Global Markets – 3Q21 Review

International equities posted a modest loss in the third quarter, with the MSCI EAFE Index returning -0.45%. On a regional basis, Europe and the United Kingdom closed lower, while Japan was a notable outperformer in the quarter. Having trailed the U.S. and European markets in recent quarters, the Nikkei is now hovering around its highest levels since mid-1990s. Investors responded favorably to the surprise resignation of Prime Minister Suga, who had only been in the Prime Minister role for a year, yet was facing increasing pressure in response to Japan’s handling of the COVID pandemic. The hope is that a new leader can unite the Liberal Democratic Party and provide a more supportive backdrop for the equity markets. Japan comprises ~23% of the EAFE Index, the largest country representation by a wide margin (the United Kingdom is the 2^nd-largest country with a 13.5% weighting).

Investors also had to contend with a sharp reversal in Chinese stocks that took place in the quarter. Having long been viewed as an attractive investment opportunity given a growing middle class and associated consumption trends, Chinese stocks sold off in response to heightened regulatory intervention and a ‘common prosperity’ agenda that looks to be at the expense of corporate profitability – not a good combination for investors. While China remains a critical driver of global GDP and a key end market for many companies, foreign investment in Chinese companies has clearly become a riskier proposition.

The Energy Crisis in Europe – A Perfect Storm

Inflation has been rising in Europe/U.K., and spiking commodity prices have been a big contributor on this front. The chart illustrates the year-to-date surge in liquefied natural gas (LNG) prices:

There are multiple factors causing the price spike – low storage levels, supply-chain bottlenecks, labor shortages (e.g., truck drivers in the U.K.), and costlier carbon emissions permits. Europe also has to compete with increased demand from Asia, adding to the upward pressure on prices. The energy crunch has resulted in ballooning utility bills for citizens across the continent, in particular those who have a variable-price contract with their electricity providers and are therefore subject to the fluctuations of the market. The increased wallet share for gas/utility bills is likely to impact broader consumption trends, thus threatening the strength of the ongoing economic recovery in Europe.

Not unlike the transitory vs. permanent inflation debate taking place in the U.S., Europe is similarly facing a moderation vs. intervention decision as it relates to the commodity market. With power forward contract prices remaining high, as we move into winter peak season, governments are taking different steps to cope with the elevated commodity price environment. France, Italy, and Germany have chosen to subsidize consumers to varying extents out of their country’s general budgets. The U.K. has not taken any meaningful action, instead choosing to let market forces come to some level of equilibrium. Lastly, the Spanish government is taking an interventionist approach to claw back profits from the private sector to subsidize consumers (although more recent reports are that Spain may be reconsidering this plan).

Cambiar believes that the current supply/demand imbalance is likely to normalize in the next 18-24 months (but could be sooner) as the current supply pressures abate. Over a longer-term arc, the E.U. remains fully committed to its energy transition plan, which should be effective in reducing the continent’s dependence on outside energy supply sources. The transition will require significant investment into renewables, storage, transmission, and inter-connectivity between countries. From an investment perspective, the heightened price volatility that has accompanied this crisis may lead to opportunities for managers with a longer-term timeframe. Cambiar is continuing to monitor the situation and its possible impact on our allocation to the Utilities sector, as well as broader portfolio implications.