MARKET RECAP
Global equity markets continued to rally throughout the third quarter, with strong positive stock performance from the U.S., international developed, and emerging markets. The two biggest narratives that have unfolded recently center on the U.S. and China. Global monetary easing is now under way after the Federal Reserve (Fed) delivered a 50 basis points rate cut in mid-September. This creates room for other central banks to follow suit, particularly in emerging markets. Additionally, China enacted measures to shore up market confidence in the face of concerns about its slowing economy and the impact of the country’s gloomy property sector.
Our investment strategies focus on the long term, allowing us to navigate short-term economic fluctuations. We prioritize businesses that align with secular trends and have strong competitive advantages and market positions. Our portfolio companies are chosen for their high profit margins, strong balance sheets, and consistent cash generation. We believe these qualities will endure even in challenging macroeconomic conditions. Our concentrated, conviction-weighted portfolios are designed to outperform market growth rates over an investment cycle. Additionally, our portfolios are diversified across a wide range of secular growth themes. For instance, within the top ten holdings of our international strategy, in addition to holdings in AI, themes include obesity, industrial automation, financial services in emerging markets, e-commerce, mobile gaming, and digitalization.
In this inflationary environment, we have consistently made adjustments to focus on assets that we consider are capable of maintaining pricing power or are more attractively valued. These characteristics should safeguard against the negative impacts of inflation on equity investors, specifically, the shrinking of profit margins and valuation multiples.
OUTLOOK
Whether or not the Fed can lower rates back to normal levels while stabilizing the economy is likely to be the final post-pandemic test for the central bank. In its latest dot plot of forecasts, the Fed anticipates cutting rates by another 50 basis points by the end of the year, to a range of 4.25%-4.50%. However, futures markets are pricing in nearly 75 basis points of additional cuts. The Fed also forecasts a more benign inflation backdrop, with consumer price inflation falling back to target in 2026, and it forecasts economic growth stabilizing at a 2% rate over the next several years.
Lower interest rates are generally considered positive for stocks because they encourage economic growth, reduce corporate debt burdens, and, importantly, reduce the discount rate for financial assets. The fact that the Fed looks prepared to continue delivering aggressive rate cuts into this economy could be a bullish set-up for equities.
Monetary policy normalization, as long as it is accompanied by an orderly slowing of the U.S. economy, is positive for emerging markets. This is particularly true for those economies with strong economic fundamentals, such as in Southeast Asia. Lower rates can reduce the cost of dollar financing and also make assets from other countries more attractive comparatively.
A long-lasting rally in China may not be sustained by easy monetary policy alone; there needs to be more details on the fiscal stimulus. Though the government has pledged more fiscal spending, it has yet to put numbers on it or offer much in the way of specifics. The concern is not just whether the measures will be enough to stimulate the faltering real economy, which may miss its official growth target of 5% this year, but if they will be enough to drive a lasting recovery and stave off the threat of deflation.
There are numerous concerns remaining around the health of China’s economic fundamentals. Official data shows that annual inflation is running well under 1%, households are hoarding savings and reluctant to spend, and trade tariffs are likely to stay or increase regardless of who wins the U.S. presidential election. More recently, manufacturers reported a fifth-straight month of contraction, while the purchasing managers’ index showed exports weakening and continued caution on hiring. The services sector has also recently gone into contraction, and there has been slowing growth in retail sales.
China stopped short of announcing a bazooka stimulus, such as when it unleashed a RMB¥4 trillion package during the Great Financial Crisis that sparked a boom and reverberated through the global economy. Given the much larger size of the modern day Chinese economy, it may take even more to reflate the economy. And the money should be aimed more at households, which have deteriorated in confidence, rather than large-scale infrastructure and industrial projects as in the past. Otherwise, household spending is more likely to remain constrained by the negative wealth effect from depressed housing and stock market prices. Perhaps the government is now seeing the stock market as a signal of a healthy economy and an important tool to manage social stability.
Over the last three-plus years, we have reduced Greater China* weightings on a net basis, inclusive of holdings in Mainland China and Hong Kong. In international portfolios, roughly 17% of assets are invested in Greater China holdings, which is overweight relative to the benchmark. In global portfolios, roughly 10% 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.
Our investment strategies focus on companies that benefit from long-term secular trends and have strong competitive advantages and market positions. Some of the most promising growth opportunities over long investment horizons may not be heavily influenced by current global events or specific regional circumstances. These opportunities include our investments in and around cloud computing, software-as-a-service, digital transformation, artificial intelligence, semiconductor technology, e-commerce, payment systems, industrial automation, electric vehicles, and innovative biologic and biosimilar therapies. Additionally, there are other exciting growth prospects related to the rapid expansion of consumer markets, particularly in emerging economies and notably in Asia, which are driving the demand for various consumer products and financial services.
The ongoing trend of economic slowdown should not undermine the enduring strength of these investment themes, or the business models and market positions of the companies in our portfolios. Additionally, we have deliberately chosen companies with healthy profit margins, robust balance sheets, and consistent cash flow generation. Essentially, we have selected portfolio companies that we consider to be financially stable, even in challenging times. As a result, our portfolios have the capacity to surpass market growth rates in the long run.
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