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7/8/2024 Baird Equity Asset Management Commentary

Q2 2024 International and Global Growth Fund Commentary

Market Recap

Global equity markets continued to appreciate during the second quarter, but artificial intelligence (AI) has been the real fuel. It has supercharged the performance of U.S. stocks in particular because the biggest, marquee AI plays are heavily represented in the U.S. index. As a result, U.S. stock market performance and earnings growth have been quite narrow recently, and U.S. stocks outside of the AI orbit have lagged. Stocks in the emerging markets and international developed markets also appreciated but have a fraction of the AI theme represented in their indexes.

On the economic side, the soft-landing scenario has gained more traction. Global inflation has continued to moderate, while economic expansion has remained relatively healthy. However, central banks remain concerned about some lingering inflation pressures, and the extent of the decline in global interest rates has also moderated.

Our investment strategies focus on the long-term, allowing us to navigate short-term economic fluctuations. We prioritize businesses that align with secular trends and have strong competitive advantages and market positions. Our portfolio companies are chosen for their high profit margins, strong balance sheets, and consistent cash generation. We believe these qualities will endure even in challenging macroeconomic conditions. Our concentrated, conviction-weighted portfolios are designed to outperform market growth rates over an investment cycle. Additionally, our portfolios are diversified across a wide range of secular growth themes. For instance, within the top ten holdings of our international strategy, in addition to holdings in AI, themes include obesity, industrial automation, financial services in emerging markets, e-commerce, mobile gaming, and digitalization.

In this inflationary environment, we have consistently made adjustments to focus on assets that we consider are capable of maintaining pricing power or are more attractively valued. These characteristics should safeguard against the negative impacts of inflation on equity investors, specifically, the shrinking of profit margins and valuation multiples.

Outlook

Global economic growth looks to be steadying, following several years of negative shocks and despite the current environment of elevated interest rates and heightened geopolitical tensions. According to the World Bank, global growth is projected to hold steady at 2.6% in 2024 before edging up to an average of 2.7% in 2025-2026. Growth this year is estimated to be faster than previously thought, due mainly to the continued solid performance of the U.S. economy. Additionally, the World Bank projects growth in developed economies to remain steady at 1.5% in 2024 before rising to 1.7% in 2025, and it projects growth in emerging economies to be 4% on average over 2024-2025.

This outlook is muted in comparison to growth rates during the decade prior to the pandemic, which averaged 3.1%, despite the anticipated moderation of various cyclical headwinds, such as supply chain shocks and high commodity prices. Slower growth is true for both developed and emerging economies, and it has weakened notably in countries that have experienced high rates of inflation.

Global trade growth is recovering, supported by a pickup in goods trade. Services growth is less of a tailwind this year, given that tourism has nearly recovered to pre-pandemic levels. However, the trade outlook remains tepid, partly reflecting a surge in trade-restrictive measures and heightened trade policy uncertainty.

There are some notable bright spots in the global economy. In particular, the U.S. economy has shown impressive resilience amidst the most drastic monetary tightening in four decades, and it is one of the main reasons that the global economy could have some upside potential.

India and Indonesia are two additional examples of global bright spots, and they continue to be relative overweights in our portfolios. India’s economy has been buoyed by strong domestic demand, growing investment, and strong services activity. The World Bank projects it to grow at an average rate of 6.7% for the next three years, making India the fastest growing large economy in the world. Indonesia is projected to benefit from a growing middle class and generally prudent economic policies, and the World Bank projects it to grow at an average rate of 5.1% for the next two years.

On the other hand, growth in China is predicted to slow this year and ease further in 2025 and 2026, with cyclical headwinds weighing on growth in the near term, along with a continuing structural slowdown.

Inflation continues to decline globally, making progress toward central bank targets, but at a slower pace than previously estimated. Core inflation has remained stubbornly high in many countries, propped up by fast growth of services prices. Recently, the pace of disinflation has slowed, reflecting a slowdown in the rate of decline of core inflation and a partial rebound in energy prices. As a result, many central banks are remaining cautious in lowering interest rates. The World Bank forecasts that global inflation will moderate to 3.5% in 2024, 2.9% in 2025, and 2.8% in 2026.

Major central banks are projected to gradually lower interest rates over the remainder of the year, but the level of real interest rates may remain a headwind to economic activity and should help reduce inflation further. Central banks continue to emphasize that the pace of easing will be cautious, reflecting persistent inflationary pressures, and even robust economic activity in the case of the U.S. Over the next couple of years, interest rates are likely to remain high, especially as compared to those of the recent decades. If further delays in the disinflation process emerge, policy rate cuts may be postponed.

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 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 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.

Our investment strategies focus on companies that benefit from long-term secular trends and have strong competitive advantages and market positions. Some of the most promising growth opportunities over long investment horizons may not be heavily influenced by current global events or specific regional circumstances. These opportunities include our investments in and around cloud computing, software-as-a-service, digital transformation, artificial intelligence, semiconductor technology, e-commerce, payment systems, industrial automation, electric vehicles, and innovative biologic and biosimilar therapies. Additionally, there are other exciting growth prospects related to the rapid expansion of consumer markets, particularly in emerging economies and notably in Asia, which are driving the demand for various consumer products and financial services.

The ongoing trend of economic slowdown should not undermine the enduring strength of these investment themes, or the business models and market positions of the companies in our portfolios. Additionally, we have deliberately chosen companies with healthy profit margins, robust balance sheets, and consistent cash flow generation. Essentially, we have selected portfolio companies that we consider to be financially stable, even in challenging times. As a result, our portfolios have the capacity to surpass market growth rates in the long run.

We have made significant efforts to protect against the most damaging risks associated with inflation on equity investments—margin pressure and multiple compression. Our focus has been on selecting companies with pricing power due to the critical nature or value-added aspect of their products and services. These companies are capable of adjusting prices in times of inflation, safeguarding their profit margins. Additionally, we have adjusted our portfolios to include companies with more appealing valuations, considering the increased market discount rates.

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The above commentary does not provide a complete analysis of every material fact regarding any market, industry, security or portfolio.