International and Global Growth Equities Commentary & Market Outlook

In this inflationary environment, we have also managed by making ongoing adjustments to emphasize 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.

Thank you for entrusting us to invest your precious capital and to navigate this increasingly uncertain market environment.

Market Update

The U.S. remains a long way from low and stable inflation, despite being over a year into the Fed’s aggressive rate hiking campaign. Headline inflation is beginning to abate meaningfully for U.S. consumers. However, there are still reasons for continued vigilance. Core inflation, which strips out more volatile energy and food costs, is exhibiting staying power, as a range of services categories continue to climb quickly in price. The Fed closely monitors monthly changes in core inflation to get a sense of the recent inflation trends, and that figure continued to pick up in May.

Furthermore, the U.S. economy is not experiencing the drastic slowdown that many had anticipated in such a tightening interest rate regime. And despite high-profile layoffs at some large tech companies, hiring has remained robust among U.S. employers and the unemployment rate continues to be low. Taken with the surprising resilience of the U.S. economy, the Fed may need to do more to cool growth even further in order to rein in consumption to prevent elevated price increases from persisting. Decisions on the interest rate path will be guided by upcoming data releases on inflation, employment, and other indicators. The big picture is that the Fed is making progress on inflation, but the progress is happening slower than desired.

The U.S. equity market has been on a tear. It is now more than 20% higher than its low reached last fall and less than 10% away from a new high. One note of caution about the U.S. rally is that it has been largely propelled by a small number of mega-cap tech companies. The average stock in the U.S. index has risen by far less than the index itself.

Bulls are citing signs of a resilient economy, moderating headline inflation, and a near end to the Fed’s hiking cycle. If the economy has survived the soaring inflation and higher interest rates so far, the thinking goes, then maybe it will continue. On the other hand, bears are focused on the obstacles ahead. Inflation is still running at more than twice the Fed’s target rate of 2% and could remain stubborn and high.

Inflation in Europe nudged back up to 7% in May, and the labor market remains red hot. The European Central Bank (ECB) raised interest rates by 25 basis points to 3.5%, which is the highest interest rate in more than two decades. Taming inflation while avoiding a recession is Europe’s biggest challenge in the months to come, as the continent continues to digest the impact of the war in Ukraine on its economy.

In China, post-Covid demand helped to push the economy in the early part of the year, but there is growing concern that its economy has not rebounded as strongly as estimated after lifting its restrictive zero-Covid measures. Both investment and exports have stagnated, and more than 20% of youths are unemployed. In fact, China’s economic recovery has seen only a few categories of spending grow robustly, such as travel and restaurant meals. The Chinese government has already taken some steps to revitalize economic growth. Interest rates on bank deposits have been cut to encourage households to spend, interest rates for corporate loans and mortgages have also been cut, and tax breaks are being introduced for small businesses.

Outlook

The global economy remains in a fragile state. Inflation pressures persist, but the drag on growth due to the tightening of monetary policy is presumed to peak this year in many major economies. Recent banking sector stress has further tightened credit conditions. And the lingering impact of the war in Ukraine will continue to weigh on growth across regions but particularly in Europe. Combined, these factors are likely to cause a growth deceleration in the second half of 2023.

Economic growth in some major economies was actually stronger than envisioned at the beginning of this year, with resilient consumption in the U.S. and a faster-than-anticipated initial reopening in China. Nonetheless, according to forecasts from the World Bank, the global economy is poised to slow in 2023 to 2.1% and edge up modestly to 2.4% in 2024. The world economy is experiencing a synchronized slowdown, and the majority of countries are likely to face slower growth this year than last year. Growth over the rest of 2023 is set to slow substantially as it is weighed down by the lagged and ongoing effects of monetary tightening and more restrictive credit conditions. These factors are very likely to continue to affect economic activity heading into 2024.

However, the outlook differs sharply across regions. The most buoyant economic activity is predicted in Asia. The economies of India, China, and Southeast Asia are forecasted to grow near or above 5% this year, making them the fastest among major economies. At the other end of the spectrum, the forecasts for growth are rather anemic in the U.S., Europe, and Japan.

Over the last two-plus 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 17% of assets are invested in Greater China holdings, which is modestly overweight relative to the benchmark. In Global portfolios, roughly 12% of assets are invested in Greater China holdings, which is overweight relative to the benchmark.

Central banks are entering a new phase in their battle with inflation. Headline inflation rates have fallen sharply across most of the world’s economies though are still mostly above target levels. More concerning is that core inflation rates, which exclude more volatile energy and food costs, remain at or close to multi-decade highs. Core inflation rates are being viewed as a gauge for underlying price pressures, and their stickiness has sparked concern that central banks will struggle to hit their inflation targets without wiping out growth.

Calibrating monetary policy is difficult. Changes in interest rates can take months, or even years, to translate their full effects, so the impacts of the Fed’s rate increases since early 2022 are still playing out. The Fed’s new forecasts have interest rates rising further to 5.6% by the end of this year, which would amount to two more quarter-point rate hikes over the course of the Fed’s four remaining meetings this year. The economy’s staying power could mean the Fed will be able to wrangle inflation gently, slowing down price increases, without tipping the U.S. into any sort of recession. But if inflation remains hot, the Fed may do even more to restrain growth. The end of rate hikes is easier to envisage in the U.S., but it is not quite yet in view for Europe. The ECB began raising rates from below 0% last July, and so it has not been hiking for as long or as aggressively as the Fed. Further rate hikes are necessary there.

Our investment philosophy emphasizes businesses that should benefit from secular trends and 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 anticipate 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 have the potential to 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.

Chautauqua Capital Management, a division of 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.

©2023 Robert W. Baird & Co. Incorporated.

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