The global economy is emerging from a shock-filled first quarter, still on the path of recovery, with growing signs of momentum in the US and Europe more than offsetting the slowing in China, some other emerging-market economies, and Japan. The shocks have been significant. War planes from NATO and Arab League countries are flying missions over Libya, and protests of varying strength are occurring across the Middle East and North African (MENA) region, toppling governments in Egypt and Tunisia and threatening governments on the doorstep of the key oil producer, Saudi Arabia. The price of oil has surged 40% above its mid-2010 level. The Japanese are still counting the tragic loss of human lives and the huge expected costs of reconstruction following a record earthquake and tsunami, while trying to resolve the dangerous situation in their damaged nuclear power plants. A destructive earthquake also hit New Zealand, while Australia had to cope with widespread flooding.
It is not surprising that global equity markets were buffeted by bouts of risk aversion due to such events, particularly since they were primed for a correction after their strong advances in 2010. The sharpest fall was between March 3 and March 16, during which time the MSCI All World Equity Index dropped by 7.7%, a loss of about $US 2 trillion, according to Datastream. With the recovery since March 16th and just several days left in the quarter, the year-to-date total returns for the main MSCI benchmarks are +4.07% for the World Index, +2.86% for the EAFE (Advanced Markets ex-North America), and -0.29% for the EEM (Emerging Markets). The fact that most advanced markets are still positive and the more risk-sensitive emerging markets as a whole are not significantly down for the year to date reflects the underlying robust nature of the ongoing global recovery. Advanced data, such as PMIs (Purchasing Manager Indices), continue to be strong, and corporate profits are reaching record levels. Looking forward, we see some headwinds, but our central expectation is that this recovery is unlikely to be derailed in 2011.
We do anticipate that the earthquake, tsunami, and nuclear plant crisis in Japan, the third largest economy in the world, will have a negative effect on the global economy; but that effect will be short-lived, falling mainly in the second quarter. In the second half, reconstruction spending will take hold; and that, together with the resolute nature of the Japanese people, monetary and fiscal policies that are highly simulative, and a weakening yen, should combine to put the Japanese economy back on a positive track. It should be kept in mind that the losses to capital stock that have occurred in Japan are not included in GDP statistics, but the outlays for reconstruction and higher government spending will be included.
Europe should be a positive contributor to the global economy this year. While the region’s sovereign debt problems in the weaker members of the Eurozone have not been eliminated, important steps have been taken with agreement on a new permanent crisis-resolution mechanism, the European Stability Mechanism (ESM), to start in 2013. In the meantime the European Financial Stability Facility (EFSF) has had its effective lending capacity increased from 250 billion to 440 billion euros. There has also been agreement on reforms designed to strengthen fiscal discipline within the Eurozone and the competitiveness of its members. The weaker member countries (Greece, Ireland, and Portugal) still face years of painful austerity and financial challenges, but the risks of contagion to the larger economies of Spain and Italy appear to have been substantially reduced.
Germany has been leading the economic recovery in Europe, and its equity market as measured by the MSCI Germany Index is up 5.75%, outperforming the EAFA’s advance, noted above. The equity markets of France (+9.72%), Netherlands (+9.79%), Italy (+14.25%), and Spain (+15.38), as measured by their respective MSCI Indices, have all significantly outperformed thus far this year. Outside the Eurozone the performance of the other major European economies has been weaker – UK (+3.95%), Switzerland (+1.80%), and Sweden (+3.69%).
We also expect the emerging markets to make a positive contribution, but rather less than in recent years. Aside from their greater sensitivity to investor concerns about risks, many of them are experiencing more restrictive monetary policies as their central banks move to counter higher inflation due to overheating of their economies and/or higher global food and energy prices. The key economy of China does appear to be moderating somewhat in response to more restrictive financial policies, but 9% growth still is expected for the year. India will likely register 8+% growth again this year. The Brazilian economy, on the other hand, is expected to slow to 4.5%, as compared with last year’s 7.5%. The South Korean economy looks well-placed to benefit from the reconstruction in Japan. The MSCI Korea Index is up 3.16% year-to-date. Reflecting the high global oil prices, the Russian equity market has been particularly strong, with the MSCI Russia Index advancing 16.05% year-to-date. The overall emerging market year-to-date return of -0.29% cited above also includes some significant market declines: India (-8.14%), Chile (-8.45%), Taiwan (-5.15%), with China at +0.87% and Brazil at -0.72% coming in close to the emerging-market average. Going forward, selectivity among the emerging markets is likely to continue to be important for performance.
The risk that concerns us most is the evolving situation in the MENA region and its effect on global energy markets. The US economy and global economy should be able to remain on their recovery tracks with an oil price in the current $100 to $110 per barrel range, or $4 per gallon gas. But should events in the MENA region lead to a major oil supply shock, sending the price of oil up to $150 or higher, the negative economic effects would likely be severe. The other risk that concerns us is that monetary authorities outside the US might tighten credit conditions earlier than warranted by inflation risks and slow their economies prematurely. We are again fully invested in our International and Global Multi-Asset Class Portfolios and are monitoring developments closely.
