Quarterly Market Review
Global equity markets ended the first quarter of 2014 in modestly positive territory. Despite experiencing a difficult start to the year, markets rallied through February and March, ultimately reaching and exceeding the levels they saw in January. Over the course of the three-month period, developed markets, as measured by the MSCI World Index, outperformed emerging markets in both U.S. dollar and local currency terms. Though the MSCI Emerging Market index was down on the quarter, the performance gap between developed and emerging markets was narrow. Traditionally risk-off sectors - namely, utilities and healthcare - delivered the strongest returns in developed economies while the information technology and consumer discretionary sectors delivered the strongest returns in emerging markets.
As global equity markets churned throughout the first quarter, many investors turned to the relative safety of the global fixed income markets. The move to safety reflected the tumultuous economic backdrop that existed during the three month period. A number of factors, including acute currency market weakness in select emerging markets, weaker-than-expected economic data out of China, geopolitical tensions in Eastern Europe, and a lack of clarity surrounding monetary policy in the U.S., weighed on investors' risk appetite at different times during the first quarter. These factors, coupled with declining interest rates in a number of countries (the most notable of which was the U.S.), combined to drive the Bank of America Merrill Lynch Global Broad Market Index higher for the quarter.
Returns were differentiated during the first quarter, in part reflecting the dramatically different economic and political environments that existed in different countries over the three-month period. Breaking the MSCI Emerging Markets index out by country, returns in U.S. dollar terms ranged from -14.45% in Russia to 21.23% in Indonesia. Russia and Hungary experienced the largest declines in their respective equity markets, while Indonesia, Greece and The Philippines each delivered positive double-digit returns in both U.S. dollar and local currency terms. Despite the broad range of performance across emerging markets, a large portion of the countries represented in the Emerging Markets index experienced modest returns - both negative and positive - during the quarter.
Returns for the European markets represented in the MSCI World Index were generally muted during the first quarter. While the returns for all but three countries were positive - the three negative performing countries being Austria, the United Kingdom and Germany - returns in most other markets were only modestly positive. Denmark, Italy, Ireland and Portugal were the exceptions, as they delivered the strongest performance during the quarter, the first three countries mentioned earning double-digit returns in U.S. dollar and local currency terms.
Equity market returns in developed Asian markets were varied during the first quarter. In U.S. dollar and local currency terms, three of the six Asian markets represented in the MSCI World Index - Israel, New Zealand and Australia - generated positive absolute returns. Israel and New Zealand delivered double-digit returns over the three-month period. Conversely, Singapore, Hong Kong and Japan delivered negative absolute returns during the quarter. Japanese equity markets delivered the weakest performance in the region, while returns in Singapore were only modestly negative, particularly in U.S. dollar terms.
Our Market Insights
Emerging markets stumbled out of the gate in 2014 as a number of issues led to a preference for relatively safer assets, driving equity markets down through the month of January. Despite the existence of headwinds that weighed on certain markets throughout the three-month period, the MSCI Emerging Market index staged a rally that began in early February, yielded to market volatility for much of the next month, and then regained upward momentum toward the end of March. Importantly, performance was varied across emerging equity markets. This provides evidence that investors, correctly in our view, are no longer looking at emerging markets in aggregate, but are instead differentiating between countries with stronger fundamentals and those without.
Numerous emerging market currencies came under pressure during the first month of the quarter. In early January, currencies including the Indonesian rupiah and the Turkish lira fell against the U.S. dollar. Downward pressures persisted throughout the month, culminating in a series of dramatic moves in late January. The Argentinean central bank allowed the currency to tumble by its largest margin in over a decade, while the Turkish lira plummeted as well. Facing selling pressure on their country's currency, several central banks, including those of Turkey and South Africa, raised interest rates in an effort to stem capital outflows. Though the efforts did stabilize the currencies to an extent, the measures are likely to harm future growth and serve to delay necessary domestic rebalancing in some emerging markets.
Weaker-than-expected Chinese economic data also acted as a headwind to emerging market equities for much of the first quarter. That said, we continue to believe that swings in the data are more noise than anything else, and that hiccups are likely as the government moves to rebalance the economy from one dependent upon foreign investment and demand to one driven by internal consumption. Should the economic environment deteriorate sufficiently to warrant policy action, we maintain that the Chinese government has both the willingness and the ability to provide stimulus measures. A series of potentially adverse events in the country's financial markets, including the threat of a wealth management product defaulting and a private firm defaulting on a bond, also caught investors' attention during the quarter. However, investors should remember that financial market liberalization will be a slow, controlled process, and that the Chinese government will take steps to contain any events that could destabilize financial markets during the reform process. In the long-term, rebalancing the country's economy and liberalizing its financial markets are positive moves.
The most attention-grabbing headlines regarding emerging markets during the first quarter came from Ukraine and Russia. Following a decision to draw Ukraine closer to Russia by then-Ukrainian President Yanukovych, protesters took to the streets and ultimately deposed their leader. This led to a disputed referendum in which the majority of Crimeans, who reside in a region with very close historical and cultural ties to Russia, voted to join the Russian Federation. The region was then annexed by Russia, which quickly led to sanctions being levied on select Russian individuals by Western governments. Though the event was, and continues to be, largely Russia-centric, given the recent escalation of tensions it is important to monitor the situation in an effort to remain aware of the ways in which global equity markets could be impacted by the geopolitical turmoil.
For some time now we have been focused on three factors regarding emerging markets. The first is the reaction that equity markets have to tapering in the U.S. Generally speaking, though emerging markets are still in a phase where they react negatively to new tapering announcements, the reactions have not been as sharp or long-lasting as they were when tapering began. The second factor we are monitoring deals with elections in emerging markets. There remain a number of elections still to be administered this year, but clarity has emerged in some countries. Finally, we are looking for signs that emerging market economies have troughed. This is tough to determine with a high degree of certainty, but some markets, such as India, appear to be further along in this process than others. When looking at these factors alongside one another, we believe select emerging markets are becoming increasingly attractive from an investment standpoint.
The story in developed Europe remained largely unchanged during the first quarter as the region's fragile economic recovery continued to plod along at a steady yet uninspiring pace. Data showed that Eurozone GDP rose by 1.1% during the fourth quarter of 2013, marking the third consecutive quarter of positive economic growth. Manufacturing surveys were also indicative of expansion throughout the three-month period. As has become the norm, however, other data releases were less positive. Disappointing data out of the U.K. and weak Eurozone industrial production data releases later in the quarter tempered optimism. The most glaring issue facing the region continues to be precariously low inflation.
An unequivocally positive effect of the improved economic environment has been the convergence of interest rates between the periphery and core countries. This trend continued during the first three months of 2014. Nevertheless, falling interest rates have yet to translate into increased bank lending. Lackluster credit expansion remains a significant headwind to an uptick in economic growth and inflationary pressures. Bank lending in the Eurozone to households and non-financial corporations continues to be depressed relative to the levels seen prior to the credit crisis. Until low interest rates at the sovereign level begin to result in credit expansion, economic growth and inflation are likely to remain subdued.
One important development was the change in tone regarding the potential for the use of unconventional monetary policy by European Central Bank President Mario Draghi and other central bank leaders in late March. Following the release of particularly weak inflation data, Draghi stated in a speech that the ECB "will do what is needed to maintain price stability." Other, traditionally hawkish central bank governors were even more explicit in their comments. Bank of Finland Governor Erkki Liikanen cited negative deposit rates, additional loans to banks and assets purchases as possible tools at the ECB's disposal during an interview with The Wall Street Journal, while Bundesbank President Jens Weidmann echoed similar sentiments in an interview with another news agency. Though no policy moves appear imminent at this time, it is clear that ECB officials are considering taking steps to combat some of the issues that are holding economic growth prospects and inflationary pressures low.
We believe that slow growth is the most likely path forward for developed Europe. Though geopolitical tensions to the east of the region have the potential to impact the economic environment and regional equity markets, for now those pressures appear to be largely contained. While the economic recovery remains intact, it continues to be fragile and headwinds certainly exist. It will be important that investors keep an eye on inflationary pressures and watch for signs that the ECB plans to undertake unconventional measures to increase bank lending and raise the rate of inflation. This could have a positive effect on the region's economy and equity markets.
News out of the two largest economies in developed Asia raised concern during the first quarter of 2014. In Australia, a fourth quarter fall in investment poses a threat to the country's economy moving forward. Perhaps surprisingly so, equity markets held up well despite the report, actually finishing the three-month period in positive territory. Elsewhere, fourth quarter GDP data disappointed in Japan. The underlying components of the report were particularly worrisome, especially when considering the imposition of a value added tax (VAT) on April 1st. Equity markets reflected investor pessimism, as Japan was the worst performing country in the region through the end of March.
Data released in late February showed that total new capital expenditures fell by a seasonally adjusted 5.7% yoy during the fourth quarter. To put this into perspective, investment in fixed capital accounted for over 25% of Australian GDP in 2013. Given the disproportionately large volume of capital expenditures that goes toward the mining sector, as well as the sector's overall contribution to GDP, the fact that the decline was equally dramatic there is a dangerous sign for the Australian economy. There are a number of factors impacting the decline in capital expenditures that are out of the control of the Australian government, such as the market price of commodities and the distance of mining projects from local supply chains. However, taking steps to improve the country's overall level of competitiveness could go a long way toward attracting increased levels of capital expenditure. We believe this would benefit the Australian economy.
The first quarter also saw the release of disappointing GDP data in Japan. A revised estimate showed that the overall economy grew just 0.7% yoy. Weaker-than-previously-estimated capital expenditures and consumer spending dragged on the revised number. Both investment and consumer spending were positive and helped to offset the negative impacts of a high current account deficit resulting from a weaker yen, but it is likely that future consumption got pushed forward into the first quarter due to the looming VAT. This means that consumer spending could decline moving forward. Positively, a number of large companies announced that wages will increase modestly, but it is certain that some of the wage increases will be eaten up by the rise in the VAT. In all, it seems likely that Japanese growth will slow during the first half of 2014, which will pose a real threat to Prime Minister Shinzo Abe's leadership.
The need for structural reform has been a common theme in our view on emerging markets for a number of years. However, the need is not limited solely to developing economies. As exemplified by these two countries, the need for structural reform can have a negative impact on some of the most modern economies in the world.
Analysis: Manning & Napier Advisors, LLC (Manning & Napier).
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The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance and consists of 23 developed market country indices. The Index returns do not reflect any fees or expenses. The Index is denominated in U.S. dollars. The Index returns are net of withholding taxes. They assume daily reinvestment of net dividends thus accounting for any applicable dividend taxation.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets and consists of 21 emerging market country indices outside the U.S. The Index returns do not reflect any fees or expenses. The Index returns are net of withholding taxes. They assume daily reinvestment of net dividends thus accounting for any applicable dividend taxation. The Index is denominated in U.S. dollars.
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