Market Commentary 

By Marc Foran, CIO

Q1 2024

After a broad market rally across asset classes in Q4 2023, investors started 2024 feeling optimistic that the US economy would experience a “soft landing,” characterized by economic expansion and earnings growth, driven primarily by robust consumer spending and renewed business expansion supported by declining interest rates (i.e. lower cost of capital) as inflation steadily declined. Furthermore it was expected that such a soft-landing scenario for the US would translate into a stronger outlook for OECD countries and select emerging markets. This expectation fueled gains in equities and bonds towards the end of 2023, with momentum carrying into the first quarter of 2024. However, as we highlighted last quarter, the impact of geopolitical events, particularly in the Middle East, alongside initial data points suggesting inflation would remain stickier than expected, signaled the potential for an environment of elevated risk which would harm global trade and disrupt supply chains.

As Q1 unfolded and geopolitical tensions rose alongside hotter-than-expected inflation data, the market’s expectations of interest rate cuts shifted to a more hawkish stance. As such, the market went from pricing in 5-7 Fed rate cuts in 2024 to 1-2 in a best-case scenario, with the US 10 Year Treasury Yield moving sharply higher from 3.8% at the end of 2023 to ~4.2% by the end of Q1 2024 and more recently to 4.6% as of mid-April. The increase in yields provided a poor backdrop for new bond issues including sustainably-linked debt instruments such as green bonds. Although the size of the sustainable bond market continues to grow, issuance increased just 3% in Q1 2024, which is far below the robust new issuance activity of 2022 when interest rates were lower.

Despite persistent inflationary pressures, the latest US GDP and employment numbers remained strong, supporting global equities with the MSCI ACWI Index up 11.1%, though this performance was largely driven by US large-cap equities (64% of the index) which rose 13.3%+ during the quarter vs. 7.8% for US small cap. Global equities also performed well, with the Eurozone up 7.8%, Japan up 15.2% and Canada up 6.6%. This performance was largely driven by GDP growth exceeding expectations (though overall growth remains below historical levels). However, from a macroeconomic perspective, we continue to see cracks emerging that we believe elevate risks for the global economy. While much has been made of strong employment data, particularly in the US, looking beyond the headline 3.9% US unemployment rate to include discouraged workers (those who are underemployed or holding part-time work but desiring full-time) reveals a “real” unemployment rate of 7.3%, which is significantly higher than the historical average of 5.7%. We also note the persistent rise of credit card delinquencies to levels last seen 12 years ago and the continued deterioration in personal savings rates as further evidence of consumers feeling stretched. According to Austan Goolsbee, Chicago Federal Reserve Bank President, consumer delinquencies are one of the most concerning economic data points at the moment and are “…a leading indicator things are about to get worse”. The impact of this becomes more evident when considering that consumer spending accounts for 70% of GDP. Overall, we believe that a period of higher interest rates for longer will negatively impact consumer spending, resulting in stagnant economic growth and a potential decline, thereby creating a “no landing” scenario (that is, high inflation with low economic growth) and eventually a “hard landing” or contraction scenario for the global economy.

Global commercial real estate may be the “canary in the coal mine” for the global banking and financial system. We are increasingly seeing signs that a weakening office real estate market could create a domino effect that goes beyond US regional banks. Most notable was US regional bank NYCB, which recorded significant losses related to its commercial real estate loans, causing its share price to collapse and necessitating a significant capital injection from private investors. In the EU, the ECB and Moody’s expressed concerns regarding persistent price declines in commercial real estate assets and declines in transaction volumes. The concern is that if managers need to liquidate commercial property holdings, the combined effect of lower prices and poor market depth could result in significant declines in asset prices, potentially leading to further banking stress where assets decline more than liabilities, resulting in a need for potential capital injections, similar to what was experienced by NYCB. In Asia, the Chinese property market for both housing and commercial real estate assets has been in steep decline for quite some time as an increasing number of property developers experienced financial stress in the wake of over-building and subsequent new Chinese regulations on debt-limits for property developers. The resulting decline in transaction prices and volumes drove Chinese developers to look overseas in efforts to “offload” their foreign properties, particularly in large Western cities such as London, which, given poor transaction volumes, could exacerbate price declines in these respective foreign markets, thereby resulting in a contagion effect. Additionally, the protracted Chinese property downturn is eroding the balance sheets of China’s largest state banks as bad loans creep up. In other words, declining property values, exacerbated by stress-sales could not only impact developers, but have far-reaching consequences stemming from issues within the Chinese banking sector.

The rise of global equities during Q1, coupled with increasing bond yields (i.e. declining bond prices) has resulted in a situation that markets have not experienced since the early 2000s: the equity risk premium (ERP), or the incremental return investors expect to receive over bonds, has contracted to just [50 bps] for US stocks as at March 31 and, more recently, the US ERP even became negative. In other words, investors are not being paid appropriately for taking US large cap equity risk, particularly within technology stocks that are experiencing Artificial Intelligence (AI) “froth”. Looking at the US Magnificent 7 (Amazon, Apple, Google, Meta, Microsoft, Nvidia, Tesla) and in particular those names associated with AI, we see an ERP of -88bps while the rest of the index trades at an ERP of 129bps, though even this remains below the 2009-22 historical ERP average of 300bps for the US index. If we are truly in period of higher inflation, and hence higher interest rates, combined with low and potentially declining growth, then we view US large caps as particularly susceptible to a market pull-back.

Despite an unfavourable environment during 2023, investor optimism for private equity and venture capital improved heading into 2024 as fund managers re-entered the market in Q4 to acquire assets that were presumed to be available at discounted valuations. During Q1, overall deal activity was down from Q4 2023 but in line with much of 2023 as fund managers became more selective on which deals to pursue in a market with reduced deal flow competition. Unfortunately, this selectivity has also led to reduced deal activity in underfunded areas of the market such as female-founded companies which constituted just 5% of Q1 2024 US deal activity and well below the 6.4% average of 2023.

In terms of fund raising, private equity funds saw a 10% decline in activity during Q1 which we believe reflects continued challenges with exits, thereby limiting the desire of investors to put capital into new funds. Heading into Q2, the rise of global public equity markets during Q1 has created a more favourable valuation environment for private equity and venture capital funds to exit their holdings, which could potentially help alleviate the log jam of captive investor capital. For the balance of 2024, we 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.

On the private-debt side, we continue to see lower levels of activity for impact opportunities, given that market interest rates remain elevated and that many impact private debt products such as those focused on social equity and community impact tend to offer below-market returns (2-5% range). Having said that, we continue to see a number of US and global private impact debt opportunities with return profiles that are closer to market returns of 8-10%. In the event of a slowing global economy, we anticipate that credit quality of certain private debt deals could come under greater scrutiny and impose more strain. We would advise investors to be very selective regarding the types of private debt opportunities they pursue. For investors open to below-market rate opportunities as part of their impact mission, we believe that the challenging fund-raising environment for many private debt impact opportunities significantly enhances the additionality of those investments and thus investors’ overall impact.

Outlook

Based on our assessment of a hard-landing scenario where certain asset classes will disproportionately benefit from an environment of reduced rates resulting from an economic downturn (such as those in rate-sensitive industries and asset classes), we recommend the following for each asset class:

• Public Equities. More defensive areas (utilities, exposure to government contracts offering stable revenues, dividend payors with a history of dividend growth). We remain cautious on areas of the market where valuations are lofty, such as US large cap and “hot” areas of technology (e.g. 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 provide investors with an opportunity to add to their holdings at more attractive valuations (i.e. in the event of a market correction).
• Real Assets. We remain bullish on assets associated with natural capital such as farmland, which will do well given that inflation is supportive of soft commodities and the demand for agricultural goods tends to be stable even during poor economic times. We continue to like (non-office) REITs, given relatively stable dividends and intensification opportunities which add incremental value. Within the REIT space, we gravitate towards recession-proof areas such as health care and 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.
• Bonds. Given the rise in yields and our expectation for declining rates in the latter half of the year, we believe that it is an opportune time to add long-duration bonds, particularly those offering investment-grade credit quality.
• PE/VC. We believe that investors under-allocated to private equity and venture capital will find the 2024 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.
• Private Debt. Generally, we see few deals within the Canadian market offering market rates of return. We do see interesting market-rate impact opportunities out of the US and more globally.

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