Market Commentary 

By Marc Foran, CIO

Q3 2024

Q3 was a strong quarter for public markets with both global equities and bonds posting solid gains – however the intra-quarter activity for markets and economic data was anything but smooth. In terms of positive economic data, inflation continued its downward trajectory towards targets established by the Federal Reserve and most developed market central banks, thus setting the stage for additional interest rate cuts. Furthermore, headline US labour and employment reported in September was an upside surprise relative to expectations and suggested that negative trends from the prior month may have been due to extraordinary factors such as Hurricane Helen. On the negative side, companies with exposure to consumer spending reported more severe declines in discretionary spending than anticipated. Also, credit delinquencies continued to rise particularly amongst lower and middle-income households. Geopolitics also continue to weigh on global markets with uncertainty regarding the upcoming US election, trade tensions between the US and China, and continued conflict in the Middle East.

Macro Environment

Q3 was full of surprises: European and Canadian central banks continued cutting interest rates in Q3 in response to both slowing economic conditions and declining inflation while Japan raised rates in a move that shocked global markets. Prior to 2024, Japan had not raised interest rates since 2006 and in fact maintained incredibly low and often negative interest rates to stimulate its economy. As such, for years many institutional investors deployed a strategy of borrowing from Japanese financial institutions at low rates and investing the proceeds in global markets (the US in particular). The sudden move by Japan to increase interest rates in Q3, albeit by a modest 15bps, was viewed by markets as a hawkish shift in policy and caused many investors to sell assets and quickly repay Japanese loans. At the same time the US published weak July payrolls and employment data which, when combined with Japan’s increase in rates, led to a broad-based global market selloff and a spike in volatility levels. The Bank of Japan responded with more dovish public statements and members of the US Federal Reserve, which had yet to embark on monetary easing, signalled that it was time to begin reducing interest rates. As such markets rebounded. However, we believe these events brought the increasing importance of macro-economic data in an increasingly uncertain environment to the forefront of investors’ minds. The Federal Reserve ultimately responded with an over-sized interest rate cut of 50bps in September which, along with better-than-expected employment data for August, helped buoy markets.

Economic data released in September showed improvement… or did it? US payroll and employment data for August showed a surprisingly strong headline number which caused equity markets to rally in mid to late September while bonds fell on expectations of a less aggressive interest rate cutting path. However, a closer look at the data showed that the better-than- expected results were the product of i) a significant increase in government employment (one of the biggest increases ever recorded), which caused the unemployment rate to decline to 4.1% (unemployment would have actually increased to 4.5% without the surge in government jobs), ii) a below-average response rate by smaller employers and ii) the introduction of methodological changes to seasonal adjustment calculations that at a future date could result in downward revisions to the data. Thus while the report seemed positive the underlying details suggested that the favourable data was likely temporary in nature.

US election angst: After a strong start, presidential candidate Harris’s initial polling traction retrenched, putting her in a statistical tie with Trump by end of the quarter. Markets have become increasingly focused on the following expected outcomes for each candidate (based on election promises and rhetoric): Trump wins – higher inflation due to tariffs, lower corporate and personal taxes (implies less government revenue and hence higher deficit), policies supporting “dirty” sectors (like oil & gas), retrenchment of policies supporting clean energy and energy efficiency; Harris wins – increased corporate and high income earner taxes (e.g. taxing unrealized capital gains), reduced low income earner taxes, increased spending on social programs, continuation of policies supporting clean energy and energy efficiency, policies restricting the growth of dirty sectors.

The net result is that entering Q4, markets were divided as to the outcome of the election and which sectors and companies would be winners and losers. For example, the Inflation Reduction Act (IRA) benefits many states in terms of opportunities and job creation in clean energy solutions which benefits companies such as Ameresco (a holding in the Rally Funds). The market expects that a Trump administration would repeal the IRA, although a deeper look reveals that many Republican- supportive states would be negatively impacted by this action.

With year-end growth targets in jeopardy, China announced a significant stimulus package to support the domestic economy: In late September, China implemented its largest stimulus package since the onset of the COVID pandemic. This triggered a surge in Chinese public equities towards the end of Q3 with the Shanghai Shenzhen CSI 300 Index up 20.5% in the quarter and up 26% from Sep 23 (when the stimulus was announced) to Sep 30. Furthermore, global consumer discretionary companies with exposure to China also reacted positively to the stimulus, with expectations that China’s support for domestic consumption would provide a lift to an otherwise negative sales trend. While the stimulus program is expected to translate into increased economic activity and consumption, the general expectation is that it’ll only provide temporary relief from systemic issues plaguing China’s economy (like the property crisis, high youth unemployment, a rapidly aging population and low birth rates). Given this, it is certainly possible that China will announce further measures over the coming quarters.

Public Markets

Global public equity markets were strong during Q3 with the MSCI ACWI Index up 5.4%, but the big story was the sector rotation to traditionally more defensive areas of the economy. Regionally, US, Canadian and European markets posted strong returns but Asia Pacific was the standout, led by China and Hong Kong indices that soared after the China stimulus package announcement. The top performing sectors in ACWI were real estate (up 15.7%), utilities (up 15.2%) and financials (up 9.3%) while on the other end of the spectrum oil & gas declined 3.3% and information technology was flat. The sector leadership in Q3 was a stark contrast to the first half of 2024 where “the Magnificent 7” (Nvidia, Meta, Amazon, Google, Microsoft, Apple, and Tesla) drove over half of MSCI ACWI returns. In Q3, the Magnificent 7, which constitute almost 20% of the ACWI, were collectively down and contributed -0.14% to index returns.

Global equity markets continue to trade at a rich valuation relative to bonds. As at September 30, the MSCI ACWI Index was trading at a price-to-earnings ratio of 22.1x (vs. a 20 year historical average of 17.2x) and an earnings yield of 4.5%, which represents a 70bps equity risk premium over the US 10-year Treasury rate. This rich valuation was largely fuelled by US equity markets, which make up ~65% of the index. At quarter end, the S&P 500 was trading at 26.3x earnings (vs. a 20 year historical average of 18x), or an earnings yield of 3.8%. US markets historically have traded at a 420bps equity risk premium to the 10-year Treasury rate. The implication for investors is that in order to justify current valuation, US equities would need to have an EPS growth CAGR of approximately 10-11% over the next 10 years. This compares to an historical EPS CAGR of 7.4% over the past 10 years and 6.1% over the past 20 years. In other words, EPS growth would need to be consistently above historical levels despite several macro  headwinds such as a less accommodative interest rate environment (over the long term), increased tensions with global trade, aging demographics, a shrinking workforce and rising geopolitical tensions. In terms of the current environment, the Q2 EPS for the S&P 500 and ACWI grew 10.3% and 9.3% annually respectively. However Q3 EPS growth has been just 3.4% for the S&P 500 with roughly 37% of index companies reporting thus far and -4.2% for ACWI. In other words, EPS growth appears to be slowing.  Global bond markets were strong, with the Bloomberg Corporate Investment Grade Bond Index generating quarterly returns of 4.6% in the US, 6.6% in Europe and 3.6% in Asia. The primary driver behind strong bond performance was the US and other countries’ central banks cutting interest rates, though the path of rate cuts remains uncertain. In particular, US election politicking has featured negative rhetoric and proposed policy for fixed income that could result in i) the potential to reignite inflation (and hence cause interest rates to remain higher for longer) and ii) the US federal balance sheet materially deteriorating, resulting in a credit rating downgrade. As such, the election has added a degree of volatility in bond markets, though we think that any election outcome where control of the House and Senate is split would mitigate much of the market’s concerns due to a lower likelihood of materially harmful economic policies being enacted into law.

Private Investments

Following improved deal activity in Q2, this quarter saw a retrenchment back to the weaker trends seen in the first quarter of 2024. Of note, cash distributions from VC funds continues to deteriorate to just 5% of invested capital, which is well below the peak of 30% in 2021 and average of 16.8% over the past 10 years. The poor exit environment has been the primary driver behind declining distributions. As a result i) VC holding periods of underlying companies has increased, ii) LPs are increasingly selling stakes in secondary markets and often at significant discounts and iii) new fund capital raising remains challenged (in particular for first-time managers) as investor capital remains tied up in current LP investments. On a relative basis, later stage and growth funds are faring better in terms of fundraising while seed and pre-seed struggle. In terms for private equity, both deal activity and exits improved in Q3, though they remain well below the peaks of 2021. Despite improved activity, private equity funds continue to hold underlying companies for longer periods which, similar to VC funds, has resulted in investor capital being tied up in existing LPs.

With interest rates declining in Canada and across global developed markets more broadly, the environment for private debt impact opportunities has begun to improve as the spread between market and below market yields narrows. At the same time, yields on low-risk assets such as impact GICs have declined meaningfully from their peaks and are expected to continue doing so in the future. This should result in capital flowing from shorter term instruments experiencing declining yields to longer duration opportunities that are offering fixed yields. We also continue to monitor several private debt impact opportunities in the US that offer market rates of return and expect demand for high quality products (i.e. lower credit risk) to increase going forward

Outlook

We acknowledge that the economy and markets have thus far remained resilient for longer than we anticipated; if history is any guide, the timing of market downturns and recessions is notoriously difficult. However when economic downturns do materialize the severity of market corrections tend to catch investors by surprise both in terms of speed and magnitude of the decline. While the Federal Reserve’s actions and the US economic data were generally celebrated by global investors, we remain cautious in our outlook and continue to believe that ultimately a hard landing scenario for the economy will prevail. Furthermore, history suggests that the impact of declining interest rates on economic activity has a lag of 8-12 months. Thus, we believe that the economy will continue to deteriorate for some time.

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; we thus favour more defensive sectors such as utility companies providing essential services to communities and also non-cyclical high-dividend paying companies. We are also becoming increasingly constructive on select clean energy transition companies as reduced interest rates should translate into improved margins. We also believe that in the event of a Trump victory, a repeal of the IRA, which has supported clean energy projects in the US, is less likely than the market perceives given that Republican states have disproportionally benefited from the Act in terms of investment and job creation. For longer-term investors, select US small/mid cap and European impact 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 provide investors with an opportunity to add to their holdings at more attractive valuations in the event of a market correction.
• Real Assets – We prefer 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 healthcare and to a lesser extent communications.
• 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 impact and returns regardless of prevailing economic conditions.
• Fixed Income / Bonds – Given our expectation for declining interest rates, we recommend adding long-duration investment grade corporate, green and social bonds to portfolios. However we acknowledge that surprise economic data and the pending US election have increased volatility in the asset class. History reveals that even during periods of economic weakness, data can remain choppy and provide false positive “head-fakes” that the market could react to. Thus we recommend that investors remain vigilant and add to impact fixed income positions should yields rise quickly.
• PE/VC – We believe that investors under-allocated to private equity and venture capital will find the 2024 and 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. This bodes well for strategies involving the acquisition of equity stakes in companies during 2024 and 2025 and exiting in 5-10 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 considering longer duration impact credits with fixed coupon payments. 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

DISCLAIMER

Rally Assets considers third-party information and data presented herein to be reliable but because it was prepared by a third-party, Rally Assets may have had to rely upon the work product of the third party to some extent, without being able to verify the accuracy of the information. Opinions expressed herein are current as of the date appearing on page 2 of this document and are subject to change without notice.

The information provided in this document is provided as a general source of information. While the information is considered to be true and correct at the date of publication, change in circumstances after the time of publication may impact the accuracy of the information. Rally Assets reserves the right to add, remove, vary or alter the information and materials contained in this document in its discretion.

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