Q1 2023 Chautauqua International & Global Growth Funds Commentary and Market Outlook
Overall, equity markets displayed incredible resilience during the first quarter of 2023. Market participants started the year decidedly optimistic. Inflation, while still very high, appeared to be decelerating. Furthermore, energy prices, which soared last year after the invasion of Ukraine, were falling in part due to a mild winter in Europe and also due to Europe’s successful pivot away from Russian fuel sources. In China, the recent removal of virtually all of the country’s strict Covid restrictions and the government’s renewed focus on economic growth raised the prospect for a strong recovery.
However, there was a change in tone as a steady flow of economic data showed that the U.S. economy was running hot. And markets then turned jittery. Stocks slid in February after the strong start in January. Data for inflation, the labor market, and gross domestic product (GDP) growth all suggested that the U.S. economy retained vigor, even after a year of significant policy adjustments aimed at cooling the economy down.
While inflation had softened a little, there was little sign of disinflation in services categories, outside of housing. The Fed had been increasingly looking at that pocket as a signal of how strong underlying price pressures remained in the economy. Despite high-profile layoffs at large tech companies, employers in the U.S. broadly continued to hire at a rapid clip.
In a Congressional testimony, Fed Chairman Jerome Powell made it clear that the Fed would be prepared to react to those signs of economic strength by potentially raising interest rates higher and faster than previously envisioned. The possibility of more rate hikes rekindled the fear that the economy would be pushed into a downturn. It was a complete turnaround from the initially optimistic view that had taken hold in financial markets at the start of the year.
The biggest shock of the quarter came in March. Silicon Valley Bank collapsed, followed by Signature Bank just days later. The biggest U.S. banks scrambled to shore up First Republic Bank to stop the panic from taking down more lenders. Elsewhere, Credit Suisse came to the brink of failure, which culminated in a hurried takeover by UBS. The Fed, Treasury, and Federal Deposit Insurance Corporation (FDIC) unveiled a sweeping intervention so that depositors at the failed U.S. banks would be made whole.
The tumult in the banking sector marked another turning point in the quarter. In March, the Fed raised interest rates by 25 basis points to a range of 4.75-5.0%, as it tried to balance two conflicting problems. On one hand was the risk that inflation could remain elevated and potentially become entrenched, and on the other hand was the threat that turmoil in the banking system could slow the economy drastically. Chairman Powell underscored the uncertainty with whether rates would have much further to rise, which was a change in message because turmoil in the banking sector could potentially weigh on lending and tighten credit conditions. Market participants have grown to expect the Fed to come to the rescue as soon as financial markets sputter.
Therefore, despite the significant uncertainty, markets proved to be quite buoyant during the quarter, and this includes strong double-digit stock appreciation in both the information technology sector and growth stocks more broadly.
Global economic growth is anticipated to slow this year as central banks continue to raise interest rates to tame inflation, and the war in Ukraine continues to sow uncertainty. According to forecasts from the International Monetary Fund (IMF), the global economy is poised to slow in 2023 to 2.9% and rebound slightly in 2024 to 3.1%. To offer another perspective, forecasts from the Organization for Economic Cooperation and Development (OECD) suggest global economic growth in 2023 of 2.6% and a slight rebound in 2024 of 2.9%.
While these forecasted growth rates remain below-trend, the outlook is actually less gloomy than what was previously contemplated at the end of last year. There are several reasons for the modest uptick. China abruptly reversed its zero-Covid policy and embarked on a rapid reopening. Furthermore, the energy crisis in Europe was less severe than initially feared, and the inflation of energy and food prices has decelerated. Additionally, the recent weakening of the U.S. dollar has provided relief to emerging economies. Overall, fewer countries are facing imminent recession threats in 2023, and it also looks like a global recession may avoided.
That said, the global economy still faces considerable risks, which remain tilted to the downside. The impact of monetary policy adjustments is still difficult to gauge. Monetary policy is a blunt tool and often acts with a lag.
Monetary policy needs to remain restrictive until there are clear signs that underlying inflation are lowered on a more durable basis, and therefore, policy rates at the major central banks are likely to remain at restrictive levels well into 2024.
Uncertainty about the course of the war in Ukraine and its broader consequences remains another key concern. Pressures in global energy markets could also reappear, leading to renewed price spikes and higher inflation.
In the U.S., the most recent forecasts by the Fed call for economic growth to be anemic at 0.4% growth and inflation to remain above-target at 3.3%. Meanwhile, in Europe, the most recent forecasts by the European Central Bank (ECB) call for economic growth of 1.0%, owing to the fading of uncertainty regarding energy prices and with that improved business and consumer confidence. The sharp adjustment in energy markets has led to a significant decline in price pressures, and inflation is now likely to decelerate more rapidly with estimated inflation this year of 5.3% and next year of 2.9%.
With muted growth rates in much of the developed world, the bright spots are in the emerging economies, particularly China and India.
Combined, the two countries are thought to account for about one half of global growth this year, according to the IMF. In China, the government has set an economic growth target of 5% this year, which is a relatively conservative goal compared with the rapid pace that was common before the pandemic. The emphasis on economic stability comes after three years of zero-Covid policies. Survey data in China has already suggested a strong rebound in business activity in the first few months of the year, as well as a rebound in domestic consumption. 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.
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.