Introduction
We have previously highlighted that the tightening of monetary policies by the major central banks poses one of the greatest risks to global markets as it pressures valuations for financial assets. We think this remains true in the long-term, but in the short-term it appears that monetary policies are very likely to diverge as Europe and Japan stay on a course of easy money. This spring will stay coiled for a little longer.
However, this did not provide much relief. The continually escalating nature of President Trump’s trade war seems to have the most potential to derail the global economy. On a percentage basis of inter-regional trade, stakes are still small, but entire industries are being played as chess pieces. And in Europe, a Euroskeptic government in Italy means the political situation in the European Union (E.U.) is poised to become thornier.
Markets became increasingly volatile in the second quarter, and each month was successively worse with respect to stock returns, as these risks congealed. Over recent quarters, we have prepared for turbulent markets such as this by selectively emphasizing businesses with more defensive characteristics. These changes have served us well, and our portfolios have held up relative to the broad market.
Market Update
For the MSCI ACWI ex-U.S. Index®, growth style outperformed value style. Within emerging markets, growth style also outperformed value style. Large capitalization stocks outperformed small capitalization stocks in both the developed and emerging markets sub-indexes.
For the MSCI ACWI Index®, growth style outperformed value style, but large capitalization stocks underperformed small capitalization stocks. Within emerging markets, growth style also outperformed value style.
In the U.S., things are humming along, and reverberations have yet to surface from President Trump’s disruption of global trade. Unemployment reached 3.8% in May – the lowest rate in 18 years, and inflation reached the Federal Reserve’s target of 2% after undershooting it for much of the past 6 years. The Federal Reserve raised interest rates for the second time this year and suggested the pace of rate hikes is on track to keep inflation in check.
The E.U. economy entered 2018 on a high note, having recorded its strongest economic growth in a decade back in 2017. But now growth in the E.U. is slowing, hurt by a combination of mostly transient factors such as unusually cold weather, largescale strikes in Germany and France, and a severe flu season. But, so far, signals of a rebound back to recent growth levels have been muted. Consumer spending seems to have picked up, but exports have fallen and the Germany Manufacturing Purchasing Managers’ Index, though still positive, has stayed on a downward trend since the beginning of the year.
The tense political climate in Italy, which is the E.U.’s third largest economy, has been borne out of economic frustration and a migration crisis. No wonder why establishment parties suffered their worst performance in years, while two anti-establishment parties, the Five Star Movement and the Northern League, secured the legislature and were able to form a governing coalition. Both of these parties have openly questioned the orthodoxy of staying in the euro, and they will seek to reboot one of the most troubled economies in Europe with tens of billions of tax cuts and stimulus spending proposed. A political confrontation between Italy and the E.U. will undoubtedly revive concerns about the future of the euro.
Despite the slowdown in growth and political turbulence in Italy, the European Central Bank (ECB) affirmed plans to wind down its bond-buying program. Slower growth is still growth, and inflation and wages have recently ticked up. The ECB will cut bond purchases in half to €15 billion per month by September and stop purchases altogether by December. With respect to interest rates, the ECB said it would likely wait through at least the summer of 2019 before raising the deposit rate, which it kept unchanged at -0.4%.
The Bank of Japan (BOJ) is now the only major central bank still committed to the purchase of bonds and other assets. But like the ECB, it plans to keep the deposit rate, which is currently at -0.1%, unchanged in the near-term. Recent economic trends in Japan have reversed. The country’s gross domestic product (GDP) growth declined 0.6% in the first quarter, after growing consistently for the last two years, while inflation stabilized at 0.7% in May. At the last BOJ meeting, the central bank said that it will stop forecasting when their 2% inflation target will be reached.
Outlook
With increasing political uncertainty in Europe, and inflation still well below target levels in Europe and Japan, it seems that monetary policies between the major central banks is set to diverge for the next year. Both the ECB and the BOJ lag far behind the Fed in raising interest rates. Meanwhile, the federal funds rate in the U.S. is now in a range of 1.75-2.0%, and the Fed is likely to exceed the neutral level of interest rates sometime next year.
Actions by the U.S. will play an outsized role in the course of global growth. Today we are in the nascent stages of a trade war, with the Trump administration antagonizing important trading partners on three fronts: China, the E.U., and North America. Retaliatory tariffs will have the potential to upset many economies worldwide, and so far, there has been no stop in escalations.
At the beginning of June, the Trump administration finally imposed tariffs on steel and aluminum imports from the E.U., Canada, and Mexico after months of failing to win trade concessions. The E.U. has countered by filing a complaint with the World Trade Organization and initiating its own package of tariffs to counter the impact from U.S. actions. The eclectic mix of goods, including Kentucky whiskey and Harley-Davidson motorcycles, was specially curated by the E.U. to inflict the most damage towards President Trump’s base. Trump responded by proposing a 25% tariff on imported automobiles, again raising the stakes and the prospect for an all-out trade war.
With respect to China, tariffs on $34 billion worth of Chinese products are expected to go into effect later this week, and the U.S. is already planning to announce new investment and trade restrictions aimed at preventing China from overtaking U.S. leadership in industries such as robotics, automotive, and aerospace. China has threatened to retaliate, and President Trump has already threatened to retaliate on that retaliation. If all of Trump’s threats are carried out, then nearly 90% of all Chinese exports to the U.S. will be covered by tariffs.
After outgrowing the U.S. for the last two years, the E.U. is currently growing at about half the speed of the U.S. economy. The ECB has also lowered its forecast for economic growth in 2018 from 2.4% to 2.1%. Slowing growth in the E.U. reduces the need to remove the ECB’s stimulus measures and start raising interest rates. Signs of weaker growth support ECB President Mario Draghi’s view that the central bank needs to move cautiously as it phases out the bond-buying program. In fact, it seems that the ECB has done everything it can to ensure the market that it will not begin a rate hiking cycle, and the expectation is that interest rates will not increase before September 2019. The central banks of Switzerland and Sweden have set interest rates even lower than the ECB has, and they are unlikely to raise them before the ECB does.
Italy has not participated in the European recovery as much as Germany and France, and its economy is still 5% smaller today than it was before the Great Financial Crisis. The governing coalition has outlined an economic plan based on the rough logic that universal basic income, higher welfare spending, and tax cuts can spur economic growth, which would then pay for these same programs. If the logic doesn’t hold, however, Italy does not have much of a backstop. The country runs on a deficit and is among the most indebted in the world, with nearly €2 trillion of debt, which exceeds 130% of their gross domestic product. Italy has also benefitted from bond purchases by the ECB. These purchases are expected to end at the end of this year. It has been estimated that over 15% of recent Italian government debt auctions were sopped up by the central bank. Yields on 10-year Italian debt rose sharply this quarter and are presently just under 3%. However, we are reminded that during the height of the euro crisis in 2012, the yield on Italy’s 10-year debt exceeded 7%.
Given this environment, rather than try to construct a portfolio to benefit from specific forecast scenarios, we will continue to manage around these challenges through security selection. To our thinking, a portfolio of high-quality, advantaged companies that provide high value-added products in areas of growth in the global economy will be best able to weather the policy storms. Therefore, at Chautauqua Capital, we continue to do what we do well. We deploy a time-tested process that involves focused and thorough multi-perspective analysis to identify these resilient, wealth-generating businesses. Our independence and small but powerful team enables us to adapt as we enter a period of higher volatility. At this juncture, the portfolios are well-positioned. We will work hard to ensure they stay so.
Respectfully submitted,
The Partners of Chautauqua Capital Management – a Division of Baird
Investors should consider the investment objectives, risks, charges and expenses of each fund carefully before investing. This and other information is found in the prospectus and summary prospectus. For a prospectus or summary prospectus, contact Baird Funds directly at 866-444-9012 or contact your Baird Financial Advisor. Please read the prospectus or summary prospectus carefully before investing.
*For the Chautauqua International Fund, Gross Expense Ratio as of 12/31/2017 was 1.21% for Institutional shares and 1.46% for Investor shares. For the Chautauqua Global Fund, Gross Expense Ratio as of 12/31/2017 was 2.26% for Institutional shares and 2.51% for Investor shares. The Net Expense Ratio is the Gross Expense Ratio minus any reimbursement from The Advisor. The Advisor has contractually agreed to waive its fees and/or reimburse expenses at least through April 30, 2019 to the extent necessary to ensure that the total operating expenses do not exceed 1.20% of the Investor Class's average daily net assets and 0.95% of the Institutional Class's average daily net assets. Investor class expense ratios include 0.25% 12b-1 fee.
The above commentary does not provide a complete analysis of every material fact regarding any market, industry, security or portfolio. Fund holdings information, opinions and other market or economic information and data provided are as of the date of the commentary, unless another date is expressly indicated, and may change without notice. Please contact us to obtain contribution methodology and a list showing the contribution of each holding in the representative account to the overall account’s performance during the measurement period. The manager will ensure that each Chart will include all information necessary to make the Chart not misleading, including presenting the best and worst performing Holdings on the same page with equal prominence, and with appropriate disclosure, in close proximity to the performance information. The manager’s assessment of a particular industry, security or investment is intended solely to provide insight into the manager’s investment process and is not a recommendation to buy or sell any security, nor investment advice.
The MSCI ACWI Index® is a free float-adjusted market capitalization weighted index that is designed to measure the equity performance of developed and emerging markets. The MSCI ACWI Index® consists of 44 country indices, including the United States, comprising 23 developed and 21 emerging market country indices.
The MSCI ACWI ex-U.S. Index® is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets excluding the United States.
The actual return and value of an account will fluctuate and at any point in time could be worth more or less than the amount invested. Performance data quoted represents past performance. Past performance does not guarantee future results.
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First use: 07/2018
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