International and Global Markets Commentary & Investment Outlook

MARKET UPDATE

The global economy continued to deteriorate through the end of 2022, but not to the extent that was previously feared. In fact, some parts of the U.S. and European economies showed resilience despite the high inflationary environment, rising interest rates, and war in Ukraine. In the U.S., the labor market is still tight, and household balance sheets are still strong. Europe has managed the energy disruption by cutting back on energy consumption and doling out fiscal support to households to help address high energy and food costs. China is currently facing a swell of Covid cases, but it has taken a momentous step by easing tough pandemic policies and setting the stage for a reopening rebound.

Still, rising interest rates and slowing economic growth are heightening recession fears around the world. In the past year, the Federal Reserve (Fed) embarked on an aggressive campaign to hike interest rates in order to tame the most rapid inflation seen in decades, and what the Fed does reverberates across the world. Other central banks also hiked rates, both to fight inflation in their own economies and to stabilize their currencies against the dollar to the extent possible.

In the U.S., personal consumption expenditures (PCE) inflation slowed to 5.5% in November. This is an encouraging sign that, after a year and a half of swift and consistent price increases, inflation in the U.S. is beginning to abate. The Fed hiked rates by 75 basis points in November and then just 50 basis points in December, with the fed funds rate now set to a range of 4.25-4.5%. After months of hiking rates rapidly, the Fed is entering a phase in which it expects to adjust policy more cautiously. However, this does not mean the Fed is letting up.

Russia’s war in Ukraine is responsible for much of the uncertainty facing the world because it has disrupted critical energy and food supplies. Recently, the U.S. and its Western allies capped the price of Russian oil in an effort to dwindle the energy-related revenues that Russia reaps and uses to finance its war. In response, Russia banned the sale of its oil to countries that impose the cap, which threatens to continue the uncertainty for global energy markets. For its part, Ukraine has repeated that it will resist until its territory is restored and Russia is held accountable for violations of international law, meaning there is still no line of sight to an armistice.

Higher energy prices have been heavily responsible for the sharp increase in inflation in Europe. Prices of food, service businesses, and wages have also gotten more expensive, as inflation has seeped into more pockets of the European economy. Uncertainty about energy prices has hampered manufacturing activity. Inflation in Europe is among the highest in developed economies and is still in the double digits. The European Central Bank (ECB) hiked rates by 75 basis points in October and by an additional 50 basis points in December, with the policy rate now set to 2%, and it is bracing for more hikes in 2023.

President Xi Jinping secured a third term as China’s leader in October, and the Chinese equity market stumbled to multi-year lows. The fear was that China would prioritize Communist Party ideology over the country’s growth and that Covid lockdowns would continue indefinitely. However, the situation has turned incrementally more positive after the government instated several moves to support its battered economy. In a remarkable pivot, the Chinese government announced a broad rollback of Covid containment measures, including mass testing, lockdowns, and quarantines, that have dragged down the economy and impacted day-to-day life. This was an implicit concession to public discontent after mass street protests in late November posed a widespread challenge to the Communist Party. Separately, President Xi Jinping called for more economic stimulus and for the central bank to instate a loose monetary policy, which has conveyed a pro-growth stance.

OUTLOOK

The global economic outlook remains highly uncertain. The energy shock has pushed up inflation to levels not seen in many decades. Higher rates slow inflation by cooling business investments and consumer demand for goods and services, paving the way for more moderate price increases. But, in the process, higher rates also curtail employment, weaken wage growth, and ripple through financial markets in disruptive ways. Just how much pain these moves will ultimately cause remains unclear. So many countries are raising rates so quickly, and so in sync, that it is difficult to determine how intense any slowdown will be once it takes full effect. Monetary policy is a blunt tool, and it often acts with a lag.

There is already a broad slowdown of the global economy. However, Asia should be the main engine of growth, whereas North America, Europe, and Latin America should see very little growth. The most recent forecast for global economic growth in 2023 is 2.2% according to the Organization for Economic Cooperation and Development (OECD), or 2.7% according to the International Monetary Fund (IMF). Global inflation is thought to have already peaked and is forecasted to be 6.5% in 2023. The big question is how quickly inflation comes down.

In the U.S., the Fed plans to hike rates higher than previously expected, to 5.1% by the end of 2023, and to keep rates elevated for longer. This will give the Fed time to see how inflation and the labor market react to policy changes it has already put in place. It expects that it will still take years for inflation to fully return to its 2% target and that inflation risks remain to the upside. In particular, the job market is still very strong, and wages are growing rapidly, so a sharper economic deceleration may be needed for inflation to fully fade. The Fed has projected economic growth of 0.5% in 2023, which would be consistent with a short and shallow recession during the year. On the contrary, because the recent inflation data in the U.S. had started to abate, there is also speculation in the markets that the Fed could pursue a less aggressive policy path in 2023 and that there is a chance of accomplishing the elusive soft landing. In the press conference following the recent Fed meeting, Chairman Powell answered “I don’t think anyone knows whether we’re going to have a recession or not, and if we do, whether it’s going to be a deep one or not. It is not knowable.”

Europe faces the strongest economic headwinds in the months ahead. It is heavily reliant on Russia for its energy, and it could face sharp increases in energy prices as additional sanctions have gone into effect in December. The ECB expects to raise interest rates significantly further because inflation remains far too high, and therefore, interest rates have still not reached the levels where they are restrictive. The situation in Europe is fundamentally different as compared the one in the U.S., where both rates have been hiked significantly and inflation has come down significantly. Economic growth is expected to be weak, and likely negative in the first quarter, due to high energy costs and softening business sentiment. The ECB has projected economic growth of 0.5% in 2023.

In China, the recent surge in Covid infections and weak consumer sentiment have raised questions on how soon the economy can rebound. However, there has been a clear pivot on Covid policies and better visibility on an exit strategy. Additionally, the government has pledged more support for the housing market and more of a pro-growth stance on the economy. Inflation is also much lower than in the U.S. and other Western economies. Taken together, the changes point to an incrementally brighter outlook for China, though the ride is still likely to be bumpy. The World Bank forecasts economic growth in China of 4.3% in 2023, rebounding from 2.7% in 2022 as the economy reopens. Lastly, for context, institutional holdings of Chinese stocks are the lowest they have been in five years, and valuations are far below average. Amidst the positive shifts in the economic picture in China, the risk-to-reward is incrementally more favorable. Over the last two years, we have reduced Greater China weightings on a net basis, inclusive of holdings in Mainland China, Hong Kong, and Taiwan. In International portfolios, roughly 18% of assets are invested in Greater China holdings, which is modestly overweight relative to the benchmark. In Global portfolios, roughly 13% of assets are invested in Greater China holdings, which is overweight relative to the benchmark.

The factors roiling the global economy explain why the dollar became much stronger for the first three quarters in 2022. However, that trend reversed in the fourth quarter, with the dollar giving back roughly half of its gains during the year, as U.S. inflation has slowed and the pace of U.S. rate hiking is set to decelerate.

As global investors, our investments in foreign ordinary securities naturally exposes portfolios to currency risk, which, in this case, is defined as the difference between portfolio return and local market return. The same is true for both the benchmark and other investors which invest in these same types of foreign securities. Dollar performance during the past year created a headwind for these investments due to the negative currency return, but again, the partial reversal of that trend was a tailwind in the fourth quarter.

We have mitigated the impact of currency movements in two ways. First, less of the assets in portfolios are directly invested in the currencies that have performed poorly, as compared to the benchmark weights. On a relative basis, this is a positive. The worst performing major currencies in the past year were the yen and the pound, which were both down by low double digits percentages. The euro was down just by a mid-single digit percentage. In International portfolios, roughly 11% of assets are invested in yen-denominated securities, and approximately 11% of assets are invested in euro-denominated securities. In Global portfolios, roughly 7% of assets are invested in yen-denominated securities, and approximately 8% of assets are invested in euro-denominated securities. Portfolios are not invested at all in any securities denominated in the pound. And as far as emerging market exposures go, portfolios are exposed to the relatively benign emerging market currencies. Roughly 9% of assets in International portfolios and approximately 6% of assets in Global portfolios are invested in rupee or rupiah-denominated securities. The economies of India and Indonesia are outperforming as they benefit from reopening tailwinds of their large domestic markets.

Second, from a revenue footprint standpoint, portfolios are more overweight revenue sources from the geographies with stronger currency performance and more underweight revenue sources from the geographies with weaker currency performance, as compared to the benchmark exposures. International portfolios are more overweight in revenue sources from North America, India, and Indonesia, and they are more underweight revenue sources from Japan, Europe, and China. Global portfolios are more overweight in revenue sources from India and Indonesia, and they are more underweight in revenue sources from Japan and China. The exceptions in Global portfolios are an overweight to revenue sources in Europe and an underweight to revenue sources in North America.

Our investment philosophy emphasizes businesses that should benefit from secular trends and that we believe possess strong competitive advantages and market positions. Over longer investment horizons, some of the most exciting growth areas can be relatively agnostic to the global picture or the specific situations impacting certain regions. 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.

We do not expect the current environment of weakening economic growth to dislodge the long-term staying power of these investment themes, nor the business models or market positions of portfolio companies. Furthermore, portfolio companies that earn attractive profit margins, carry strong balance sheets, and generate cash on a consistent basis are purposefully selected. In other words, portfolio companies we believe are on solid footing, even when times are tough. For these reasons, portfolios can outgrow market growth rates over the long-term.

We have also taken great care to try to insulate against the most pernicious risks that inflation poses to equity investments, namely 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 2021 and 2022.

For additional important information about the fees, expenses, risks and terms of investment advisory accounts at Baird, please review Baird’s Form ADV Brochure, which can be obtained from your financial advisor and should be read carefully before opening an investment advisory account.

The above commentary does not provide a complete analysis of every material fact regarding any market, industry, security or portfolio.

©2023 Robert W. Baird & Co. Incorporated. First use: 01/2023

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