Fidelity International: Investment themes to watch in Q3
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Is this the post-pandemic normalisation we were waiting for? Economic activity has held up this year as labour markets and consumer demand find a healthier balance. These improving fundamentals have shaped Fidelity International’s thinking around three main themes heading into Q3, as Henk-Jan Rikkerink, global head of solutions & multi asset at Fidelity International outlines:

1.     Soft landing, risk on

“The story of 2024 so far has been one of solid economic fundamentals. Signals suggest that the US still leads the pack, but Europe and the UK appear to be turning a corner, while continued stabilisation in China should mitigate its drag on the global economy.

“Sticky inflation continues to temper expectations, however labour market reports for June looked hotter than the US Federal Reserve (Fed) would like, but softening inflation in May adds to our growing confidence that price rises won’t reaccelerate from here. The range of outcomes when it comes to the magnitude of potential rate cuts by the Fed have narrowed significantly since the start of the year. We think that the bar for the cutting cycle to start remains high but recent progress on the inflation front has been encouraging.

“A soft landing looks to be the most likely outcome - and that’s a good thing for global growth and investors who are willing to take on additional equity risk.  

2.     Controlled stabilisation in China

“It’s unwise to take your eye off the world’s second largest economy, even if some international investors have withdrawn from its shores for now. We continue to believe that 2024 will be a period of 'controlled stabilisation' for China. Policymakers continue to reduce the dominance of the property sector and rebalance the economy towards higher-end manufacturing and consumption.

“Wider policy shifts are starting to bear fruit in certain corners of China’s economy. The most obvious is manufacturing, supported by a resurgence in overseas demand. There are some upbeat signals from consumption too, led by the rebound in holiday travel.

“This stabilisation is good news for China. It also bodes well for other economies in the region and for investors”.

3.     Time to be tactical

“Solid fundamentals and a strengthening China mean we are adding risk to our portfolios. But doing so requires a nose for nuance: we expect divergence between regions and sectors is likely to be high in Q3, which means being tactical with that risk.

“One point of divergence is monetary policy across developed markets. The eurozone has cut rates ahead of the US, as we expected. While this lays some groundwork for Europe to build on the positive momentum it’s established over recent months, the risk of a devaluing euro means that the European Central Bank’s (ECB) easing path from here is closely tied to the Fed’s. We think it’s unlikely the ECB will cut much further without the Fed following suit.

Conditions look ripe for US and Japanese equities to continue their strong run. Robust growth and healthy earnings in the former, coupled with structural tailwinds and corporate reforms in the latter, go some way to justifying rising valuations in these regions. But they don’t go all the way - in the US in particular, we’re looking beyond frothier parts of the market to uncover value. Mid-caps offer strong long-term growth potential at a reasonable price, and they should also prove resilient to higher rates.

“On a sectoral basis, it’s hard to look beyond the earnings momentum of technology companies, and we also like the positive earnings revisions of US and European financials.

“We like convertible bonds, which can benefit from any continued momentum in equities and can offer some protection if credit spreads don’t widen substantially. It’s a segment of the market that’s becoming increasingly populated by higher quality issuers, including some from attractive growth sectors like technology.

“It’s finding seams in the market like these which could lift portfolio performance this quarter. The global economy now marches to a positive beat, but diverging policy will breed differentiating performance across assets.”

Deep dive on Asia: Policy shifts give investors reasons for optimism

Many of Asia’s markets are being supported not only by policy measures to stimulate local economies, but also by capital market reforms and economic transitions aimed at longer-term growth. This is positive because when both work in tandem, the region draws investors in.

Marty Dropkin, head of equities, Asia Pacific, Fidelity International comments: “Corporate governance reform has been a common theme across Asia in recent months. China, Japan, and South Korea have all stepped up efforts to push companies for higher dividends and share buybacks. China's Nine-Point Guideline, which was unveiled in April, includes measures to encourage dividend payments and to improve on corporate governance. Earlier this year, South Korea introduced its Corporate Value-Up Programme to reduce the so-called ‘Korea discount.’ In Japan, plans for corporate-governance reform received a boost more than a year ago when the Tokyo Stock Exchange started pressuring companies to increase returns for shareholders.

“The ongoing changes should raise dividend payout ratios across the region. The average payout ratios for Chinese, South Korean, and Japanese companies in the past five years have been 31 per cent, 33 per cent, and 40 per cent, respectively. The global average is 48 per cent and in Europe it is 65 per cent; so there is some way to go. It may take time for Asia’s ‘iron roosters’ - a term used in China for companies that do not pay stock dividends - to change their ways, but we have seen clear improvements this year already. Reforms like these will help burnish the appeal of companies with consistent dividend growth and bring about welcome progress to local capital markets.

“Beyond that, we also continue to see green shoots emerge in many corners of China’s economy. The most obvious is in manufacturing, supported by a resurgence in overseas demand and Beijing’s focus on high-tech production. Manufacturers of electric vehicles, medical imaging equipment, and heavy machinery continue to eye foreign markets as domestic demand stays relatively subdued. There are some upbeat signals from consumption coming through, such as the rebound in holiday travel, but the property sector, which accounts for a big portion of Chinese household wealth, continues to weigh on consumer sentiment.

“China’s policymakers ramped up support in May, trying to absorb unsold apartments while avoiding any new asset bubbles. But we should be clear that these policies are not intended to kickstart a renewed acceleration of economic growth. Instead, the aim is to engineer a stabilisation in property to facilitate an ongoing, multi-year transition into a new growth model driven by consumption and high-end manufacturing. We expect policymakers will remain focused on the economic transition goals but will also use targeted and countercyclical policy easing to stimulate the economy and restore business and consumer confidence.

“While mainland China’s economy moves to recovery, its Asian peers are also forging ahead. India is benefiting from robust growth momentum, a sizeable working-age population, and strong consumer spending. At the same time, the surprise election result has introduced some volatility into Indian markets, however we don’t expect this to disrupt the country’s long-term growth story. A coalition government with additional checks and balances should contribute to investor confidence. In the near term, we expect some consolidation in small and mid-cap sectors where valuations are at frothy levels, while financials and consumer businesses should see positive moves.

“Taiwan offers another bright spot, as home to the world’s leading semiconductor and high-technology companies, which now form a significant part of global supply chains. We are still in the early stages of the AI technology cycle, and the evolving AI story will continue to fuel demand for advanced chips, supporting optimism around Taiwan’s leading firms.

“While the outlook for Asia is becoming more positive, we are mindful of the risks in the coming months, ranging from geopolitics to the impact of higher-for-longer US interest rates on Asia’s currencies. However, supportive policies and long-term reforms should give investors much to cheer about in the third quarter and beyond,” Mr Dropkin says.

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