Marc Foran, CIO

 

Q4 2024

During Q4, both equity and credit markets were significantly influenced by US elections, with the Republicans winning the presidency and majority control of the House and the Senate. The markets reacted decisively to the so-called red sweep, rewarding stocks and sectors expected to benefit from Trump’s agenda (like US big tech, banks and oil) and punishing those that are not (such as clean energy, food companies and medical technology).

Macro Environment

We believe the Trump administration’s proposed and implemented policies will have mixed implications for the US economy overall and have negative environmental and social impacts. Trump says he’s focused on i) promoting economic growth through lower taxes, deregulation of industries such as banking, taking an isolationist “America first” approach to foreign policy, removing barriers to fossil fuel production and use, supporting the advancement of technologies and products (such as AI), and reshoring manufacturing businesses (for example, autos and semiconductors); ii) addressing the growing national deficit through reduced government spending (for example, reducing the number of federal employees, eliminating EV subsidies and freezing government-funded health research), implementing tariffs to raise the government’s revenue base, and reducing financial contributions to global initiatives (for example, pulling out of WHO); iii) promoting supposed Republican values by eliminating federal DEI programs, ending birthright citizenship and deporting undocumented migrants. While promoting growth and reducing the deficit should be positive events, the means by which Trump intends to achieve these goals seem to be conflicting. Actions such as tariffs could backfire and trigger renewed inflationary pressures, the fear of which has been reflected in rising long-term US Treasury yields despite the Federal Reserve’s 100bps in interest rate cuts. We believe this is why US and global consumer confidence and expectations have generally decreased since the election, which ultimately could lead to reduced spending.

The election result led to a profound sector rotation in equity markets with the Magnificent 7, in particular Tesla, posting significant gains to lead global markets higher. Conversely, the worst performing sector was clean energy, down over 20% post-election. Generally speaking, companies driving positive environmental outcomes and valuing DEI initiatives experienced declines while companies that would profit from a renewed US fossil fuel renaissance or deregulations fared well. We view this market reaction as being incredibly short-sighted for several reasons: i) During Trump’s first presidential term, clean energy deployment actually accelerated. Regardless of what government policies may be, climate change has and will continue to have a profound impact on the world and thus attract investment from long-term minded investors. For example, the recent wildfires in the Los Angeles area were intensified due to excessive dryness of which at least 25% was estimated to be due to the effects of climate change; ii) Genuine DEI initiatives help companies compete for high-quality workers. Furthermore, research from several institutions validates that companies with strong DEI create superior value relative to peers over the long term. For example, a 2019 McKinsey study showed that gender-diverse companies were 15% more likely to outperform their peers while ethnically diverse companies were 35% more likely to do so. However, we acknowledge that the anti-DEI movement perpetuated by Trump’s administration, including potential legal ramifications for companies maintaining DEI policies, could result in certain companies introducing biased labour practices regardless of the long-term negative consequences to both society and profits.

Despite the multitude of compelling financial reasons for businesses to continue delivering positive environmental and social impact, we believe the Trump administration’s policies will significantly affect which companies and sectors are best positioned to achieve impact and financial goals for investors. For environmental impact, we view climate initiatives and solutions that require government subsidies or regulation to be commercially viable as likely to face challenges under the Trump administration (for example, EV companies that have been bolstered by government programs and high-cost alternative energy solutions such as hydrogen power). In terms of winners, we favour service companies that support the overall growth of climate initiatives (for example, clean energy financing) and companies that provide climate solutions that deliver an economic benefit (such as helping building owners reduce energy costs). In terms of social impact, we believe that critical sectors which historically have utilized lower-skilled immigrant labour (such as agriculture or medical care assistance) will require alternative solutions (for instance, automation and staff management or optimization systems). We also think that companies offering products and services that support equitable economic participation (such as digital marketplaces) will benefit, particularly if the anti-DEI movement at federal agencies and certain US companies results in a greater number of discouraged marginalized workers.

Public Markets

Public equity markets were generally strong during Q4 with the MSCI ACWI Index up 5.6%, led by mega cap tech names such as the Magnificent 7 (22% of the index weight) which collectively increased 18%, driving the bulk of returns. Canadian equities also posted strong returns with the TSX up 3.8% in the quarter, while the MSCI Europe Index declined 3.8%. In Asia, after a strong Q3, Chinese stocks underperformed with the MSCI China Index down 1.6% which contrasted with Japanese equity performance up 2% for the Nikkei 225 index.

In our view, US equity markets continue to trade at rich valuations with a price-to-earnings ratio of 27.3x, which is well above the 20-year historical average of 17.2x, and an earnings yield of just 3.6% while the US risk-free rate of return is 4.5% (based on US 10-year treasury yields). We would highlight that the excessive valuation is predominantly driven by mega cap technology stocks and that, excluding these companies, US markets trade at more acceptable levels. As such we believe that investors should remain underweight or outright avoid frothy areas of the market as history suggests that the long-term earnings growth required to justify these excessive valuations seems unlikely to materialize. European equities appear reasonable by comparison at 14.5x price-to-earnings, though lacklustre growth in the region could hinder performance in 2025. Therefore, we prefer EUR region service-oriented equities that derive their sales from diversified global markets, and ideally with limited exposure to import-export markets in the US.

Global bonds had a difficult quarter due to fears of inflation reigniting, particularly given the impact of potential US tariffs. As a result, investors began to price in fewer interest rate cuts for 2025 in several regions as central banks were viewed as preferring a wait-and-see approach before reducing rates further. The Bloomberg Corporate Investment Grade Bond Index declined 4% during Q4 in USD terms with US bonds posting a decline of 3%. Overseas European corporate bonds in USD terms were down 5.1% and Asia was down 2% but US Global green bonds fared even worse with the Bloomberg MSCI Global Green Bond index down 6.3% in USD terms. Translating these returns into Canadian dollars would have yielded a modestly positive quarter due to the US dollar appreciating a stunning 6.4% relative to the CAD and 7.5% relative to the EUR. Going forward, bonds are likely to remain relatively volatile until there is greater certainty regarding the path and impact of the US tariff policy. Our current view is that the Trump administration is unlikely to implement inflationary policies over the long term (but is likely to do so as a negotiating tactic over the short term) given that inflation was one of the key voter concerns that resulted in Trump’s election and the “red wave”. However, we acknowledge that, in the short term, risk and uncertainty could remain elevated. 

Private Investments

Deal volume activity for US VC continued to be sluggish in Q4 at down 12%, while the total dollar value of VC investment increased by 57%, the highest dollar amount since 2022 due to sizable AI deals, which constituted 60% of total investment activity in the quarter and 44% for the year. If we exclude AI deals, the balance of the VC market saw total investment increase by 17% for the year. Meanwhile fundraising continued to be sluggish as well with Q4 experiencing the lowest number of closings since Q2 2020. In PE, both deal activity and value declined in Q4 from the prior quarter, though they showed an improvement over Q4 2023. Both VC and PE exits continue to be a challenge, as average holding times increased to 6.1 years, which is considerably higher than the 5.6-year average holding times achieved in 2022. However, exits for 2025 could rebound given elevated valuations in public markets (particularly for the technology sector) and potential deregulation encouraging acquisition activity, though uncertainty regarding tariff policy may limit activity to specific sectors. In Canada, deal value and volume for VC and PE in 2024 mirrored the trends in the US, though fundraising activity was notably weaker with PE fundraising down a remarkable 94% from 2023, reaching levels last seen in 2018.

As we have written in prior quarters, impact private credit opportunities that offer below-market rate of returns continue to face fundraising challenges. However in Canada, as interest rates continue to decline the spread between impact and non-impact opportunities has narrowed. On the other hand, investors may be cautious about locking into long-duration credit investments until there is more certainty regarding tariffs and their influence on inflation trends. At the same time, yields on low-risk assets (such as impact GICs) have declined meaningfully from their peaks and are likely to continue doing so unless inflation rebounds, causing the BOC to raise rates. As stated previously, we do not believe that the US administration is interested in long-term tariffs or other policies that promote inflation, which ultimately should dampen the severity of any retaliatory tariffs implemented by Canada. Consequently, the BOC could continue to cut interest rates once trade disputes are resolved.

 

Outlook

Our current outlook on the global economy remains consistent with views of prior quarters – we are now seeing increasing signs that an economic slowdown has occurred with the notable exception of the United States, which has remained surprisingly resilient despite worrying consumer trends. We remain cautious about the EUR region where Germany, the main economic engine of the region, posted a second consecutive year of declining GDP growth, down 0.2% in 2024, while the UK saw growth stagnate. In Canada, GDP growth was just 0.3% in Q3, a slowdown from the 0.5% in Q2, with GDP per capita down for the sixth consecutive quarter on the back of a notable sluggish business environment. China achieved its target growth rate of 5% due to industrial exports and despite lacklustre domestic demand due to declining wages, real estate, and rising unemployment. While US tariffs could be quite devastating to the growth prospects of many countries, it is China in particular that could face tremendous pressure because of its reliance on exports to the US. Given these factors we are maintaining positions in i) companies that have diversified global businesses, ii) companies that have limited reliance on exporting to or from the US, iii) businesses that are more defensive in nature (that is, not tied to economic cycles), and iv) companies with compelling valuations.

 

Based on our outlook we recommend the following for each asset class:

• Public equities – We remain cautious on areas of the market where valuations are lofty and fundamentals are cyclical. Within clean energy and energy efficiency, we prefer companies with commercially viable solutions and service companies that support the overall growth of climate initiatives. In terms of social impact, we favour companies that address infrastructure deficiencies, labour shortages, and that enhance the productivity of critical industries (for example, agriculture and health care). We also favour companies that profitably empower marginalized individuals and communities (for example, digital marketplaces). We also continue to favour defensive sectors, such as utility companies providing essential services to communities as well as non-cyclical high dividend paying companies.
• Real Assets – We continue to favour assets associated with natural capital, such as farmland, given the demand for agricultural goods tends to be stable even during poor economic times. We continue to like (non-office) REITs in non-cyclical sectors, such as health care and to a lesser extent communications. We also believe that investments related to forest management or restoration and clean water scarcity are attractive for long-term investors given the need to mitigate the impacts of climate change.
• Alternative Assets – We continue to favour market-agnostic investments that have low-correlations to other asset classes, thereby reducing portfolio volatility. As an example, impact litigation funds which provide marginalized individuals and communities access to the justice system tend to produce attractive impacts and returns regardless of prevailing economic conditions.
• Fixed Income / Bonds – Bond markets are likely to remain volatile given the high degree of uncertainty regarding Trump’s policy effects on inflation and ultimately interest rates. We recommend a nimble approach seeking to add long-duration investment grade corporate, green and social bonds to portfolios during market pull backs.
• PE/VC – We believe that investors under-allocated to private equity and venture capital will find the 2025 vintage of new funds entering the market to be particularly well positioned to deploy capital towards impact opportunities with less competition for deals and potentially lower valuations compared to previous years. We also believe that the poor exit environment for VC/PE funds provides an opportunity for investors to acquire LP units on secondary markets and often at material discounts.
• Private Debt – For impact investors willing to accept below-market rates of return, we recommend longer duration impact credits with fixed coupon payments, particularly in Canada, where spreads to traditional debt markets have narrowed. For investors seeking market rates of return, we see a limited number of deals in Canada but have identified several impact opportunities out of the US and more globally.

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