Introduction
Equity markets declined in the first quarter and exhibited heightened volatility. Inflation has remained elevated, and its containment is the near-unanimous priority for the major central banks. The Federal Reserve (Fed) and others have responded by tightening. The war in Ukraine is the latest factor to upset the global economic picture, as it is likely to dampen growth and simultaneously push inflation even higher. And therein lies the challenge: higher inflation and softer growth.
In this inflationary environment, 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 against two of the most pernicious effects of inflation for equity investors, namely the compression of profit margins and the compression of valuation multiples. Furthermore, our investment philosophy, which emphasizes businesses that benefit from secular trends and possess strong competitive advantages, means that portfolios can outgrow the market over the long-term. Thank you for entrusting us to invest your precious capital and to navigate this increasingly uncertain market environment.
Market Update
After weeks building up a large military force along its border with Ukraine and in neighboring Belarus, Russia launched a full-scale invasion of Ukraine in late February, marking a grim new chapter for the European continent. Russia’s aim is to threaten any future ambitions of the North Atlantic Treaty Organization (NATO) and to overrun Ukraine and depose its pro-Western government.
Russia is the 11th largest economy in the world. It is a major supplier of energy to Europe, accounting for 40% of the eurozone’s natural gas supply, and it is also an important source of metals, fertilizers, and wheat worldwide. The U.S. and its Western allies have imposed a wide array of economic penalties to punish Russia. President Biden has said they were designed to weaken the ruble, crash the Russian stock market, and erode the Russian economy. These penalties have included blocking the Bank of Russia from accessing foreign currency reserves and removing some Russian banks from the Swift network of international interbank payments. Additionally, many large multinational corporations have curtailed, or stopped outright, their business operations in Russia. So far, Russia has been undeterred by Western sanctions, proceeding further with the invasion of Ukraine on multiple fronts.
Inflation has continued to broaden out. U.S. personal consumption expenditure (PCE) inflation reached 6.1% in January and has stayed above the Fed’s target inflation rate of 2%. The bout of inflation has several causes, many linked to the pandemic. For one, consumers are flush with savings accumulated from depressed levels of household spending and stimulus programs in the early stages of the pandemic. Since then, the reopening has seen a big snapback in the demand for goods and services. Second, supply bottlenecks have arisen from the reopening and ranged from component shortages to transportation shortages. The added costs, at every step, have led to higher prices. Third, labor markets have tightened rapidly. The unemployment rate reached a pandemic high of 14.7% and has since fallen to 3.8%, and current wage growth is near its highest pace in years. Unemployment is already below the Fed’s estimate for the natural unemployment rate, which is 4%, below which price and wage pressures can build. In an expected move and in order to stave off high inflation, the Fed raised interest rates to a range between 0.25% to 0.5%. It has also penciled in a series of six additional rate hikes by the end of this year.
The European Central Bank (ECB) has warned that the war can significantly dampen economic growth and simultaneously push inflation considerably higher. Eurozone inflation reached 5.9% in February, as compared to the ECB’s target inflation rate of 2%. However, the ECB scaled back its bond-buying program, in an unexpected tightening move to respond to higher inflation. The ECB faced a difficult choice, given the rapid deterioration of the economic situation, but containing inflation has become the priority issue. The situation will be particularly challenging in Europe. The European economy was slowing even before Russia invaded Ukraine. The war is likely to curb trade between Europe and Russia and exert further pressure on stressed supply chains.
The central banks of Singapore, Hong Kong, Taiwan, and South Korea have already begun raising interest rates to stem inflation and have signaled even more tightening ahead. Furthermore, some of these central banks have needed to tighten to keep pace with the Fed in order to maintain currency exchange rates with the U.S. dollar. Elsewhere in Asia, China, and Japan are not expected to tighten any time soon. Inflation rates in these countries are much more muted, giving their central banks more leeway to keep policies loose to support growth.
Outlook
Just as global economies were beginning to put the worst of the pandemic behind, the Russian invasion of Ukraine risks stoking inflation and weakening economic growth worldwide. As a result, higher energy and food prices and more supply chain disruptions have pressured inflation, while consumer and business confidence have recently weakened. The Organization for Economic Cooperation and Development (OECD) has forecast that global inflation will increase by an additional 2.5% and that global economic growth will decrease by an additional 1.1% because of the war. Previously, when war was not on the table, the OECD had forecast inflation of 4.4% and economic growth of 4.5% in 2022.
A “soft landing” scenario is not so straightforward in the current context. The Fed has the task of raising interest rates to moderate demand and bring down inflation. If it raises too slowly, then it risks inflation getting even further out of hand. And if it raises too aggressively, then it may trigger a recession.
Real interest rates are already deeply negative. When real rates are negative, borrowing becomes more attractive, which leads to more spending and higher demand. This would be the opposite of what the Fed is currently trying to achieve. The scenario is all the more precarious because of escalating sanctions on Russia, higher energy and commodity prices, and recent pandemic lockdowns in China. Therefore, much higher interest rates are likely needed to get inflation back down to 2%, and consequently, the hiking cycle would increase the risk of causing a recession.
The median forecast for U.S. inflation is 4.3% in 2022, 2.7% in 2023, 2.3% in 2024, and 2.0% in the long-run. Meanwhile, the median forecast for U.S. interest rates is 1.9% in 2022, 2.8% in 2023 and 2024, and 2.4% in the long-run. The reality is that the Fed has been taking up its forecasts for near-term inflation and interest rates for the last four quarters, which underlines the difficulty of forecasting inflation in the post-pandemic world. However, notably, the Fed’s long-run forecasts for inflation and interest rates have not changed at all.
The longer the period that high inflation lasts, the higher the risk that high inflation will become self-reinforcing if consumers and businesses ratchet their inflation expectations higher. The good news is that long-term inflation expectations by consumers, as depicted by the University of Michigan consumer sentiment survey, have remained well anchored at 3.0%. Historically, this metric tends to be higher than the future inflation level that is eventually reached. Additionally, the long-term inflation captured by bond markets in the five-year inflation breakeven rate is just above 3.3%. This would say that long-term inflation expectations by consumers and bond markets have not run amok.
Chautauqua’s portfolios do not have any direct exposures to Russia or Ukraine. (In Global portfolios, we exited our position in EPAM Systems during the quarter.) We considered possible indirect disruptions that could affect the semiconductor and auto-related companies in the portfolios, but we believe the impacts are not material. Furthermore, portfolios are also underweight exposure to Europe and therefore we believe they are relatively shielded from the collateral economic damage in the region.
Among emerging economy countries, China is the most significant. 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. The abrupt ways that regulatory policies have been introduced, from both sides, have proved extremely disruptive for financial markets.
Additionally, the U.S. has demanded that audit papers of U.S.-listed Chinese companies need to be able to be inspected by U.S. regulators, and that non-compliance for a three-year period would result in prohibiting trading on U.S. securities exchanges. Overall, we are constructive that U.S. and Chinese regulators will find a solution that prevents delisting of identified issuers because both sides have interests in preserving the value of investments made by U.S. investors and preserving the ability of Chinese companies to access foreign capital.
In order to contain the specific risks from China, we actively trimmed China weightings by approximately 6% in the International portfolios and by approximately 4% in the Global portfolios since the beginning of last year. 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.
With respect to managing the portfolios in an inflationary environment, we have taken great care to insulate against the most pernicious 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 long series throughout last year and in this past quarter.
Our investment philosophy emphasizes businesses that benefit from secular trends and that we believe possess strong competitive advantages and market positions. And some of the most exciting growth areas are agnostic to the growth potential of the global economy or 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 and payments, industrial automation, electric vehicles, and novel biologic and biosimilar therapies. Other exciting growth areas pertain to rapidly expanding consumer classes, broadly in emerging economies and especially in Asia, which are propelling the uptake of various consumer goods and financial products. Because of these reasons, we believe our managed portfolio can continue to compound wealth at faster-than-market rates, even when the global growth environment is moderating.
Business Update
There have been no changes to the investment team at Chautauqua Capital Management nor have there been changes to the ownership structure of our parent company, Baird.
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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: 04/2022
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