International and Global Markets Commentary and Investment Outlook

INTRODUCTION

Global markets enjoyed a strong start to the year, marking a steep reversal from the downdraft that maligned the fourth quarter. Weak or decelerating growth in virtually every major economy, coupled with lingering overhangs from international trade frictions, have compelled the major central banks to adopt stimulative policies for the foreseeable future. This is an enormous pivot, and indeed, much of the rally in the first quarter was fueled by this relief. We have maintained that a slower pace of rate hikes, ceteris paribus, would be relatively more favorable for asset valuations. Now, there may be no rate hikes at all.

MARKET UPDATE

After a period of exceptional market volatility during the fourth quarter of last year, the Federal Reserve signaled a reversal from their plans to keep raising interest rates. Beginning in January and despite a rate hike in just the previous month, Chairman Jerome Powell framed a cautious economic narrative citing sluggishness in Europe and Asia, ongoing global trade policy frictions, and mild domestic inflationary pressures.

Effectively, this new caution fomented a pivot by the Federal Reserve away from its prior course of monetary tightening. And with each passing month, Chairman Powell’s message on pausing U.S. rate hikes seemed to grow only more forceful. After meetings in both January and March, the Federal Reserve left the federal funds rate unchanged, in between a range of 2.25% and 2.5%. Furthermore, the Federal Reserve announced that it will slow the “run off” of its Treasury portfolio starting in May and will begin reinvesting bond maturities starting in October.

As market participants seized on this change, equity markets rallied, emerging market currencies strengthened, and long-term government bond yields and corporate credit spreads both fell. Within the equity asset class, this strength was universal. Returns from every sector and country in the global index were positive in the first quarter.

The U.S. economy remains relatively healthy when compared to the other major economies in the world, and it is a definite bright spot. Some recent data, however, appears mixed on the margin. Gross Domestic Product (GDP) growth during the fourth quarter was 2.2%. Capital investment by businesses and corporate earnings growth were strong, but monthly growth in consumer spending turned negative in December and failed to show a meaningful snapback in both January and February. It is possible that the recent consumer softness incorporated transient setbacks such as the U.S. government shutdown and unseasonably cold winter. More recently, both the Purchasing Managers’ Index (PMI) and spending on the services sector have decelerated meaningfully. Mild inflation is one of the factors that has informed the Federal Reserve’s new direction with its monetary policy. An economic environment with high employment and rising wages, as is currently found in the U.S., should be supportive of inflationary pressure, but inflation figures have remained below the Federal Reserve’s target of 2%. The Core Personal Consumption Expenditures (PCE) index, a measure of inflation that excludes food and energy prices, increased 1.94% in 2018 and only 1.79% in January.

In Europe, the economic slowdown in the region has accelerated. GDP grew 0.3% in the fourth quarter, the slowest pace of expansion in the last five years, and European Central Bank (ECB) President Mario Draghi made a fifth straight cut to growth forecasts. Much of this weakness is attributed to falling export demand and manufacturing activity, but even retail sales suffered one of the steepest monthly declines in the last decade this past December. Moreover, recent PMI data is not encouraging as economic activity in both Germany and France has contracted. Furthermore, Italy has slipped into a technical recession, afflicted by slowing global trade, weak consumer confidence, and pushback from the European Union (E.U.) to shrink its budget.

In response to the slowdown, the ECB also reversed its policy to favor economic stimulus. Recall that the ECB just ended quantitative easing in December. Now, President Draghi has pledged to keep the deposit facility rate, currently -0.4%, unchanged through the end of the year. Moreover, he announced that the ECB will restart a direct lending program to commercial banks, something that has not been offered since the Eurozone debt crisis. Under this program, banks will be able to access cheap, long-term loans directly from the ECB.

OUTLOOK

As we have previously stated, markets can move directionally opposite to economic fundamentals. During the first quarter, equity markets climbed, but the underlying economic data deteriorated.

Of all the major economic regions, the slowdown was most acute in Europe. The E.U. continues to face pressure from Brexit, slowing demand from China, and mounting debt in Italy. The ECB has already cut GDP growth forecasts twice this year, most recently to 1.1% in 2019. Meanwhile, recent PMI figures that show contracting economic activity hardly bode well for meeting the new full year target. Slowing global growth will be another headwind for the E.U., especially as the U.K. and China are top export markets after the U.S.

Business uncertainty resulting from trade frictions will continue to put downward pressure on economic growth, and these concerns are unlikely to dissipate soon. While progress has been made in several rounds of negotiation between the U.S. and China, and President Trump has indefinitely suspended a scheduled increase of tariffs on $200 billion of Chinese goods, the final resolution is hardly certain. Multiple complex issues will need to be negotiated such as purchase guarantees of U.S. goods, forced technology transfer, intellectual property protection, and market access.

China’s economy is slowing faster than expected, with more than half of the nation’s 31 provinces failing to meet growth targets last year. Also, industrial production continued to weaken and has been hurt by soft automotive and property markets. Slowing demand from China has not only impacted the E.U., but exports from Japan and South Korea have also slowed sharply. The Federal Reserve, on the other hand, has articulated a positive outlook for the U.S. economy this year, citing low unemployment, rising wages, and high consumer confidence. The latest forecast is for U.S. GDP growth of 2.1% in 2019, but this does not contemplate a continued deterioration of global growth due to business uncertainty resulting from unresolved trade policy.

If there are any silver linings to the economic backdrop, then it is undoubtedly the end of the U.S. interest rate tightening cycle. Low interest rates are typically constructive for financial assets. This is especially true for growth stocks.

Back in December, the median forecast by members of the Federal Open Market Committee was two rate hikes in 2019. Now, most members forecast none. Furthermore, the Federal Reserve’s pivot ensures that the loose monetary policies of major central banks will continue. The ECB and Bank of Japan (BOJ) are likely to sustain negative interest rate policies for the foreseeable future, while the central banks of Switzerland, Sweden, and Demark, which also have negative interest rate policies, will be confined to follow suit in order to protect their exchange rates with the euro. An additional implication of the trajectory of monetary policy is that higher bond yields in the U.S. relative to other developed markets are likely to persist. This should support continued dollar strength.

Separately, central banks in emerging markets will enjoy a reprieve, as pressure to raise rates to maintain a dollar peg abates. Furthermore, low yields in developed markets should support investment in emerging market bonds. The central banks of South Korea, Indonesia, and the Philippines kept their rates unchanged in the first quarter. What is more, the Reserve Bank of India actually cut its policy rate in February.

One downside of the Federal Reserve’s pivot is that it will have little room to maneuver the next time the U.S. economy slides. The federal funds rate is just 0.25% when adjusted for expected inflation, and the Federal Reserve will hold a bond portfolio equivalent to 17% of GDP (approximately $3.5 trillion) when it ends the “run off” in September. By comparison, after the last tightening cycle ended in 2006, the real rate was 2.75%, and the Federal Reserve held a bond portfolio equivalent to 6% of GDP. Meanwhile, the ECB and BOJ never managed to raise rates out of negative territory or shrink their balance sheets. It is clear they will not have the tools to reverse the next recession.

Undulations in economic growth are cyclical, so we invest in businesses that benefit from secular trends and are structurally well-positioned to grow over time. Typically, they sell mission-critical or high value-added products and services, which enable them to survive a slowdown. Over longer investment horizons, these businesses become more valuable because they can generate wealth for shareholders even in challenging times. Portfolios are concentrated, which enables us to know holdings and watch list ideas better than most competitors and operate effectively as a small portfolio management team. Our faith in our investment process remains firm.

BUSINESS UPDATE

During the quarter, Dan Boston resigned from Chautauqua Capital for personal and family reasons and intends to relocate outside of Colorado. We appreciate Dan’s contributions over the past 5 years and wish him the very best.

Given the collaborative nature of our investment process, it is important that everyone works from our one location in Boulder, Colorado. Dan's responsibilities have been reassigned to existing team members. While we believe that we are adequately staffed, we intend to replace this position. Accordingly, in our hiring process our emphasis is going to be on making the right hire as opposed to a fast hire.

No further organizational changes have taken place.

Respectfully,
The Partners of Chautauqua Capital Management – a Division of Baird

International and Global Markets Commentary and Investment Outlook

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