Introduction
Equity markets performed strongly in the second quarter. Nearly all sectors and regions benefited, though the U.S. continues to lead relative to international developed and emerging markets. Notably, growth stocks outperformed value stocks (aside from emerging markets), which was a reversal of the trend from the first quarter, but not a complete unwind of that massive rotation.
Monetary and fiscal stimulus, economic reopening, and rebounding corporate earnings continue to be tailwinds for stocks. Inflation normally coincides with strong economic expansions, and it has been often cited as the primary risk to the market rally. We have made ongoing adjustments to portfolios by emphasizing holdings that we believe are well-suited to transmit pricing power or are valued more attractively. These attributes should help protect portfolios from deleterious inflationary pressures.
Market Update
Last year, the Federal Reserve (Fed) adopted a new approach to setting interest rates by targeting average inflation of 2% over time. It also aimed to let inflation run moderately above that level for a while, after many years of inflation shortfalls. Personal consumption expenditures (PCE) inflation reached 3.6% in April and 3.9% in May. The spike in inflation has been quicker and stronger than expected, but it is chalked up to transitory factors such as low base effects, supply chain bottlenecks, and pent-up demand. As things get back to normal, inflation should moderate. The Fed expects inflation to slow to 3.4% by the end of this year and to hover modestly above 2% in 2022 and 2023.
Most Fed officials are more comfortable that the U.S. will be able to achieve maximum employment and sustained 2% inflation on a quicker timeframe than originally expected. Labor markets are improving. Industry breadth is at its greatest point since the pandemic started, and there is still further room for recovery in the industries adversely impacted by the pandemic. The latest data shows an unemployment rate of 5.9%, which is roughly 7.6 million jobs lower than pre-pandemic levels. The long duration of enhanced unemployment benefits has been cited as one of the main reasons for the difficulty employers have faced filling jobs, yet unemployment levels have still remained elevated. These enhanced benefits are set to expire in September, which may help these frictions release.
The median forecast from Fed officials projects two interest rate hikes by the end of 2023. When the last set of projections was released back in March, the median forecast projected no hikes through 2023. Additionally, the Fed has signaled that it will take care to avoid a repeat of a taper tantrum. In 2013, the Fed surprised markets by reducing the Great Financial Crisis stimulus programs, which created significant volatility.
With regards to inflationary pressures, parallel developments have occurred in many other parts of the world too. In Europe, inflation reached the European Central Bank’s 2% target in May, which has been much sooner than the expectations of reaching the target late this year. In China, producer prices reached a 13-year high. Some central banks have started to remove some of the extraordinary pandemic stimulus and begin their tapering processes. The Bank of England and the Bank of Canada both cut the pace of bond purchases by approximately one quarter and, likewise, have accelerated the timetable for a potential rate hike.
Outlook
The global economic outlook continues to improve, driven by vaccinations and reopening. The Organization for Economic Cooperation and Development (OECD) upgraded its forecasts for global economic growth to 5.8% in 2021 and 4.4% in 2022. If that is true, growth this year will be the fastest in nearly five decades.
Among major economies, the U.S. has enjoyed one of the most dramatic economic recoveries, and its growth will have a multiplier effect on the economic recoveries of other nations. Under President Biden, U.S. fiscal policy is expected to remain highly stimulative. According to the OECD, the U.S. fiscal budget alone in 2022 is expected to raise economic output by nearly half a point in China, Japan, and Europe and by nearly a full point in Canada and Mexico.
On the other hand, a strong U.S. economy portends inflationary pressures and higher interest rates. The U.S. dollar has strengthened in the last few weeks since the Fed released new projections to raise rates by late 2023. The knock-on effect is that this may restrain economic recoveries in other places and lead to generally tighter global financial conditions.
With respect to managing portfolios in an inflationary environment, we have taken great care to emphasize companies that we believe have pricing power due to the mission-critical or value-add nature of their products and services. Because of these features, these companies have a greater ability to transmit price, and therefore protect their profit margins. Furthermore, we have made incremental adjustments to portfolios to emphasize companies with more attractive valuations, in light of higher market discount rates. These measures should help protect portfolios from deleterious inflationary pressures.
Emerging economies are among the most vulnerable to a chain reaction of U.S. economic growth and interest rate hikes. In emerging countries, populations are largely unvaccinated, and governments cannot afford sustained stimulus measures, causing these economies to fall behind. For example, central banks in Brazil, Russia, and Turkey, which are countries where portfolios are not invested, have already raised interest rates several times this year to counter currency depreciation and arrest inflation that is at multi-year highs. These countries are still wrestling with the pandemic, and yet these actions will not help in their recoveries.
For the most part, portfolio companies in emerging markets are more insulated from the broader economic woes impacting emerging economies. China was actually the first major economy to enjoy a rapid recovery, and its economy is still strongly growing. The OECD forecasts that the Chinese economy will grow 8.5% in 2021. The specific threat to some portfolio companies in China stems from increased regulatory pressures. Chinese tech giants had previously been allowed to flourish without a lot of scrutiny, and they grew undeterred during the pandemic. Now, they face regulatory enquiries on a range of topics. The tech entrepreneurs that successfully navigate these enquiries will do so by keeping a low public profile and aligning with the Party’s agenda. China also faces a worsening demographic outlook and has mulled policies to rein in the cost of education, which has been seen as a deterrent to couples from having more children. While the framework is still being decided, the risk of encountering a worst-case scenario led to our sale of a holding engaged in private afterschool tutoring.
Portfolio companies in emerging markets benefit from strong secular tailwinds for electronic devices and compute power, digitalization, e-commerce, novel drug therapies, and health care distribution, to name a few. Emerging markets banks benefit from a long runway for banking access and the adoption of financial products, but they are generally more sensitive to a weak economic environment. India has been ravaged by a second coronavirus wave, and the delta variant has been spreading quickly in Indonesia. Portfolio companies in the banking sector entered the pandemic with exceptional asset quality and well-capitalized balance sheets. Though in the last quarter, these investments were modest detractors to performance, in many ways, their competitive positioning has strengthened in the pandemic with accelerated deposit growth and well-protected balance sheets to deploy once fundamentals improve.
We take a great deal of comfort investing in what we believe are advantaged businesses that benefit from long-lived trends. These businesses often have leading market shares and a wide growth path ahead of them. Therefore, their ability to continue growing and compounding returns over the long-term is ultimately what proves them to be so valuable for portfolios, irrespective of the market environment or the economic cycle. We thank you for entrusting us with your capital.
Business Update
Our strategies reached a 15-year track record this year. During the quarter, our mutual funds—the Chautauqua International Growth Fund and Chautauqua Global Growth Fund—reached their five-year track records. Additionally, the Chautauqua International Growth Fund earned a Bronze Rating from Morningstar (rating date as of 6/25/2021).
There have been no changes to the investment team at Chautauqua Capital Management nor have there been any changes to the ownership structure of our parent company, Baird.
Respectfully submitted,
The Partners of Chautauqua Capital Management – a Division of Baird
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