markets hit all-time highs in May. In that respect, the week’s action was reassuring: previous returns solidified, and stock valuations looking less stretched than they did earlier in the year. That bodes well.

Donald Trump’s “hush money” conviction was of course the biggest news story, but it had little impact on markets. It is hard to say whether it will impact his chances of winning the presidency again, but this difficulty is one of the reasons markets are more focused on other factors. The all-important US consumer is becoming less confident, but a lot of that seems to be down to political allegiance (‘my preferred candidate is/isn’t in office so the economy must be good/bad’ – as we discussed last week) so it might only have a gentle impact on growth and inflation.

The Federal Reserve’s actions are much more important for markets. Interest rate expectations have stabilised after shifting dramatically earlier in the year. Markets expect the Fed to cut just once, by 25 basis points, by the end of the year, but have accepted that as a fair level for a gently slowing but fundamentally strong economy. That strength means upwards creeping corporate profits, which are pushing up markets without overheating them. Interestingly, Europe is gently accelerating, with above forecast inflation, but this is not expected to deter the ECB’s June rate cut.

Markets seem tuned into the growth benefits that come with inflation rather than just worrying about rates. Companies that disappoint are being punished – like Salesforce shares last week – while only those with provable growth potential are being rewarded with high valuations. That is good news, considering that stretched valuations were one of the biggest concerns earlier in the year. Even if this week seemed dreary, the message is positive: returns are based on fundamentals, and the fundamentals are improving.

ESG out of fashion?

ESG investing was once the financial sector’s biggest growth area, but underperformance and political backlash have weighed heavily in recent years. ESG funds have reportedly seen $38.5bn of net outflows this year, while non-ESG funds have seen $216bn in net inflows.

The controversy around ESG was also on display during the shareholder drama at ExxonMobil. Exxon took the extreme decision to sue certain activist shareholders for repeatedly bringing a resolution to reduce the company’s emissions. The board’s actions garnered the activist investors sympathy with some of Exxon’s larger institutional investors, many of whom are angry about the apparent assault on shareholder rights. This shows the changing for the worse attitude towards ESG from corporates.

In the UK and Europe, controversy around ESG investing is mainly about ‘greenwashing’ – where ESG credentials are misrepresented – and the opacity of ESG investments. New regulations have been brought in to tackle these issues, by giving stricter rules on investments using labels like “sustainable”. We have argued in our ESG Honestly blog that these should improve transparency and make things clearer for end-investors and providers alike.

There is a long way to go, though. Aggregate ESG ratings, for example, are typically very opaque and present a network of complicated issues and judgement calls as a single number. Those ratings get used in building ESG investment products, but it is usually extremely hard to work out whether the ratings system reflects matches up to your own principles. That is a problem, because without knowing why certain companies are judged as ‘better’ on ESG metrics, we cannot know whether we agree with that company’s inclusion or exclusion from our investments.

New regulations are a sign that ESG investment is still hugely important, even if the sector has fallen on hard times. The demand is still there, investors are just worried they might not get what they want. Hopefully the new rules and shifting attitudes will soothe these fears.

Will Yen weakness last?

The yen has lost nearly 10% of its value against the dollar since the start of this year, making it the weakest major currency in 2024. But it would be wrong to view this as markets turning sour on Japan. Its stock market has gained nearly 16% year-to-date at the time of writing. This rally has stalled since March, but market positivity about Japan is underlined by meaningful reforms to corporate structures, which have helped firms’ profitability.

Currency weakness is instead down to interest rate differentials, with Japanese rates at 0.1% compared to 5.5% in the US. That makes the ‘carry trade’ (borrowing where rates are low and keeping the money where rates are high) more attractive, sending money from yen to dollars.

That will change, though. The Bank of Japan has raised rates already and officials have hinted it could again, pushing 10-year Japanese government bond yields above 1% for the first time in more than 13 years. Meanwhile, the expectation is that the Federal Reserve will cut rates this year, even if the timeline has been repeatedly delayed. That inevitably means a pull back in the US-Japan rate differential. On the other hand, the BoJ has made clear it cares only about inflation and not the dollar-yen rate. It tends to step in only when sharp devaluations threaten price stability, and is otherwise nonchalant about a weak yen. We therefore expect no big swing up – even if further falls are unlikely. This matters because Japanese stocks have been some of the best performers in 2024, but the yen’s fall has taken the shine off those stellar returns. Going forward, currency issues should be less of a barrier, allowing international investors to take advantage of Japan’s positivity.

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