Introduction
Global equity markets whipsawed in the fourth quarter but ultimately logged gains. The U.S. market was up significantly, developed markets were up modestly, and emerging markets were down modestly.
The Federal Reserve started and then accelerated the normalization of its monetary policies, while the spread of the Omicron variant threatened to undermine the economic recovery. That back and forth, between conflicting forces, was the fuel for the dramatic gains and losses in stocks. Additionally, the regulatory environment surrounding Chinese companies remained cloudy.
In this past year, which was exceptionally volatile, all of Chautauqua’s portfolios appreciated in value. The International portfolios outperformed their benchmark and the Global portfolios performed in line with their benchmark. The challenges included vaccine rollouts, economic recovery, resurgent coronavirus waves, supply chain disruptions, elevated inflation, changes in monetary policies, and regulatory uncertainties. We made continuous adjustments to emphasize holdings, including initiating several new positions, that we believe are valued more attractively or are better suited to transmit pricing power. We also actively trimmed the weightings of Chinese holdings in order to contain the specific risks from regulatory uncertainties. Thank you for entrusting us to invest your precious capital and to navigate this challenging environment.
Market Update
In the U.S., economic growth has continued well-above potential, and the labor market has continued to recover much closer to full employment. Additionally, inflation has broadened out, increasing the threat of it becoming entrenched. In order to tame inflation, the Federal Reserve (Fed) will accelerate the taper of its bond purchase program, with plans to remove the pandemic stimulus by March. The Fed also expects to raise interest rates soon thereafter, for a total of three times next year. While these are notable shifts from the forecasts the Fed communicated just one quarter ago, the response is sensible.
In Europe, economic growth and inflation are by far at their highest levels in the eurozone’s modern history. However, the European Central Bank (ECB) is more reluctant to wind back its support. It is still scarred by raising rates too early following the Great Financial Crisis, which set off the double-dip recession and years of anemic growth compared to the U.S. The ECB said it will rule out interest rate increases next year but continue bond purchases, though at a lower rate than in 2021, which was supercharged by extra pandemic stimulus.
The risk that economies might be overheating in the post-pandemic recovery may be causing concern in the U.S. and Europe, but Japan is wrestling with the opposite problem. In Japan, the economic recovery has been underwhelming, and the government has recently responded with a fresh fiscal stimulus. Whether this will reach the desired impact is still uncertain, as the government had already tried with massive pandemic stimulus to no lasting avail. Supply chain disruptions have played a part in the comparative performance gap, but those are issues the U.S. and Europe also face. More likely, severe and persisting coronavirus restrictions play a larger role.
Outlook
Some market participants see the Fed’s faster taper and new interest rate forecasts as signs that it has been forced into a dramatic shift in its approach. Over the short run, it may appear so. But in the long run, not really. While it is true that the “dot plot” has unmistakably moved up for the next two years, the median forecast for interest rates in 2024 is 2.1%, and the long-run forecast of 2.5% has not changed.
Furthermore, the median forecast for personal consumption expenditure inflation is expected to dip from the most recent pace of above 5% to 2.6% in 2022, 2.3% in 2023, and 2.1% in 2024. In other words, above-target inflation will last about three years, and only one of those years should really be categorized as “especially high”, 2021.
Again, on the long-term inflation and interest rate outlook, the Fed’s median interest rate forecast is 2.1%, and its median inflation forecast is 2.1%. Thus, the real interest rate then is 0%. While the Fed officially retired the word “transitory” to describe the current inflation paradigm, in actuality, the long-term view has not changed much at all.
If that is the Fed’s view, then also consider the views of the average consumer and the bond markets. They all appear to be similar. The most recent estimate of five-year forward inflation from the University of Michigan consumer sentiment survey remains under control at 3%, despite all the bad press on rising prices. And historically, this metric tends to be higher than the future inflation level that is eventually reached. Additionally, the five-year inflation “breakeven” currently priced by the bond markets are near 2.7%, even trending down in December.
Once inflation subsides, the “new normal” will probably look a lot like the “old normal”. Prior to the pandemic, this was the situation that worried many. The Fed’s median forecast for economic growth in 2024 and beyond is 2%. That sort of growth is fine but uninspiring, and the long-term headwinds of weak productivity growth and demographics will be a drag.
From a stock market perspective, historically, rate hiking cycles have been associated with positive stock market returns. That includes the Fed’s last hiking cycle between 2016 and 2019, which was temporarily challenged by the market selloff in the latter part of 2018. Moreso, for investors that believe low bond yields are a critical support to the stock market in the current environment, then the fact that bond markets have priced long-term bond yields to go nowhere should be very reassuring. This is in spite of elevated inflation and three rate hikes next year. On the other hand, nerves are still on alert because stock market performance has been exceptionally good the past few years.
On a global basis, the Organization for Economic Cooperation and Development forecasts inflation to slow to 4.4% in 2022 and 3.8% in 2023 and for economic growth to slow to 4.5% in 2022 and 3.2% in 2023. The big picture is that above-trend inflation and growth rates on the global scale will slow back to their pre-pandemic trendlines, just as in the U.S. scenario.
We believe our investment philosophy, which emphasizes businesses with competitive advantages and strong market positions, should continue to compound wealth at faster-than-market rates in this normalizing environment. Some of the most exciting growth areas pertain to strong secular trends, many of which are agnostic to the growth potential of any geographic region. These include our many investments in and adjacent to cloud computing, software-as-a-service, digitalization, artificial intelligence, semiconductor advancement, e-commerce, industrial automation, electric vehicles, and novel biologic and biosimilar therapies. Other exciting growth areas pertain to rapidly expanding middle classes, broadly in emerging economies and especially in Asia, which are propelling the uptake of various consumer goods and financial products.
The most significant country among emerging countries is China. The specific threat to portfolio companies in China stems from increased regulation, not just from within China itself, but also externally from the U.S. With respect to the Chinese government, the list of policy considerations is diverse and broadly encompasses socioeconomic disparities, data privacy, national security, and stronger oversight of the internet sector. With respect to the U.S. government, relations with China have weakened considerably in recent years, making way for higher levels of trade protectionism, an arms race mentality with technology, and quasi-big stick diplomacy. The abrupt ways that regulatory policies have been introduced, from both sides, have proved extremely disruptive for financial markets.
In order to contain those specific risks, we actively trimmed China weightings by approximately 6% in the International portfolios and by approximately 4% in the Global portfolios over the past year. The performance drag from holdings in China alone were substantially higher than the drag from any other grouping by sector or geographic region. Valuations for holdings in China have compressed substantially, and yet these businesses still possess considerable competitive advantages and leading market positions. These reasons underlie our continuing investment in these companies.
Lastly, valuation matters. It is a core deliberation in our investment process, alongside growth rates and returns on capital. Over the past year, we made a series of adjustments to reduce weightings in holdings with extended valuations and to increase weightings in holdings with comparatively attractive valuations or that we believe were well-suited to transmit pricing power in the inflationary environment.
Business Update
Brian Beitner, CFA, announced his planned retirement effective December 31, 2022. On behalf of the Partners of Chautauqua Capital Management, we would like to express our gratitude and appreciation to Brian for all his immense contributions to our organization. He is not only the Founder and long-time Managing Partner of Chautauqua Capital, but he is also an exceptional investor, a sage teacher, and a dear friend.
During the course of 2022, Brian will remain a portfolio manager on the Chautauqua portfolios, continue to contribute his thoughts and perspectives as part of the team-oriented investment process, and transition to an advisory role in support of Jesse, Haicheng, and Nate. As always, Brian and the rest of the team are available to speak with you further should there be any questions.
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The above commentary does not provide a complete analysis of every material fact regarding any market, industry, security or portfolio.
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First Use: 01/2022
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