Market Commentary 

By Marc Foran, CIO

Q2 2024

Markets were generally higher in Q2, with both global equities and bonds posting gains, albeit at a more modest pace than in Q1. As the quarter unfolded, the US economy began to show signs of weakening with GDP growth of just 1.4% in the most recent Q1 2024 data versus a robust 3.4% in Q4 of last year. Meanwhile Canadian GDP growth came in at 1.7% growth in Q1 which was notably below forecasts. Labour markets also started to show cracks, with US unemployment breaking through the 4% level for the first time since November 2021, Canada’s unemployment rising to 6.4% (the highest since October 2021), and US workers hourly earnings increasing at the slowest pace since May 2021. The subdued economic data coincided with indicators showing a gradual retrenchment in inflation, which markets reacted favourably too by pricing in two or three rate cuts by the FED during 2024 which is a slight increase from last quarters expectations. It was this shifting expectation of interest rates alongside slowing though still positive GDP growth that drove generally positive investor sentiment across global public markets.

Macro Environment

Several signs emerged in Q2 that an economic slowdown has already begun, led by pronounced declines in consumer spending – as evidenced by a large number of companies reporting that customers were trading down purchases towards cheaper goods and reducing their discretionary spend on areas such as restaurants and entertainment. We expect these trends to continue, particularly given i) initial signs of weakness in the labour market and ii) the fact excess savings post-pandemic are now largely depleted. We are also seeing signs of a slowdown in business spending, as evidenced by recent data such as the S&P Global Market Intelligence capital spending survey that predicts growth slowing to 3.9% in 2024, a steep decline from an expectation of 6.7% earlier in the year. A recent survey of capital expenditure intentions by US manufacturers revealed that business leaders expected a miniscule 1% increase in capital outlays for 2024, which is a significant decline from the 12% increase expected during the December 2023 survey. Also, US business bankruptcy filings increased by over 40% in March while personal bankruptcy filings rose 15%. On the positive side, the decline in economic activity is translating into reduced inflation for consumers – Canada’s June CPI increased just 2.7% from the prior year and US CPI increased 3%, the lowest level since June 2023. While we are encouraged that inflation is coming under control and thus likely to result in global central banks and the US Federal Reserve reducing interest rates by 50-75bps by end of year (both Canada and the ECB have already cut by 25bps), we are concerned that officials remain overly cautious in their policy stance and thus intend to reduce interest rates only gradually over the next few years. As such, we think the probability of a sharper economic downturn taking hold has increased significantly, due to overly restrictive interest rates remaining in place for too long which is being further amplified by shifting global political elections and regimes that tend to favour more protectionist policies, such as increasing tariffs, which are by nature inflationary.

Last quarter we wrote that commercial real estate may be the “canary in the coal mine” for the global banking and financial system and we have seen further data points to maintain that view. US commercial properties have now fallen 25% from last year and at present there is $1T in maturing debt coming due over the next 12 months during a time when banks are tightening lending standards. In Europe, there is fear that balance sheets are materially overstating the value of commercial real estate assets given that valuation adjustments are made less frequently in regions such as Germany. Ultimately, there is a risk that distressed property sales could begin to accelerate, which in turn could drive valuations even lower, creating a vicious liquidation cycle. Based on a recent analysis by Oaktree, the number of US banks at risk would exceed levels seen in the 2008 financial crisis levels if commercial real estate values fell by only 20 per cent from their peak. As such, more regional bank failures are anticipated which could roil markets and/or lead to lost confidence in the banking system.

Public Markets

Following an impressive rally in Q1 on the back of strong economic data and enthusiasm for AI, global equity markets continued their upward trajectory, though more modestly so, during the second quarter led by large-cap tech giants. In fact, more than three quarters of the MSCI ACWI Index’s 3.9% gain this quarter was due to Nvidia, Amazon, Google, Microsoft and Apple which represent 16.3% of the Index weight. On an equal weight basis (i.e. if all of MSCI ACWI’s 2700+ constituents had the same weight) the index would have been down 0.4% with most sectors other than technology underperforming. We believe that the equal weight measure of the index better reflects the markets’ reaction to economic data; hence we view the decline as being consistent with weakening macro data. Of note this quarter is the rich valuation that the ACWI index is trading at with a price-to-earnings ratio of over 21x (which equates to an earnings yield of 4.7% – a minuscule ~50bps equity risk premium over US 10-year treasuries). We view the combination of softening economic data and a rich valuation for public equities (mostly US large cap) as laying the foundation for a pullback in equities as further signs of economic weakness materialize.

In terms of fixed income, global investment grade (IG) bonds were generally positive in Q2, with the US Bloomberg Corporate Bond Index up 1.5%, and its European and Asia Pacific equivalent indices up 1.1% and 0.8% respectively. Global IG green bonds increased by ~1.3% this quarter, in line with traditional bond markets. This performance was driven by the relatively stable environment for high-quality non-cyclical corporate credit combined with increased confidence of gradual global central bank interest rate declines. Given our macro view, we view long-duration IG sustainable corporate, green, social, government and sovereign credits as offering a more favourable risk-adjusted return than public equities and recommend clients increase portfolio allocations to the asset class.

Private Investments

In the US, private equity deal activity increased 12% in Q2 relative to the same period last year although total deal value somewhat lagged. Financial performance, however, has remained subdued for older vintage funds which have produced single digit rolling annualized returns for the past 7 quarters – in stark contrast to the consistent double-digit returns during the prior 40 quarters. As mentioned in our Q1 commentary, rising global equity markets have improved the environment for private equity exits, which rebounded in Q2 from trough levels in 2022 and 2023, though they remain 50% below peak deal exit activity in 2020-21. Despite this increased activity, private equity GPs have extended their hold periods which now average over seven years per holding, well above the average of five years during 2020-21 and the prior peak of six years in 2014. As such, larger private equity firms have begun to embrace new models for exits, such as employee ownership, which has been gaining traction including in Canada since recent legislative changes. Meanwhile, venture capital exits remain near historic lows and as such have reduced the level of fundraising activity (now at a nine-year-low for global VC funds) as investor capital remains tied up in older vintage funds. The combination of a poor exit environment and increasing holding periods has resulted in increased secondary market activity for investors in both PE and VC funds with supply outstripping demand by 2x. This has resulted in secondary transactions occurring at 20-40% discounts to most recent NAVs. We believe secondary markets are an attractive opportunity for investors seeking to increase their allocation to PE and VC given the favourable valuations and ability to deploy capital quickly. Furthermore, providing a fund’s existing investors an immediate exit helps increase the availability and size of capital to re-invest into new funds, helping managers achieve capital raise targets, which has been a challenge in 2024, particularly for smaller impact fund managers. Heading into the second half of the year, we continue to believe that private equity and venture capital funds that are able to raise capital today stand to benefit, given: i) relatively attractive valuations compared to previous years, particularly if the economy enters recessionary conditions during 2024 or 2025 as these funds begin to deploy, and ii) reduced competition for deals, further supporting valuation and improved funding terms for investors.

Private debt opportunities continue to be limited in the Canadian impact investing space given that most funds are offering returns that are not too dissimilar from low-risk assets like GICs; however, we believe the environment is poised to change as interest rates decline. We note that we are tracking several US-based private debt impact opportunities offering more favourable rates of return. Although credit quality of private debt is very deal specific, we note that impact-oriented opportunities tend not to be associated with high leverage situations which differs materially from the traditional private debt market, 78% of which goes towards funding private equity activity such as leveraged buyouts. As such we generally view impact private debt as being less sensitive to interest rates and declines in economic activity than traditional private debt markets. Although traditional private debt returns appear highly attractive relative to opportunities focused on impact, there often is a significant difference in underlying risk.

Outlook

Our assessment that a hard-landing scenario for the global economy remains the likeliest outcome remains unchanged from last quarter. This scenario would lead to a sharp decline in interest rates barring any unforeseen rapid pick-up in inflation, which in turn would benefit rate-sensitive industries and asset classes. We acknowledge that our view is in the minority based on a recent poll by the Wall Street Journal where 68% of investors expect a soft landing for the economy while 11% expect a material slowdown. The balance of investors expect a no landing scenario (i.e. slow but positive growth and continued inflation). However history reveals that it is common for investors to feel exuberant and optimistic immediately preceding a sharp downturn. According to TD Securities rate strategy team “The prevailing consensus right before things went downhill in 2007, 2000 and 1990 was for a soft landing,” and from a recent New York Times article “In late 2000, a column in The New York Times was titled “Making a Soft Landing Even Softer.” And in late 2007, forecasters at the Federal Reserve Bank of Dallas concluded that the United States should manage to make it through the subprime mortgage crisis without a downturn”. In other words, recessions and market pullbacks generally surprise both investors and central banks.

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

• Public equities – We favour more defensive areas of the economy (for example, utilities, companies with exposure to stable government revenues and non-cyclical dividend payers). We remain cautious of market areas where valuations are lofty, such as US large cap and “hot” areas of technology (like AI). For longer term investors, US small/mid cap and European stocks look relatively more attractive, though our expectation is that market volatility will remain for some time, especially if the global economy slows. This could give investors the opportunity to add to their holdings at more attractive valuations if there is a market correction.
• Real Assets – We prefer assets associated with natural capital such as farmland, which will do well given that i) inflation is supportive of agriculture-related commodities, and ii) 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 healthcare and to a lesser extent communications.
• Alternative Assets – We continue to favour market-agnostic investments such as impact litigation funds which have low-correlations to other asset classes, thereby reducing portfolio volatility.
• Fixed Income / Bonds – Given our expectation for declining interest rates, we recommend adding long-duration IG corporate, green and social bonds to portfolios.
• PE/VC – We believe that investors under-allocated to private equity and venture capital will find the 2024 vintage of funds entering the market to be well positioned to deploy capital towards impact opportunities with less competition for deals and potentially lower valuations compared to previous years. This bodes well for strategies involving acquiring equity stakes in companies during 2024 and 2025 and exiting in 5-10 years.
• Private Debt – For impact investors willing to accept below-market rates of return we recommend considering longer duration Canadian impact credits with fixed coupon payments. For investors seeking market rates of return we see a limited number of deals in Canada, however we have identified several impact opportunities out of the US and more globally.

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