Global developed markets advanced again this quarter, although there were some areas of relative weakness. The MSCI World ex USA and MSCI World ex USA Small Cap Indexes finished the quarter up 5.7% and 4.8%, respectively. After a rally last quarter the U.S. dollar weakened slightly, but is still higher on the year.
Markets were up across every region and sector, although there were some divergences by country. Asia was the laggard again this quarter, with Japan actually down –0.9%, while North America was up almost 10% and Western Europe was close behind. Israel, Denmark, and Italy led, while Japan was the notable outlier and the only country with a negative return. Unlike last quarter, the Japanese yen was not to blame as it was stable against the U.S. dollar. On a sector basis, Energy remained on top, followed by Real Estate and Health Care. Consumer Staples, Utilities, and Materials lagged, but were still higher. Energy diverging from Materials highlights how demand is recovering, while supply continues to be constrained.
After conversations with various company managements and listening to first quarter earnings calls it is clear that the market still faces two major sources of uncertainty: the timing of COVID-19 recovery and the path of inflation. The countries that did well at preventing COVID’s spread early in the pandemic have generally performed poorly during the vaccination process. Inflation meanwhile is showing up everywhere in higher input costs, but the more sticky wage inflation and how likely companies are to pass along their cost increases differs by country. As a result, for the first time in about a decade, different countries are at different stages of the economic cycle.
China was the first to feel the impact of COVID, but has also been the first to recover. It experienced a strong recovery in mid-2020, but has since seen growth slow as government support has waned. A bit ironically, China is running the most orthodox monetary policy of any of the major economies. However, a slowing credit impulse, increasing regulations, and a post-peak economy have resulted in continued underperformance of its stock market.
After feeling the full brunt of the pandemic during 2020, the U.S. and UK led the major developed economies in vaccine deployment and have seen strong economic recoveries as a result. They will likely reach growth peaks in the second or third quarter of 2021. Europe fumbled its initial vaccine roll out, but has since improved. While its economy is behind by several quarters it’s on the same recovery path. Also in Europe’s favor is much of their fiscal EU support package has yet to be spent. As a result, Europe may become a driver of global economic growth just as the U.S. and China decelerate.
Japan did a remarkable job containing infections, however, their vaccination process has been almost embarrassingly inept. Though, they seem to have addressed the issues and will likely have the population vaccinated by the end of the year. The remaining countries fall into two categories: those like New Zealand or Australia, whose success in keeping out the virus will become a liability once the rest of the world reopens; and mostly emerging countries, which have yet to ramp vaccinations and will likely not see a recovery until 2022 or beyond.
The topic of inflation deserves its own note. Inflation and interest rates are likely to diverge based on local fiscal and monetary policies. For example, the U.S. used enhanced unemployment payments to support workers impacted by the pandemic, while Japan and Europe paid companies directly to keep workers employed. Now, during the recovery, U.S. companies are finding they need to increase wages to entice workers to return. In countries where the workers never stopped receiving paychecks, that problem doesn’t exist. Given that wages are some of the “stickiest” prices there may be an element to inflation in the U.S. which is not seen overseas.
The takeaway is that these differences in the timing of economic recoveries are likely to provide both problems and opportunities for investors. While no one knows what the future holds, our approach has been to strengthen our commitment on investing in companies with strong business franchises and improving visibility, mostly independent of the broader economy. Where this is not possible, we have looked to invest ahead of expected recoveries where the long-term business prospects are strong, but the near term is uncertain. We expect patience and discipline to be rewarded.