Global equities ended the quarter close to all-time highs, bolstered by a record improvement in earnings surprises and robust forward-looking economic indicators. That said, market leadership was impacted by pandemic, inflation and policy crosscurrents. Optimism regarding generally successful vaccination efforts in the US and Europe was somewhat offset by the emergence of the more contagious COVID-19 delta variant, which has resulted in renewed lockdowns and restrictions in several countries. Reopening-related supply constraints has many countries experiencing sharp increases in inflation, with diverging policy responses. Developed market central banks generally view the increased pricing pressures as transitory, and policy remains accommodative. Emerging market central banks, which are less confident in the transitory narrative, have been hiking rates.
Regional and country performance was prominently impacted by COVID-19 vaccination levels, delta variant-related lockdowns and restrictions and robust energy prices. The US market benefited from high vaccination levels, a quicker reopening and higher growth-oriented exposure while the Canadian market was aided by the persistent climb in oil and gas prices. Despite an impressive vaccination effort, the emergence of the delta variant has delayed or hindered reopening plans in Europe and weighed on equity market performance. In the Pacific region, lagging vaccination numbers tempered the near-term economic outlook, which also restrained markets. Fed taper talk, weak currencies and COVID-19 challenges held back emerging markets overall; however, energy-levered markets in Brazil, Russia and the Middle East were notable outperformers.
Sector leadership was a mix that reflected the crosscurrents mentioned above. Superior global economic and earnings revisions data coupled with the more hawkish views of future central bank policy resulted in a rotation from cyclical sectors such as financials, consumer discretionary and industrials to faster growing sectors such as information technology, health care and communication services. The energy sector unsurprisingly outperformed, benefiting from the strong performance of the underlying commodities mentioned above. Defensives such as utilities and consumer staples, which typically outperform in the late stages of the cycle, lagged significantly.
Sector allocation was the biggest detractor from performance. Information Technology was the worst performing sector, mainly from poor stock selection. Consumer staples was the next weakest sector. Materials was the best-performing sector, driven primarily by solid stock selection. Stock selection in industrials also contributed.
North America was the worst performing region, mainly from poor stock selection. Asia Pacific ex Japan was the next weakest region, due to an underweight allocation. Europe ex UK was the best performing region, driven by solid stock selection. Japan was the next strongest region, also due to constructive stock selection.
The synchronized global recovery generally remains on track and likely to broaden as economies reopen. Monetary support has likely peaked but remains broadly accommodative, and fiscal support is passing the baton to the private sector as economies reopen. Bond yields, central bank rate actions and market leadership point to leading economic indicators such as manufacturing PMIs remaining at elevated levels through the end of the year. The Global Services PMI, which is an important indicator of the success of the vaccination programs and reopening of economies, also remain strong. Earnings revisions, which are highly correlated with manufacturing PMIs, have similarly peaked; however, they are likely to remain at elevated levels and continue to favor cyclicals.
Despite the robust outlook, there are several issues that bear watching. The emergence of the COVID-19 delta variant is already altering reopening plans; however, vaccines, particularly in developed economies, have so far proven effective against variants. Inflation continues to surprise central bankers, which could lead to earlier-than-expected policy tightening if it persists longer and rises higher than currently projected. Valuations, which remain close to 20-year highs, have contracted as they typically do in this phase of the cycle given strong reported and projected earnings.
MFS continues to be encouraged by the broadening market leadership and factor rotation. MFS believes the recent broadening of performance to include growth and momentum factors will occur as the cycle transitions to the midcycle and expansion phases. The recent underperformance of value factors, which typically outperform until earnings growth peaks, is likely only a tactical correction common to value cycles. A peak in the economic cycle would, based on history, coincide with sustained outperformance of quality factors and the quality-focused fundamental research input to our process.
Significant impacts on performance