Q2 2023 Chautauqua International & Global Growth Funds Commentary and Market Outlook
The global economy remains in a fragile state. Headline inflation is above-target in almost all major economies, and core inflation is sticky and elevated. As inflation pressures persist, economic growth has been weighed down by the lagged and ongoing effects of monetary tightening. From a regional perspective, the brighter spots in the global economy are the fast-growing major Asian economies including China, India, and Southeast Asia. On the other hand, growth in the major developed economies such as the U.S., Europe, and Japan are poised to be much more lukewarm.
Something else to note is that growth style stocks underperformed value style stocks in both international developed and emerging markets. However, this was not the case in the U.S. market, where growth style stocks significantly outperformed value style stocks. The market leadership in the U.S. was concentrated in a small number of mostly mega-cap tech stocks, and it is for this reason that the U.S. market also significantly outperformed international markets in the quarter.
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 believe these attributes hold tack even if the macro backdrop is deteriorating. For these reasons, portfolios have the ability to outgrow market growth rates over the long-term.
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.
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.