The second half of 2023 kicked off with widespread gains across global small cap markets. Softer inflation readings, a more dovish tone from the European Central Bank, and surprisingly good US economic data were key catalysts in the strong performance of North America and Europe. Along with falling inflation, a strong labor market, and increased consumer confidence, better than expected business activity raised hopes for a US soft landing. The rally was brief, however, as global markets began to decline in August on hawkish Fed commentary, fading consumer and business sentiment in Europe, rising energy prices, and continued concerns around China. Japan was the sole bright spot due to strong earnings and better than expected GDP growth. However, macro concerns continued to build in September, bond rates marched higher, and Japan finally weakened on growing expectations for BOJ policy changes driven by a rapidly weakening yen.
Regional returns ended lower with Europe (-5.7%) weakest, led by the Nordics. Only Portugal ended the quarter higher. North America (-3.2%) and Asia (-1.3%) also ended lower. Once again, the strength in the US dollar (USD) offset some better local returns. During the quarter foreign exchange (FX) hurt returns for USD investors by about 2.7%. Most sectors were lower with the large exception of Energy (+14.2%) and very modest gains in the defensive Consumer Staples (+0.1%), and more cyclical Financials (+0.4%).
The third quarter tends to be a time of travel for our investment team where we re-underwrite our investment cases and look for interesting new ideas. Given the recent weakness in the market we thought it might be interesting to discuss some broad ideas we currently find attractive and that the market seems to be mispricing.
The Covid years of 2020–2022 made comparative analysis very difficult. Year-to-year numbers varied significantly, and it was unclear for much of this period if many of the unusual demand trends unleashed by the pandemic were sustainable and how far we, as analysts, should extrapolate cost increases. There is a group of companies which saw a boom in demand during Covid and are now seeing revenue headwinds. However, we have found some that are actually delivering higher margins as sales come down. A good portion of this is due to improved product ‘mix,’ such as lower sales of hardware, but more value-added services, while others are purely related to delayed price increases and improving costs.
We remain bullish on Japan with the weak currency providing a well-known cost advantage for companies competing overseas. What is less well known is that Japanese wages are incredibly competitive even without the FX benefit. Given language barriers, Japanese wages are set based on local rather than global markets. We are exposed to several companies which benefit from this trend and expect the gap to actually increase as labor action (such as the United Auto Workers strike) drives up the cost of labor in other developed markets.
In the short-to-medium term we continue to expect very strong capex-related demand in areas such as electric vehicles, batteries, and semiconductors. We remain quite cautious in the longer term, expecting global subsidy competition to result in massive over capacity. However, we have several holdings which benefit from the current capex boom and are well positioned to take share due to their focus on electrification and automation.
Another area where we remain watchful is with companies whose businesses may get caught on the wrong side of a geopolitical event or trade dispute. For example, we have recently seen the discussion about how China has surpassed Japan as the leading auto exporter. While true, it totally misses the point. In the 1980s, Japan realized how vulnerable their auto sector was to trade barriers and so began to produce locally for local demand. Japanese cars sold in the US are likely to be made in one of the NAFTA countries, Chinese demand is satisfied by local production, and countries like Thailand supply demand for the ASEAN countries. We expect that China will quickly re-learn this lesson as well.
Overall, we continue to see very attractive opportunities in developed markets. Stocks have sold off at higher rates, but this provides the chance to pick up high-quality, growing, and profitable investments at bargain prices. For those who can buy using the stronger USD, the value on offer is even more attractive.