Global developed markets finished the year higher with the MSCI World ex USA and MSCI World ex USA Small Cap Indexes up 3.1% and 0.4% for the quarter, and 12.6% and 11.1% for the year, respectively. The local returns were much stronger than they appeared as renewed USD strength subtracted about 1.1% for the quarter and 6.5% for the year when translating back from foreign currencies to the U.S. dollar.
It was difficult to draw any macro conclusions from results this quarter. On a sector basis Real Estate, Materials, and Utilities had the best returns, while Consumer Staples, Health Care, and Communication Services sold off. Geographically, both Europe and North America had positive returns, but Asia fell on weakness in Japan and Hong Kong. The yen weakened through a trading range that has held for five years. Historically a weak yen has been supportive of the equity markets, but that correlation did not hold true this quarter. The best markets during the quarter were mostly outside of Asia with a strong rally in Israel, the Nordics, and Australia.
The fourth quarter felt like an intermission prior to COVID-19’s final act. We expect a tentative start to 2022 and then an accelerating recovery in Asia and Europe. Apart from China, and to some extent Japan, most governments have moved towards treating COVID-19 as endemic, and as a result restrictions on travel and services should ease. Global supply chains will also improve although some issues will persist. In particular, we expect a significant improvement in the auto industry. The industry continues to see strong demand but has been unable to fully capitalize as production constraints and lean inventories depress sales. High prices have offset the impact on the Original Equipment Manufacturers (OEMs), but many suppliers are suffering from low production levels. As supply issues resolve and production ramps up, the impact across the supply chain will provide a strong tailwind for global expansion. At the same time, industrial capital expenditures should continue to be strong as companies invest to offset labor shortages and reshape supply chains. If services demand also picks up and global travel resumes the international markets should see a growth catch-up boost to rival what has already occurred in the U.S.
Unfortunately, the year ahead is likely to be just as full of risk as opportunity. The expected monetary tightening in the U.S., happening just as we approach a potential fiscal cliff caused by an end to pandemic-era stimulus spending, could prove to be a very bearish combination. If the Fed is successful in raising rates they may find demand is more sensitive than expected to monthly payment terms, causing a sharp slowdown in spending.
Political risks are also increasing, both long term and short. In Europe, the risk of a Russian “annexation” of Eastern Ukraine grows and the West’s response will likely be an important input into China’s future strategy towards Taiwan. In Asia, Xi will be focused on securing his third term as General Secretary and potentially Party Chairman. Meanwhile, Japan begins rearming for the first time since World War II. In the Middle East, the long-running Iranian nuclear program drama potentially reaches a climax.
One frustration in 2021 was our view that there was a disconnect between the underlying fundamental results at a company level and the market’s recognition of those results. We tend to think changes in portfolio fundamentals that exceed the market returns as compressing a spring. Eventually the spring is sprung and fundamentals will win out.
With so much happening we think the best approach is to focus on bottom-up stock picking with a quality bias. The four key portfolio metrics to focus on are: faster projected growth, lower valuation, better return metrics, and stronger balance sheets than the Index. It is difficult to find all four characteristics in any individual company, but this mixture should be attainable at the portfolio level. Over the long term, we expect that combination of characteristics should result in attractive relative returns, but sometimes patience is required. This is representative of how we invest, with eyes on both risks and opportunities and a focus on long-term company specific fundamentals.