International and Global Growth Equities Commentary & Market Outlook

MARKET UPDATE

Among the primary concerns for the markets seemed to be the Fed’s “higher-for-longer” monetary tightening mantra and the markets’ growing acceptance of this. Additionally, in the U.S., there have been debates over to what extent consumers have exhausted their pandemic savings and how the coming resumption of student loan payments will also filter through spending. The spike in energy prices was also seen as a threat to consumers and the potential soft-landing scenario. Lastly, economic data from China has continued to come in weak.

The U.S. economy has so far proved surprisingly resilient to the steep rise in interest rates that commenced in the first quarter of 2022. Most recently, the Fed left interest rates unchanged at a range of 5.25-5.50%. The Fed also indicated that they are still likely to raise rates one more time this year and will cut rates more slowly in 2024 and 2025 than it had previously forecasted. U.S. economic growth has continued to come in stronger than anticipated, and the slowdown in inflation has given the Fed some time to assess when its next move may take place. The U.S. dollar has strengthened notably since July, as markets have reflected a lower likelihood of imminent U.S. rate cuts, and economic data has weakened somewhat in other large economies.

Inflation has slowed down considerably in Europe too. Despite climbing oil prices, inflation in most European countries dropped in September, causing the overall rate to dip to an estimated 4.3%, which is its lowest level since before the start of Russia’s invasion of Ukraine. Core inflation, which strips out volatile food and energy prices, has also been easing lately. The European Central Bank (ECB) raised interest rates to 4% in its last meeting. Slowing inflation will bolster assumptions that the ECB may pause its rate hiking campaign, but it also may not begin bringing rates down soon.

Recently, China released economic statistics that showed some modest improvement in retail sales and industrial production during August. The government has taken a series of small steps over the summer to stimulate the economy, including two rounds of interest rate cuts and lowering reserve requirements in the banking sector. However, policy easing remains piecemeal. Whether and how soon the real estate market can stabilize remains perhaps the biggest factor in the strength of China’s recovery.

Within energy, supply concerns arose from production cuts estimated to last through the end of this year by Saudi Arabia and Russia. And with U.S. oil inventories already at relatively low levels, the price of oil gained almost 30% during the quarter, and the energy sector was far and away the strongest performing sector in the equity markets.

OUTLOOK

The start to 2023 was stronger than anticipated, helped by lower energy prices and the reopening of China. However, that pick-up may prove short lived. Global economic growth is presumed to moderate and remain below-trend both this year and next. The impacts of tighter monetary policy are becoming increasingly visible, business and consumer confidence have turned down, the rebound in China has lagged, and energy prices have risen higher.

According to the Organization for Economic Cooperation and Development (OECD), global GDP growth is estimated to slow from 3% in 2023 to 2.7% in 2024. The Fed has forecasted that U.S. GDP growth will slow down from 2.1% in 2023 to 1.5% in 2024, as tighter financial conditions moderate the demand pressures. In the eurozone, where demand is already subdued, the ECB has forecasted GDP growth to ease to 0.7% in 2023 and then edge up to 1% in 2024, as the adverse impact of high inflation on real income fades. The OECD is also forecasting that growth in China should be held back, easing to 5.1% in 2023 and 4.6% in 2024, due to subdued domestic demand and structural stresses in the property market.

Recent signals, especially from economic surveys, point to a loss of momentum. At a global level, the Purchasing Managers’ Index (PMI) indicates manufacturing output and new orders are at levels normally consistent with stagnation or contraction. Service sector indicators are stronger but have also softened recently. The gradual recovery in consumer confidence over this past year has also stalled in many countries, with confidence still lower than pre-pandemic norms.

Labor markets generally remain tight, with unemployment at or near multi-year lows and job vacancies still high by historical standards in most major advanced economies. However, there are signs the labor pressures are easing. The number of job vacancies has slowed, and quit rates have started to ease. Real wage losses over the past two years and tighter financial conditions continue to restrain consumer spending in most major economies, though the U.S. has been a notable exception.

Among the large emerging market economies, China stands apart as having its own cyclical and structural stresses. High debt and the ailing property sector provide significant challenges, and consumer spending has been slow to recover after the reopening. Numerous policy initiatives have been announced recently to stimulate economic activity, but it remains unclear how effective these will be. Economic growth in China is seen as slowing through this year and next after an initial rebound earlier this year from the reopening. In contrast, GDP growth in the other major Asian emerging economies is projected to remain relatively steady in 2023 and 2024 (e.g., around 6% for India and 5% for Indonesia).

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 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. We believe our Chinese holdings are at valuation levels, in the context of their long-term growth outlooks and competitive positioning, that more than compensate us for the risks. Our Chinese holdings are exposed to secular growth areas of the domestic economy (private consumption and health care) that align with government priorities, have strong balance sheets and resilient cash flows, and are not reliant on restricted Western technology inputs for future growth.

A key factor shaping global growth is the rise in interest rates in most major economies since early 2022. Even if policy rates are not raised further, the effect of prior rate hikes will continue to work their way through economies for some time, as the rates on existing mortgages and corporate loans are adjusted or rolled over. Interest rates appear to be at or near peak in most economies, including in the U.S. and eurozone, but monetary policies will remain restrictive until there are signs that underlying inflation pressures have durably abated.

Risks remain tilted to the downside. Uncertainty about the strength and speed of monetary policy transmission and the persistence of inflation are key concerns. The adverse effects of higher interest rates could prove stronger than predicted, and greater inflation persistence would require additional policy tightening that might expose financial vulnerabilities. A sharper-than-anticipated slowdown in China is an additional key risk that would restrain economic growth around the world.

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, we purposefully select portfolio companies that earn attractive profit margins, carry strong balance sheets, and generate cash on a consistent basis; 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.

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: 10/2023

https://chautauquacapital.com/

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