Introduction
Markets were turbulent in the second quarter. Escalations in trade tensions weighed on confidence in the global economic expansion. However, stocks proved resilient in June thanks to commentary by the Federal Reserve that was interpreted to indicate that, in the face of slower global growth, it may reduce bank borrowing rates to sustain the economic expansion. Several major central bankers, who are also contending with economic fallout from trade tension, have followed suit with more accommodative rhetoric.
A negative repercussion of this pivot is that central bankers will be left with little room to maneuver the next time their economies actually recede. The U.S. federal funds rate is just 0.25% when adjusted for inflation. At the end of the last tightening cycle in 2006, it was 2.75%. Since the “Great Recession” ended, both the European Central Bank (ECB) and Bank of Japan (BOJ) never managed to raise rates out of negative territory. It is clear they are inadequately prepared to reverse the next recession. When combined with high levels of indebtedness, this should be worrisome, yet the markets are not pricing in these concerns.
Market Update
Negotiations between the U.S. and China seesawed in the second quarter. Hope for a trade resolution climbed in April, only to falter in May. Tensions flared subsequently when the U.S. threatened to impose additional tariffs on a final tranche of $300 billion worth of Chinese imports and also ban U.S. companies from selling electronic components and technology to Huawei, China’s “national champion” in the telecommunications industry. China announced its own set of retaliatory tariffs, and Chinese state media ramped up nationalistic rhetoric against the U.S. At the end of June, parties were able to agree to a temporary truce between President Trump and President Xi, laying the groundwork for bilateral talks to restart.
Similar events occurred with Mexico. In May, President Trump announced new tariffs on imports from Mexico in an effort to reduce the inflow of Central American asylum-seekers to the U.S., and he subsequently reached a deal to avoid tariffs after Mexico committed to stronger countermeasures. The impacts of such tariffs would have been substantial for the U.S., given the deep economic linkages between the U.S. and Mexico. Moreover, new tariffs would have imperiled the ratification of the recent U.S.-Mexico-Canada trade agreement.
Dovish comments by the U.S. Federal Reserve were the key tailwind for the markets, helping offset worries about trade frictions and providing cover for other central banks to turn more accommodative. The Reserve Bank of India (RBI) and Reserve Bank of Australia (RBA) were among central banks that cut rates in the second quarter. Among G10 currency region countries, only Norway’s central bank is firmly in a tightening regime.
Overall, the U.S. economy remained healthy, with unemployment near 50-year lows and inflation expectations remaining stable despite missing the 2% objective. Inflation had picked back up recently, but the increase was less than expected. Nevertheless it’s worth noting that second quarter 2018 economic data, that benefited from inventory building ahead of increased tariffs and a massive reduction in corporate tax rates, will make for a very difficult comparison this year. The Fed kept rates unchanged, but signaled an openness to cut rates if downside risks grew more pronounced. Data that will be released in early August may prove pivotal.
The ECB also left policies unchanged, but extended forward guidance for continued negative interest rates until the middle of 2020. Moreover, the ECB raised the possibility of further rate cuts and even restarting their quantitative easing program. Such moves would be a significant policy shift that amplifies a global trend toward continued aggressive monetary stimulus. Recent economic data in Europe has been tepid. The Manufacturing Purchasing Managers’ Index (PMI) has contracted for four consecutive months, and the Services PMI was also weaker due to a deceleration in new export activity.
Similarly, the BOJ also left policies unchanged and extended forward guidance for negative rates until the spring of 2020. This does not mean policy normalization would begin immediately after; in fact, there is a reasonable probability that current policy may be maintained beyond this period. The BOJ made no major changes to its economic assessment. The Japanese economy is expanding modestly, but it, too, is affected by the slowdown in global growth, given its economy’s emphasis on exports and industrial production.
With respect to oil, tensions in the Middle East have failed to spark a sustained increase in oil prices. This is partly due to excess supply. Increased U.S. production has offset the impact of supply outages. As a result, crude inventories are at their highest levels in the last two years. A softening in demand, as a result of the deteriorating trade outlook is also a factor. In this environment we are emphasizing high value added service providers who can help oil companies be more efficient.
Outlook
Trade tensions continue to plague confidence about the trajectory of economic growth. Trade tension-induced cost pressures, disrupted supply chains, capital tied up in excess inventories, and the uncertainty which impedes business investment plans continue to be headwinds.
After 10 years of economic growth, the near future is worrisome. Economic slack has been absorbed and growth from here will be reliant on gains in productivity and innovation. We invest in innovation leaders that benefit from secular trends and, as a result, we believe we are structurally well-positioned to grow faster than the global economy. Typically, they sell mission-critical and high value-added products and services, which enable them to succeed even in an economic slowdown. Over longer investment horizons, these businesses become more valuable because they can generate wealth for shareholders even in challenging times. The portfolios that we maintain are concentrated, which enables us to know the holdings and watch list ideas better than most of our competitors.
Despite an agreement to put negotiations between the U.S. and China back on track, there remains lots of uncertainty about what happens next. We find it interesting that there has not been any meaningful pressure from the market to get a deal done. The U.S. insists on real structural reforms for key issues such as intellectual property protection, forced technology transfer, and state-sponsored industrial subsidies, while China is determined to protect its economic sovereignty. Scheduling for the next round of negotiations is in flux. We are not structuring investments based on a favorable resolution of the U.S.-China trade war.
Monetary policy is the other big factor. Some Governors of the U.S. Federal Reserve have argued the case for returning to more accommodative monetary policy given a slowdown in business investment and weaker manufacturing data. Chairman Jerome Powell has stated the Fed’s primary purpose is to sustain the economic expansion. This goes beyond the Fed’s original mission to control inflation and promote economic stability. Six months after the last rate hike, the Fed now appears more accommodating with seven members forecasting two cuts, one member forecasting one cut, eight members forecasting that rates remain unchanged, and one member forecasting one hike through the end of this year.
At the annual ECB conference, President Mario Draghi was similarly dovish. The central scenario of the ECB is a soft patch in the eurozone economy, not a recession, but President Draghi signaled that rate cuts and quantitative easing could be used if the outlook deteriorates further. The most salient economic issues the European Union (EU) must contend with are weaker global growth and fading prospects for a rebound in the second half of the year, strengthening the case for lower rates.
Ultra-loose monetary policy could eventually create risks in Europe, but this may not deter the ECB from action. With depleted monetary ammunition, the onus may be on a potential fiscal response instead. Italy’s debt-to-Gross Domestic Product (GDP) ratio may exceed the levels sanctioned by the EU’s fiscal rules. Italy needs a credible strategy to reduce its government debt load as it risks constraining its economy. The EU, being a political union and a monetary union without a fully synchronized fiscal union, remains as unstable as a two-legged stool.
Trade issues between the EU and U.K. proved insurmountable for Prime Minister Theresa May. In the second quarter she resigned her post after repeated failures to get Parliamentary approval of a Brexit deal. European Commission President Jean-Claude Juncker has said there will be no change in the EU’s position on Brexit. In the event that Ms. May’s replacement is unable to renegotiate Brexit, the available options for the U.K would be to call a second referendum (to decide if they may now want to remain in the EU), call a general election (to see if the people want a new Parliament), or exit the EU without any definite trade terms whatsoever. This last “no deal” Brexit option is the legal default position if the U.K. cannot sort it out. The Bank of England (BOE) has kept its policies on hold and cut economic growth forecasts. As expected, the policy path will be very reliant on the outlook for Brexit. The BOE has said that uncertainty over the timing and terms of Brexit has prevented some businesses from investing and that U.K. economic growth may be worse than their own forecast. As a result, we continue to steer clear of U.K.-dependent investments.
The BOJ suggested the slowdown in overseas economies will be prolonged and that the magnitude will be greater than previously expected. BOJ Governor Haruhiko Kuroda reiterated that the central bank is prepared to ease policies if necessary and that it has a number of options to do so, including reducing short-term rates below the current -0.1%, lowering the bond yield target below 0%, expanding asset purchases, and accelerating monetary base expansion. Our Japanese holdings are all product-advantaged exporters who are not dependent on demand from Japanese consumers.
China remains the epicenter for global growth concerns. While exports increased unexpectedly in May, due to front loading after the last tariff threat, imports declined the most in two years. Industrial production growth slowed to a 17-year low, and fixed asset investment growth also decelerated. The Chinese government has lent additional policy support, announcing new measures to support infrastructure investment and various tax cuts to businesses and consumers. As a result, top-line growth continues to be among the highest in the world. In the face of trade concerns, several of the Chinese-domiciled portfolio holdings reflect very attractive valuations.
Business Update
In May 2019, Nate Velarde joined our investment team. Nate began his investment management career at TCW where he was initially hired by Brian Beitner as an MBA (University of Chicago) intern, then as an analyst. At TCW he worked extensively on investment ideas for Chautauqua’s predecessor strategy. In order to invest globally, he worked for Nuveen Investment divisions Tradewinds Global and NWQ Investment Management as a managing director, senior analyst, and director of research. He also served as a member of the global equity team at PIMCO in London. Upon returning to the U.S., he has worked toward a Master’s degree in Data Science at the University of California – Berkeley. Most recently, he conducted data science-based investment projects at j2 Cloud Services. Like all members of the investment team, he is a portfolio generalist.
No further organizational changes have taken place.
Respectfully submitted,
The Partners of Chautauqua Capital Management – a Division of Baird
© Robert W. Baird & Co. Incorporated
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