Q3 2023 Chautauqua International & Global Growth Funds Commentary
Equity markets started off strong in the third quarter, reaching year-to-date highs in July. However, an amalgamation of factors, with perhaps the most important being the growing acceptance of higher rates for longer, led equity markets lower in August and September. International developed, U.S., and emerging equity markets all finished negative in the quarter, and in that order from worst to best performing. Additionally, growth style stocks significantly underperformed value style stocks in international developed and emerging markets, but the same effect was less pronounced in the U.S. market.
The Baird Chautauqua Funds underperformed their respective indexes during the quarter, but they were more similar in performance to the respective growth style of their indexes. Not only was growth style a headwind overall, but there were also several holdings that were idiosyncratic detractors to performance. Additionally, there was no exposure to holdings in the energy sector, which was the best performing sector during the quarter.
Our investment philosophy emphasizes businesses that benefit from secular trends and possess strong competitive advantages and market positions. Additionally, we purposefully select portfolio companies 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 made 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.
Thank you for entrusting us to invest your precious capital and to navigate this increasingly uncertain market environment.
In the third quarter of 2023, the Baird Chautauqua International Growth Fund Net Investor Class returned -8.69%, underperforming the MSCI ACWI ex-U.S. Index® ND, which returned -3.77%. The Baird Chautauqua Global Growth Fund Net Investor Class returned -5.73% during the quarter, underperforming the MSCI ACWI Index® ND, which returned -3.40%.*
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.