Q4 2022 Commentary and Market OutlookInternational and Global Growth Funds
An era of low inflation and low interest rates has ended. Inflation is running at its fastest pace in decades in many places, and a range of central banks are pushing rates quickly higher. The war in Ukraine has only intensified the picture. It has been the geopolitical wild card, and it has further disrupted critical energy and food supplies. More likely, interest rates will probably need to stay high enough for some time to meaningfully weigh on the economy.
For these reasons, 2022 was an extremely difficult market environment, and there looks to be more choppiness ahead. While portfolios underperformed their respective equity benchmarks in the past year due to a broad rotation to value stocks, they were not far behind. But more striking, portfolios significantly outperformed the growth styles of their respective equity benchmarks, due to a consistent application of our investment process that not only considers growth, but also returns on capital and valuation.
Our investment philosophy emphasizes businesses that benefit from secular trends and possess strong competitive advantages and market positions.
Additionally, portfolio companies are purposefully selected that earn attractive profit margins, carry strong balance sheets, and generate cash on a consistent basis.
We expect these attributes to hold tack even if the macro backdrop is deteriorating. For these reasons, portfolios can outgrow market growth rates over the long-term.
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.