Global equity markets rallied in the final days of the second quarter as investors became increasingly confident that a default by Greece will not occur in the near term. This upturn reversed much of the quarter’s earlier losses that occurred in volatile markets buffeted by largely negative economic news and the significant tail risk of a financial market crisis in Europe. Is this more than a relief rally – does it signal we are nearing the end of the “soft patch” of slowing growth in the global economy? The publication at the end of last week of weaker than expected PMIs for many countries (China, UK, the Eurozone) suggested we have not yet seen the bottom of the slowdown in global manufacturing. (The PMI [Purchasing Managers Index] is a composite index combining data on the state of the manufacturing sector and confidence indicators.) The US PMI for June was an important exception to this negative trend, registering a modest rebound, but the increase was mostly due to inventory accumulation.
Markets, of course, are looking forward to the second half of 2011, not backward. The outlook for the second half of this year is for a resumption of somewhat higher growth in both the US and the global economy, as it recovers from several transitory negative influences, including unusually adverse weather, high oil prices and, most important, the Japanese supply disruptions. This note focuses on markets outside of North America.
Global equity markets ended the quarter just about where they started, with the MSCI World Index for equity markets up 0.63% over the last 3 months. They were up 5.62% over the first half on a total-return basis. The benchmark MSCI EAFE Index for advanced markets ex-North America was up 1.83% for the quarter and +5.35% for the first half. Emerging markets underperformed. The benchmark MSCI Emerging Market Index was down 1.04% for the quarter and up only 1.03% for the first half.
Turning to Europe, while sovereign debt concerns in the Eurozone raised investor fears that roiled markets around the globe, European equity markets managed to outperform other advanced markets in both the second quarter and year-to-date. The MSCI EMU Index for the Eurozone equity markets gained 3.17% for the quarter and 13.33% for the first half. This was largely due to the strong performance of the two core economies, Germany and France. While in Paris last month I found a city bursting at the seams, with full hotels and restaurants. The French we met were much more interested in discussing domestic politics and US reactions to the Strauss-Kahn affair than any economic concerns.
The growing gap between the stronger core economies and the weaker peripheral countries in the Eurozone is striking. Germany’s GDP is projected to advance 3.5% this year, and France’s 2.3%. In contrast, Spain’s growth for 2011 is likely to be only +0.9%, Italy’s + 1.3%, Ireland’s +0.2%, and Portugal’s -1.8%. However, the respective equity market performance has not fully reflected these differences in economic growth. The year-to-date advances in the respective MSCI equity market indices are Germany, 15.09%; France, 16.38%; Spain, 16.17%; Italy, 11.69%; Ireland, 17.61%, and Portugal, 10.38%.
Recent data, including the PMIs for June noted previously, indicate some increased softness in the Eurozone economies. Despite these data, prospects have increased for the European Central Bank to raise interest rates at their next meeting, a move that would be expected to further strengthen an already high euro and hamper export growth. Coupled with continuing uncertainties as to how the sovereign debt situation will evolve, we expect European equity market performance to moderate in the current quarter.
Outside of the Eurozone, the UK is looking particularly soft. The Swiss economy is dealing with a strong currency that is hampering export growth, while low unemployment and inflation are favorable for domestic demand growth. Sweden has the most robust growth of the three. Indeed, its projected 4.5% GDP growth for the year is higher than that of all other advanced economies except Hong Kong (+5.8%) and Singapore (+6.0%). Switzerland’s equity market has had the best performance of these three economies in the first half, as measured by their respective MSCI equity market indices, +9.32%, compared with +6.34% for Sweden and +5.59% for the UK.
The equity markets of the major commodity-exporting countries, Australia and Canada, were negatively affected by uncertainties over China’s future demand for commodities and more general concerns about the implications for commodity markets of a slowdown in global growth. The MSCI Index for Australia advanced 3.90% over the first half, and that for Canada only 2.87%. That underperformance, which was particularly marked in the second quarter, should ease somewhat with the expected quickening in the pace of the global economy.
Japan’s manufacturing is recovering more rapidly than many expected from the severe earthquake, tsunami, and nuclear crisis. The economy should rise sharply in the second half of the year. While there will be some power cuts in the summer, the plans for these have been reduced significantly. Uncertainties about action on supplementary budgets cloud the outlook. Japan’s equity markets understandably are down for the first half (MSCI Japan, -4.68%). Prospects look better for the remainder of the year, particularly should there be an improvement in the political situation.
Following a positive spurt in April, emerging-market equities as a group lost ground in the latter two months of the second quarter. As noted earlier, the MSCI Emerging Market Index is down 1.04% over the past 3 months and up only 1.03% for the year to date. The adjustment in these markets has been very broad-based. Indonesia and Chile are the main exceptions, up respectively 7.95% and +8.84% during the second quarter. The recent decline in emerging markets reflected the global equity market correction that was due to a growth slowdown in advanced economies, the concerns about Greece, supply disruptions in Japan, high oil prices, and concerns about MENA – in other words, issues that affected risk appetites in general, not specific emerging-market issues.
On the contrary, emerging-market economies continue to perform well. Tightening of monetary policy by their central banks is pretty much completed. China, now the second largest economy in the world, appears to have achieved a soft landing and is continuing to advance at a 9% rate. Elsewhere, India is growing at a 7.5% clip, Indonesia at 6%, Chile at 6.5%, Korea at 4.4%, and Brazil at 4.2%. The anticipated quickening of economic growth in the advanced-market economies in the second half should lead to better emerging-market equity market performance. However, we note that emerging-market equities are no longer as attractive as they once were as a value proposition. This may help to explain why over the period since last November, emerging markets have failed to rally, even though capital inflows were at record levels and their economic growth rates led the world. The market may well have already priced in the strong positives that have characterized many of these markets in recent years.
In sum, we have an overall moderately bullish view of global equity markets going forward, based on expectations of an end to the current soft patch in the economy. There are downside risks to this outlook, such as the uncertainty about effects of ending QE2 in the US and the expected credit tightening in Europe, further chapters in the sovereign debt saga, possible political developments in the MENA region, and the future course of oil prices. Moreover, the third quarter historically has been a difficult one for equity markets. It will be important to monitor developments closely and differentiate between national markets to identify opportunities to add value and situations where risks are mounting.
