October 11, 2021
Introduction
Global equity markets were mixed in the third quarter but biased to the downside. The U.S. market was up modestly, developed markets were down modestly, and emerging markets were down significantly. The latter was due in large part to a sell-off in Chinese equities following broad and continuing regulatory pressures. Furthermore, September was a unique month because equity markets sold off wholesale as inflation worries came back into focus.
In this environment, Chautauqua’s portfolios appreciated in value and protected against the downside. This year, we have actively trimmed weightings in China to contain the specific risks from regulatory pressures. Additionally, we have made a series of adjustments to reduce holdings with extended valuations and increase holdings we believe are well-suited to transmit pricing power or have more attractive valuations. These adjustments should help insulate against the most deleterious risks of inflation.
Market Update
Global economic output has already surpassed pre-pandemic levels, helped by strong policy support, progress in vaccinations, and the resumption of many economic activities. However, from a regional perspective, the recovery remains uneven. Large differences in vaccination rates between countries are one of the biggest contributors to the unevenness, and output gaps are most pronounced in emerging markets where vaccination rates are low. The economic impact of the highly transmissible Delta variant has lowered near-term momentum and added pressures on global supply chains, but the fallout in countries where vaccination rates are high has been relatively mild.
In the U.S., the Delta variant caused consumers to slow spending in categories such as travel and dining, but it did not knock the recovery off its course. The drag from the Delta variant has been less severe than in previous surges. As case counts and hospitalizations have already peaked in this wave, economic growth is expected to reaccelerate during the fourth quarter, and growth forecasts for next year have been revised higher too.
Inflationary pressures remain a key macroeconomic theme. Personal consumption expenditures inflation, which is the Federal Reserve’s (Fed) preferred gauge, reached 4.3% in August and marked a 30-year high. New case waves have disrupted supply chains for longer and have led to broader supply bottlenecks. Furthermore, consumer spending has significantly outpaced overall economic growth this year, driven by the confluence of vaccine distributions, business reopenings, and trillions in emergency federal aid that has coursed through the U.S. economy. While the Fed has broadcasted its view that these pressures are transitory, it seems that on the margin, it may be more concerned with inflation upside risk, and it has accepted a level of uncertainty of when exactly these pressures will abate.
The labor market continued to improve. With the addition of about 5 million jobs this year, the U.S. unemployment rate has declined from 6.7% at the start to 5.2% in August. Comparatively, the pre-pandemic unemployment rate was 3.5%. Further improvements in the labor market are likely because pandemic extended benefits lapsed in September, and therefore, job seekers are more likely to engage with open positions in the coming months. This should help alleviate some of the supply-demand imbalance in labor markets that has been one of the big contributors to bottlenecks and inflationary pressures. With inflation persisting and labor markets improving, the Fed indicated that it is likely to announce tapering monthly asset purchases by the end of the year.
The eurozone economy has expanded strongly in recent months, driven by higher consumer spending as containment measures have been rolled back. The European Central Bank (ECB) expects the eurozone economy to return to its pre-pandemic level by the end of the year, which is much earlier than expected, but it still lags the recovery enjoyed by the U.S. Inflation in Europe reached 3.4% in September, which marked the highest rate in more than a decade but is viewed as a temporary phenomenon linked to reopening. Additionally, the ECB updated its policy framework to allow temporary overshoots to its 2% inflation target. Overall, this signals a longer period of accommodative policy that can provide additional stimulus to the eurozone economy.
In Japan, inflation was mired in negative territory, unlike in the U.S. and Europe. Also, the economic recovery has been much more lukewarm since emergency curbs to contain the Delta variant restricted the rebound in consumer spending. Supply chain disruptions have added further complications to an export-led rebound. Due to low growth and low inflation, the Bank of Japan (BOJ) will continue an accommodative policy stance.
Outlook
Since global economic output has surpassed pre-pandemic levels and inflation has spiked around the world, policymakers must consider whether and how to phase out pandemic stimulus measures. Those decisions, especially the Fed’s, are set to impact global financial markets. The longer the period that high inflation lasts, the higher the risk that it will become self-reinforcing if consumers and businesses ratchet their inflation expectations higher.
According to the Fed, the current inflation spike is the consequence of supply bottlenecks during a period of very high demand. Both of these factors are temporary and related to the economic reopening. Although supply bottlenecks are expected to continue into next year, the thought is inflationary pressures will abate, and high inflation rates will moderate. Importantly, the Fed does not view the current spike as a new inflation regime, in which inflation remains high year-after-year.
Regardless, by starting tapering, the Fed will have more flexibility to manage inflation risk, especially with the uncertain timing of when inflationary pressures subside. There is broad agreement within the Fed that tapering should conclude by the middle of next year. If the economy is stronger or if inflationary pressures persist to a greater degree than anticipated, the Fed can potentially raise interest rates too. Currently, Fed members are split on whether to raise interest rates in 2022. However, there is nearly unanimous agreement that rates will increase in 2023, and moreover, half of the Fed members expect rates to increase by at least 1% in 2023. This means that Fed expectations for an eventual liftoff have moved meaningfully higher over the course of this year. Additionally, the Fed increased its forecast for U.S. economic growth in 2022 to 3.8%, up from 3.3%.
In Europe, the jump in inflation, on the one hand, adds to the challenge faced by the ECB to justify continuing supportive policies through next year and beyond. On the other hand, the ECB wants to reassure that it will not repeat the same mistake made in the fragile early part of the recovery from the Great Financial Crisis. In 2011, the ECB raised interest rates too early, which triggered a long double-dip recession and low inflation rates in the remainder of the decade.
In contrast, weak inflation and weak growth in Japan have reinforced expectations that the country will lag others in dialing back accommodation. More so, inflation and growth in Japan have been virtually anemic for the past two decades, despite the government’s and the BOJ’s attempts at supportive policies. The new Prime Minister Fumio Kishida has outlined a plan centered on stimulating the growth of the middle class, which has created some renewed optimism for the country.
With respect to managing the portfolios in an inflationary environment, we have taken great care to insulate against the most deleterious risks that inflation poses to equity investments: pressure on company profit margins and compression of valuation multiples. First, we have emphasized companies that we believe have pricing power because of the mission-critical or value-add nature of their products and services. Because of these features, these companies are able to transmit price in inflationary environments, 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. We have implemented these adjustments in a series throughout this year, including in the last quarter.
Emerging economies are among the most vulnerable to a chain reaction of U.S. economic growth and interest rate hikes. Rising treasury yields could initiate capital flight from emerging economies and pressure their currencies. Furthermore, populations are still largely unvaccinated, and governments cannot afford sustained stimulus measures, making these economies especially vulnerable to weak economic recoveries and high inflation. Near-term, the fact that the wave of Delta variant cases has declined significantly is a big positive, but vaccine access will need to increase in order to drive a sustainable recovery.
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.
The specific threat to some portfolio companies in China stems from increased regulation. The government’s list of policy considerations is diverse but broadly encompasses socioeconomic considerations, data privacy, national security, and a recognition that regulatory oversight has not kept abreast with the expanding reach and influence of the internet sector. Many of these issues are not China-specific, and other governments have advanced related reforms in recent years too. Nonetheless, the abrupt way that policy changes have been introduced has proved disruptive to financial markets. In order to contain the specific risks, we have actively trimmed China weightings by approximately 4.6% in the International portfolios and by approximately 3.1% in the Global portfolios in a series of adjustments this year. Furthermore, we believe that valuations for holdings in the internet sector have compressed substantially, while these businesses remain market-leading and check the boxes for mission-critical and high value-add. Meanwhile, holdings in the biotech sector are world-class businesses that are congruent with the government’s goals of growing this domestically important sector.
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
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
© Chautauqua Capital Management
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