Q4 2023 Chautauqua International & Global Growth Funds Commentary

Market Recap

During the fourth quarter, the risk appetite of equity markets rebounded substantially, as financial conditions loosened in November and December and reversed the tightening that occurred in October. This rally in equity markets to close out the year was extremely broad, buoying both U.S. and international stocks, as well as growth and value stocks. The main driver of this rally was a reassessment of U.S. monetary policy, which placed a higher probability of interest rate cuts in 2024, and as early as the first half of the year, following recent U.S. inflation data that came in much softer than predicted.

On the economic front, despite signs of resilience in 2023, the lagged and ongoing effects of elevated real interest rates are set to keep global activity weak, thereby moderating inflationary forces further in the coming months. Additionally, the divergence across economies is anticipated to persist, and weakness in manufacturing and trade is beginning to spread into services. In other words, the global economy is beginning to normalize following the substantial dislocations in the pandemic and post-pandemic periods.

For better or worse, managed portfolios may become dislocated from benchmarks on a short-term basis too. And this is why we invest with a long-term time horizon, that can look through shorter term economic perturbations. Furthermore, our investment philosophy emphasizes businesses that benefit from secular trends and possess strong competitive advantages and market positions. 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 soft or deteriorating. And we deploy this strategy in concentrated and conviction-weighted portfolios. For these reasons, portfolios have the ability to outgrow market growth rates over an investment cycle.

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.

Outlook

Global growth is set to remain modest, with the impacts of tight monetary policies and soft business and consumer confidence all being felt. Additionally, weakness in manufacturing and trade is beginning to spread into services. A growing divergence across economies is presumed to persist in the near term, with growth in the emerging economies generally holding up better than in the developed economies, and growth in Europe being relatively subdued compared to that in North America and the major emerging Asian economies.

According to the Organization for Economic Cooperation and Development (OECD), global GDP growth of 2.9% in 2023 will be followed by a mild slowdown to 2.7% in 2024. Asia is projected to continue to account for the bulk of global growth in 2024, which will continue to be below the pre-pandemic rate of global growth. GDP growth in the U.S. is projected at 2.4% in 2023 and will slow to 1.5% in 2024. In the euro zone, GDP growth is projected at 0.6% in 2023 before rising to 0.9% in 2024. China is projected to grow at 5.2% in 2023 before slowing to 4.7% in 2024, on the back of ongoing stresses in the real estate sector, weak manufacturing activity, and continued high household savings rates. 

Inflation has declined steadily from the peak in mid-2022. Headline inflation has fallen in almost all economies. Core inflation has also fallen but remains high. Global demand is easing, supply disruptions are fading, and commodity prices are moderating, while monetary policies remain restrictive. Inflation is projected to continue easing gradually, given moderating cost pressures and the effects of prior rate hikes continuing to work their way through economies. In the absence of further large shocks to energy and food prices, inflation is projected to be at or near target for most major central banks by 2025, or even by 2024 in some cases.

Policy interest rates appear to be at or close to peak for most economies. Eventually, gradually easing inflation should pave the way for interest rate cuts as the jobs of central banks are completed. But monetary policies will remain restrictive until there are signs that underlying inflation pressures have durably abated. The implication is that even if central banks start cutting interest rates, they will keep them high enough to maintain downward pressure on prices.

Yet there are at least two key reasons to be cautious about the rate of disinflation, including pressures that have kept core interest rates high and an inflationary shock stemming from geopolitical tensions. The decline in global core inflation has been smaller than that of headline inflation over the past year. Core inflation must continue to decline to convince central banks that inflationary pressures have been brought firmly under control. This will likely require further moderation in demand, particularly for services. Geopolitical tensions have also historically been an inflationary force. The latest conflict in the Middle East, on the heels of the invasion of Ukraine, could be another driver of inflation by destabilizing energy markets. However, the impact has been extremely limited so far. 

There is optimism in the U.S., as it is looking more likely that its economy will achieve the coveted soft landing, which was once thought of as highly improbable. Inflation is continuing to ease, the Fed is likely done raising rates, and economic growth and the labor market have outperformed estimates. The Fed sent equity markets rallying after it revealed forecasts for at least three rate cuts in 2024 and four rate cuts in 2025. The futures market is even more convinced of lower rates. It is currently pricing six rate cuts in 2024, with the first to occur in March. In Europe, the picture is somewhat different. Both the ECB and BOE pushed back against market predictions for interest rate cuts, drawing attention to persistence in price and wage pressures such as services inflation and wage growth. Monetary policy will remain sufficiently restrictive until it can be assured that inflation returns to the target level.

Among the large emerging 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. The government has opted for a broad but piecemeal approach to stimulus, characterized by modest cuts to interest rates, extended tax breaks for companies, and lowered mortgage costs for consumers. Recently, the government has signaled that more help is coming by way of new fiscal stimulus and supportive central bank policies, but it has also telegraphed that stimulus will continue to be measured rather than aggressive. Economic growth in China is seen as slowing in 2024 to 4.7%. In contrast, GDP growth in the other major Asian emerging economies is projected to remain relatively steady in 2023 and 2024. It is projected to be 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 17% of assets are invested in Greater China holdings, which is modestly overweight relative to the benchmark. In Global portfolios, roughly 11% 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 healthcare) 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 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 will 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.

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