The quarter began with President Trump’s “Liberation Day” on April 2nd, which marked an unprecedented increase in tariffs on imports into the United States. This was the country’s largest shift in trade policy in a century. The tariffs announced went further than had been expected, rocking global equity markets which declined more than 10% in the first week of the month. There was a notable disconnect between investor expectations for an in-depth policy assessment by the US government of bilateral trade relationships with different countries and the reality of the policy that was announced, in particular the seemingly crude approach to calculating the tariff rates to be applied. Concerns grew about the clarity and direction of the new administration’s trade strategy.
Despite the background uncertainty and the cooling economic momentum in the quarter – cracks in the US employment data, weakness in construction data, factory activity in contraction – markets have subsequently rebounded strongly, with US stocks wiping out their losses for 2025 later in the quarter as President Trump backed away from some of his most severe tariffs and trade talks progressed. While the US index marginally lagged EAFE in the quarter, relative performance largely reflects US dollar weakness: in local terms, MSCI USA outperformed EAFE by more than 6%. Growth equities have outperformed, with AI euphoria returning to markets following the DeepSeek reversal earlier in the year: although model releases during the quarter were mixed, the continued growth of high-profile AI tools, alongside increased hyperscale capex commitments, helped ease concerns that innovations from DeepSeek might dampen investment in the sector.
While tariff rates have been temporarily reduced as the US administration negotiates deals with its trade partners, the current effective tariff rate remains materially higher than where we began the quarter, representing a significant drag on the US economy. The US tariffs that remain in place are steep, despite what appears to be a developing détente between Washington and Beijing: the last time that the US saw a 10% tariff on all trading partners was more than fifty years ago. There is much to be positive about in terms of recent efforts to end the tariff standoff. However, these negotiations have been volatile: witness President Trump’s cutting off of trade talks with Canada over its digital services tax on US tech companies at the end of June, only for Canada to rescind the tax to salvage discussions days later.
At current levels, with markets resurgent, investors appear complacent that countries can successfully deescalate from their current tariff stance with limited impacts on global economic growth. Alongside renewed geopolitical instability, including the latest conflict in the Middle East, trade policy is likely to be a continued source of equity market volatility in the year ahead.
Long-term borrowing costs hit new highs in the US
After more than a decade of very low interest rates in advanced economies, real long-term government bond yields have been on the rise, surging in recent months. In the US, higher long-term rates, initially driven by monetary policy tightening, have persisted as the result of higher expected inflation and increased issuances to finance the federal deficit. Recent tariff announcements have led to a further spike, with the yield on 30- year US bonds pushing past 5% in the quarter. Fiscal support during the pandemic and at the onset of the war in Ukraine sharply increased debt-to-GDP ratios. Budget deficits remain large, with fiscal space now much tighter than a decade ago. The US ended 2024 with a budget deficit of 6.4% of GDP (the percentage was even higher as at the end of Q1 2025, close to 8%, although quarterly numbers need to be treated with some caution given the seasonality of tax collections). This is a weak fiscal position, previously unheard of at a time when the economy is growing and there is no war or immediate emergency.
At the beginning of July, Congress passed the President’s Big, Beautiful Bill, ahead of Trump’s self-imposed Independence Day deadline. The bill is expected to add at least $3.3tn to the US debt by 2034, according to the independent Committee for a Responsible Federal Budget. Notably, as the bill made its way through the legislative process, there were few signs of serious attempts by members of Congress to restrain the deficit. The worsening fiscal situation has not gone unnoticed: Moody’s downgraded the US credit score from Aaa to Aa1 in May, citing chronic budget deficits and rising debt service costs – they forecast that as a result of President Trump’s bill, the deficit may rise to just under 9% of GDP by 2035 (Fitch and S&P, the other main agencies, had previously removed the US’ pristine rating in 2023 and 2011, respectively).
Higher US government borrowing increases the cost of money, crowding out the public and private investment that should lead to greater economic growth. A remarkable milestone was passed in 2024: for the first time, US spending on debt servicing surpassed US defense spending. US government debt servicing costs as a percent of tax revenues are near post-Second World War highs, despite current interest rates far below historical averages (see the chart below), given the volume of debt now required to finance the deficit. For more than a generation, low debt servicing costs have made it possible for the US to cut taxes, increase spending and grow its debt, without a meaningful impact on interest costs. This allowed US policymakers to support the economy in the case of negative shocks or marked downturns, such as the financial crisis or COVID. In today’s more limited fiscal environment, high public debt levels make that challenging.
Despite the potential drag on economic growth from tariffs, the US economy is unlikely to receive the same level of fiscal support in the coming years as it has in the recent past. The US has had structural deficit problems for some time but worries about the deficit tend to increase when interest costs crowd out other priorities. With debt servicing costs near all-time highs, investors appear to be growing increasingly concerned about America’s fiscal trajectory.
Japan confronts a familiar economic dilemma
Yields on long-dated Japanese government bonds surged to more than 25-year highs in the quarter. This recent rise in 30-year JGB yields reflects a lack of domestic investor appetite for longer durations, rising inflation expectations and the Bank of Japan’s tapering efforts.
Japan’s gross government debt to GDP ratio is high but Japan has often been considered a special case in bond markets, given that its government debt is mostly held domestically, which helps to mitigate the risk (unlike the US, which has significant foreign ownership of its debt). Japan’s public net debt is also far lower than its gross debt − around 134% of GDP*– given the government’s substantial financial assets. That ratio remains higher, however, than that of the US and most other advanced economies. Approximately half of Japan’s vast bond market is held by the Bank of Japan and not traded. Nevertheless, Japan continues to face challenges from high levels of public debt that are forecast to rise, with increased interest payments and expenditure pressures related to spending on health and long-term care for an aging population. According to the IMF, interest costs, which already account for 10% of central government spending, are on track to double by 2030. A robust, near-term debt management strategy from Japan’s ruling coalition may be required to offset these pressures.
Importantly, risks from the country’s debts could impact markets far beyond Japan: its sovereign debt market, the world’s second largest, has the potential to be a destabilising force more broadly. If higher JGB yields lead to repatriation by Japanese investors from the US, this could result in an unwinding of yen carry trades and a global market sell-off as happened in August 2024. Also of concern, in the event that the JGB curve keeps steepening, is that global investors may start to buy longer duration JGBs at the expense of US Treasuries, with the potential to rattle the US Treasury market still further. We continue to monitor this closely.
From an equity investment perspective, Japan’s high government debt stands in contrast to the strength of its corporate sector – reflected in robust balance sheets that support a positively skewed range of outcomes for the Japanese holdings in Mondrian portfolios. Despite parallels in sovereign debt dynamics with the US, Japanese companies generally trade at more attractive valuations and start from a stronger financial position, offering compelling stock-picking opportunities for bottom-up investors like Mondrian.
We do not assume that Japanese corporates will successfully unlock all of the balance sheet value in our base-case scenarios. However, when analyzing companies, we consider not only the base-case, but also worst- and best-case scenarios. Balance sheet strength plays a crucial role in both, supporting the skew of outcomes in our bottom-up valuation analysis.
More pertinently, a strong balance sheet provides resilience against future macroeconomic or company-specific challenges. All else being equal, we would expect a well-capitalized company’s worst-case to be meaningfully better than that of an equivalent, highly leveraged company. Many Japanese companies’ worst-case scenarios appear more favorable than the broader macro environment might imply – reflecting the tendency of these businesses to maintain conservative, well-capitalized balance sheets.
In a best-case scenario, the balance sheet value may be returned to shareholders, providing additional value on top of operational outperformance. Improving corporate governance in Japan and a growing focus on capital allocation are increasing the likelihood of such positive outcomes for these holdings. Mondrian portfolios have benefited from positive stock selection in Japan over multiple time periods. Improving corporate governance in the country has continued to unlock shareholder value through better capital allocation decisions and improving distributions. There can, however, be challenges along the way. We have seen this in the most recent quarter with our holding in Toyota Industries, an investment discussed in greater detail below.
Japanese corporate governance reform faces a stiff test
As long-term shareholders in Toyota Industries, the global leading supplier of forklifts and auto air-con compressors, we have seen meaningful progress towards unlocking shareholder value, while also encountering the pitfalls associated with weak corporate governance. Since first investing in the business in 2020, we have flagged the unrealized value in the company’s mix of businesses, alongside its heavily over-capitalized balance sheet. Indeed, at the time of initiation, the value of Toyota Industries’ cross-shareholdings exceeded its market capitalization. We have made cautious assumptions around capital allocation in our modelling of the company. While acknowledging the Toyota Group’s undue influence, the company’s exceptional balance sheet value supported the skew of outcomes. Over several years, we have actively engaged with the company to encourage improvements in governance practices. It was encouraging to see recent steps in the right direction, including the reduction of group cross-shareholdings and the initiation of a multi-year program of share buybacks. However, there is still considerable progress to be made.
In April 2025, media rumors first emerged that the Toyota Group wanted to privatize Toyota Industries for around ¥20,000 per share, a 40% premium to its market price at the time. The share price shot up on the news. We spoke to the company and flagged that we felt this offer undervalued the business. In June 2025, the formal announcement of a tender offer from the Toyota Group at ¥16,300 per share was released. While 23% above the undisturbed share price (and well above our purchase price), we believe this offer grossly undervalues Toyota Industries. On a simple, sum-of-the-parts valuation, the implied multiple for the strong underlying businesses of less than 4x EBIT is unjustifiably low, even without including the potentially significant real estate value (which remains undisclosed) or any control premium. We have not been alone in pointing this out to the company.
The unwinding of Toyota Group cross-shareholdings has the potential to be a win-win for all parties, and for Japan more broadly, but the way the transaction is currently being executed risks undermining that outcome. The lack of transparency over valuation assessments given the myriad conflicts of interest in this complex transaction is indefensible. With Japan’s new M&A rules being tested and the Tokyo Stock Exchange seeing unprecedented angst from market participants, this case has attracted significant media attention domestically and internationally, emerging as a bellwether for Japan’s corporate governance reform. The Asian Corporate Governance Association described the proposed Toyota Industries’ privatization as “a governance test Japan cannot afford to fail”. This transaction, as currently proposed, is an egregious example of the poor governance practices that corporate Japan, helped by the Tokyo Stock Exchange, has been moving away from and risks undermining the significant progress that has been made.
Nevertheless, the level of public anger in response is itself a strong signal that Japan is changing. Notably, the Tokyo Stock Exchange is set to introduce new protections for minority shareholders in July – this may explain the timing of the Toyota Group’s offer, shortly ahead of these changes. With the global spotlight on this deal and on the broader trajectory of corporate governance in Japan, and time still remaining until the proposed December completion date, we remain committed to engaging both privately and publicly in the pursuit of a fair outcome for our clients as shareholders in Toyota Industries.
Despite our frustrations with the specifics of this proposed transaction, the broader momentum behind corporate reform in Japan continues to build. One key recent positive has been the sharp increase in share buybacks, which have reached record highs despite increased market volatility. This marks a clear shift from the past tendency to adopt a defensive stance during periods of uncertainty. Share buybacks are up 20% year-over- year so far this year, following a doubling in FY24. This development, alongside the continued unwinding of cross-shareholdings, supports our broader thesis that corporate Japan is undergoing meaningful change for the better, even as isolated cases remind us that further progress is still required.
Conclusion
There has been a dramatic turnaround for markets over the past quarter. Investors have enthusiastically welcomed the possibility that global governments can successfully reorder trade policy with a limited impact on economic activity. Exuberance has returned, though it has manifested itself slightly differently across market segments. Global indices have rallied strongly off April’s lows, ending the quarter near all-time highs, with recent geopolitical shocks failing to disrupt the sharp recovery. Despite this strength, we believe that uncertainties in markets are large and that the range of outcomes between our scenarios is widening. 2025 could still turn out to be a testing year for equity markets.
Faced with high debt and rising financing costs, many governments – including those in the US and in Japan – may soon have to make difficult trade-offs between near-term spending pressures and medium-term debt sustainability. This may not be straightforward: post-COVID experience has shown, across economies, that it is far easier to turn on the tap of fiscal support than it is to turn it off.
For Mondrian, high government debt levels bring risks to investing in Japan, which we monitor closely (as we wrote above, high domestic ownership helps, while normalization towards modest inflation in Japan is healthy for economic functioning and debt repair, so long as kept to reasonable levels).
At the same time, it is important to highlight the attractive opportunities in Japan today: there are currently strong, bottom-up value ideas in this broad and deep market, especially in those companies with overcapitalized balance sheets. We are focused on identifying those mis-priced securities, in what we believe is probably the least well-covered developed equity market, using our fundamental, forward-looking, bottom-up, and value-focused approach.
Given continued policy uncertainty, with President Trump’s 90-day pause on reciprocal tariffs expiring early in July, turbulence could soon return to markets. We welcome that, because we think that our investment approach offers a competitive advantage in complex times. We have a robust, long-term, disciplined valuation framework. While we try to anticipate how the future might develop, we do not rely on any single point forecast. The evaluation of stocks under different scenarios, and thinking about the skew of possible outcomes, has always been central to our investment process and decision-making. We believe this structured scenario analysis framework, within a disciplined valuation methodology, will help us understand the likely distribution and skew of future returns. It is a framework that can be particularly attractive in a highly uncertain environment.
Disclosures
Views expressed were current as of the date indicated, are subject to change, and may not reflect current views. All information is subject to change without notice. Views should not be considered a recommendation to buy, hold or sell any investment and should not be relied on as research or advice.
This document may include forward-looking statements. All statements other than statements of historical facts are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results to differ materially from those reflected in such forward-looking statements.
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This material is for informational purposes only and is not an offer or solicitation with respect to any securities. Any offer of securities can only be made by written offering materials. The information set forth herein is a summary only and does not set forth all of the risks associated with the investment strategy described herein.
The information was obtained from sources we believe to be reliable, but its accuracy is not guaranteed and it may be incomplete or condensed.
It should not be assumed that investments made in the future will be profitable or will equal the performance of any security referenced in this document. Examples of securities will represent only a small part of the overall portfolio and are used to illustrate our investment approach. Any holdings are subject to change and may not feature in any future portfolio. More information on holdings is available on request.
Unless otherwise stated, all returns are in USD
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Past performance is not a guarantee of future results. An investment involves the risk of loss. The investment return and value of investments will fluctuate.
Mondrian Investment Partners Limited is authorized and regulated by the Financial Conduct Authority (Firm Reference Number: 149507). Mondrian Investment Partners Limited is also registered as an Investment Adviser with the Securities and Exchange Commission (registration does not imply any level of skills or training).
