Each quarter, our Investment Management teams publish their key observations and portfolio updates across Global Equity and Fixed Income markets. This is a summary of our views for the Third Quarter of 2024. You can download the full reports via the links shown below.

KEY OBSERVATIONS

Yet another good quarter for both the S&P500 and TSX has come to a close, with the S&P 500 up +5.89% in U.S. dollars or +4.59% in Canadian dollars, and the TSX total return up +10.54%. 

The much-anticipated monetary policy easing cycle started earlier this month when the Federal Open Market Committee (FOMC) cut interest rates by 50 basis points as Chairman Powell signaled that he was shifting from an inflation hawk to an employment dove. That is, he now cares as much about maintaining employment as he does about reducing inflation. 

According to comments from the Fed, we have inflation moving sustainably toward 2%, an unemployment level that, by historical standards, would still be considered low, and a stable real GDP growth outlook of about 2%. 

The fact that the Fed has so far successfully engineered bringing inflation down without causing a credit crunch would seem to continue to support the soft-landing outcome that we’ve been a proponent of for some time. Indeed, our own checklist of economic indicators, including the latest GDPNow forecast for Q3, the payrolls data, the current level of credit spreads, and the performance of regional bank stocks, does not suggest any economic stress is present at this time.

In terms of corporate earnings, the S&P500’s third quarter earnings growth of 11.9% bested the estimated earnings growth of 8.9%, according to FactSet Earnings Insight. Forward earnings estimates have been a pretty good proxy for actual trailing estimates, and they are currently hitting all-time highs with an earnings growth outlook for 2025 and 2026 up 15.1% and 12.4% respectively.

Putting this all together, we think a robust earnings outlook, solid economic growth and lower interest rates is a positive backdrop for further share price appreciation. That said, we could see some near-term volatility leading into the U.S. election. However, beyond the election, if history repeats itself, market performance usually improves, and within the framework we just described, we remain constructive on the market outlook from here.

NORTH AMERICAN EQUITY UPDATE

Peter Jackson, HBSc, MBA, CFA

Chief Investment Officer

Portfolio Manager, North American Equities

Our overall equity exposure increased 1% to 97% and cash decreased from 4% to 3%.  Our U.S. equity exposure is 55% while our Canadian equity exposure is currently 42%. For portfolios invested in our North American plus International Equity strategy, the US and Canada weights will be proportionately less than this given the current 20% allocation to international companies.

Over the past 12 months, we continued to shift our allocation in favour of US equities (+13%) over Canadian equities (-10%). US earnings growth continues to outpace Canadian earnings growth, and this is estimated to continue in 2025 and 2026. While we are not calling for a recession in Canada, we do believe the risk of one is higher, with economic growth slower and unemployment higher here than in the US. That said, so far, we have been seeing interest rates decline faster here in Canada than in the US, which may mitigate that risk. 

We added three new positions during the quarter:

Nvidia Corporation needs no introduction, being the leader in the production of graphics processing units (GPUs) that power Artificial Intelligence (AI). We took advantage of the macro-pullback in the market this summer to initiate a position at a now-reasonable valuation as earnings continue to grow rapidly.

Eli Lilly is a healthcare company that has taken the place of Novo Nordisk in our portfolio, in which we had over a 50% gain. While both Novo and Lilly are strong players in the growing diabetes and obesity market, several factors helped make a compelling case for the switch.

Stantec is a global leader in engineering consultancy with a focus on water and infrastructure. With a strong 5-year compound annual EBITDA growth rate of over 20% and record current backlog, Stantec is positioned to continue to deliver strong operating results.

A detailed review of these companies can be found in the full report per the link above.

GLOBAL EQUITY UPDATE

Phil D’Iorio, MBA, CFA
Portfolio Manager, Global Equities

Global equity markets continued their upward climb this quarter. The S&P was up 20.8% over the first three quarters of the year, the strongest such showing since 1997. Key factors that drove markets higher included strong corporate earnings, interest rate cuts around the world, and reduced fears about a global economic recession.

Japan was an exception, with the Tokyo Stock Price Index falling -5.8%. This was partially driven by concern that recent strength in the Yen will weaken Japan’s exporters. However, we do not believe that this will derail the multi-year uptrend in Japan’s equity markets.

In the latest Bank of America Global Fund Manager Survey, 79% said that an economic soft landing is now the most likely outcome. We share this view for a number of reasons. Among them, strength in the U.S. and global economies, stock market gains that are broadening out beyond the big tech names, and an absence of recessionary signals from the bond market.

We believe conditions look steady across most of the major economic regions with China as the notable exception. During his most recent press conference, Fed Chairman Jerome Powell said that the U.S. economy is growing at a solid pace and that inflation is coming down. In Europe, the economy is growing modestly and is expected to improve significantly in 2025. Meanwhile, China’s economy continues to struggle in the face of sluggish GDP performance, sagging consumer confidence, and a collapse in property prices. The country recently announced a series of stimulus measures to lower borrowing costs, inject funds into the economy, and ease the mortgage repayment burden for households.

The lead-up to U.S. presidential elections has historically been associated with elevated volatility in the stock market. While we were spared from the market weakness that typically occurs in September, we’ll be on guard for potential volatility during October. Furthermore, we will be ready to act and take advantage of any opportunities that are presented to us.

In our Global strategy, we established the follow new positions during the quarter:

Amphenol makes connectors and sensors that are used across a wide range of applications. The company’s products are positioned to benefit from secular growth themes including increasing electrification in automobiles, Artificial Intelligence through data centre growth, and the Internet of Things.

Nvidia Corporation needs no introduction as described above, being the leader in the production of graphics processing units (GPUs) that power Artificial Intelligence (AI). We took advantage of the macro-pullback in the market this summer to initiate a position at a now-reasonable valuation as earnings continue to grow rapidly.

In the International strategy, we initiated three new positions:

3i Group is a private equity company with over 70% of its net asset value accounted for by a company called Action, which is Europe’s fastest-growing non-food discounter. Management is currently considering expanding its store base within and beyond Europe, and we believe there is a long runway of growth ahead for Action.

Disco Corp is the dominant semiconductor dicer and grinder equipment provider with market share of 85% and 65%, respectively. Disco is a beneficiary of more than $10 billion in additional semi-conductor backend processes announced by Taiwan Semiconductor and Intel in Malaysia and New Mexico.

Recruit Holdings is a dominant Human Resources Technology company. Recruit is pursuing a long-term strategy to transform its technology from a pay-per-click model to a pay-per-hire model that could expand its total addressable market tenfold to $327 billion and increase its take rate from less than 1% to a significantly higher level.

A detailed review of each company can be found in the full report per the link above.

On June 5th, preceding the close of the second calendar quarter, the Bank of Canada cut the overnight interest rate by 25 basis points. This represented the first decline in the overnight rate following the beginning of the hiking cycle in March 2022, and the first cut in the overnight rate since March 2020. In the most recent calendar quarter, the Bank of Canada continued to ease interest rates, making cuts at both its July and September meetings by an additional 25 basis points in each instance. The Bank of Canada broadcast these moves ahead of time, and investors largely anticipated them. However, the market continues to believe that rates are heading even lower. The yield curve shifted downwards as a result of these moves over this period. A familiar theme in our recent commentaries is the reminder that when interest rates decline, the prices of fixed income instruments and securities increase. As a result, the third quarter was again a positive period for returns to fixed income investors.

Following a challenging Q1 for interest rates, Q2 saw fixed income investments perform more positively. The tone of the interest rate cycle changed in June. First, the Bank of Canada cut rates by 25 bps on June 5th, to bring the overnight rate to 4.75%. This was the first cut by the Bank since the outset of the pandemic. The European Central Bank (ECB) followed suit the next day, cutting rates by 25 bps as well, to bring its headline rate to 3.75% (its first rate cut since early 2016).

The month of April saw income yields rise, as economic data, here domestically and from the US, provided evidence that inflation was continuing to prove tough to extinguish. For example, in early April, US ISM, which summarizes the economic activity in the manufacturing sector, was stronger, and prices paid by purchasing managers were higher than expected. The same reaction occurred again in mid-April and late April in response to higher than forecast US CPI (inflation) and US PCE (Personal Consumption) figures.

Recall that in last quarter of calendar 2023 the yield curve decreased markedly (and as you readers and investors know, when yields drop, bond prices rise). The resulting bond price rally that occurred was the strongest quarterly return performance by Canadian bonds in over 20 years. At the time, some believed there was a reasonably good chance interest rate cuts by the Canadian and US central banks might start as early as March 2024.

It would be difficult to repeat such a strong performance, as a result, the first quarter of 2024 always had a tough act to follow and the bond market return performance was in fact a mixed bag. Interest rates drifted slightly higher (see Canadian Yield Curve chart below), which is a negative factor for bond return performance. Inflation continued to trend downwards at a slower than anticipated pace, but the Canadian economy remained stronger than expected with a very modest beat in GDP growth in January (the latest data released), thus creating the environment for mixed bag return profile.

Well, 2023 was one of the most challenging years for fixed income investors with the converging challenges of combating inflation by governments around the world, regional wars, political instability, global warming and the impact and threat of economic recession all playing a role in determining what investors were looking for with respect to fixed income returns.

Despite a challenging first 9 months of the year, fixed income investors were rewarded for their patience in the final quarter of 2023, with the FTSE Universe Canada Bond Index gaining +8.27% for the quarter, bringing the YTD return to +6.69%. The rally in bond prices was remarkable in November (+4.29% for the month, the second largest monthly gain in over 20 years) and continued in December (+3.43%). There was outperformance in credit as well, helping further.

In a reverse from Q1, the Canadian yield curve level (the general, reflecting overall value of interest rates across the curve) shifted higher in Q2, with the more pronounced moves occurring in the short to medium term tenors (encompassing the 3 month to 7 year bonds). This is shown in the Canada Yield Curve chart below. Rates moved higher by an average of almost 60 bps across the curve. As bond investors, you know that when interest rates (yields) rise, bond prices fall, albeit modestly in this case.

The drivers of positive fixed income returns for Q1 2023, in no particular order, were the effective management of the isolated bank liquidity crisis, the central banks’ (Canada and the US) higher interest rate policies and the increase in corporate interest rate spreads (incremental return over government bond yields). After this positive start for fixed income investors, based on the fundamentals we continue to see, we retain our positive bias for income investments for the remainder of the year.

During the last quarter, fixed income markets continued to wrestle with
(i) inflationary data and expectations,
(ii) global central banks’ attempts to tame inflation through ongoing interest rate hikes and reducing money supply
(iii) the elevated recessionary risk concerns for the economy, both domestically and globally.

The drivers of fixed income valuation and thus its performance in Q3 2022 remained similar to those we spoke about for the first half of the year, resulting in a modest quarterly gain in total return. Inflation remained public enemy number 1,peaking at 9% in the US and 8% in Canada during the quarter, before receding through quarter end due primarily to declining energy prices.
Both the Federal Reserve and the Bank of Canada hiked their benchmark interest rates very aggressively during the quarter in response to extended inflation concerns.

Discussion of a global recession continued with increasing prices, consumer debt burden, employment levels and supply chain issues consuming the majority of the bandwidth for slowing growth theories in several key markets.

The Kipling Strategic Income Fund had a solid August 2022 relative to its benchmark. The M series of the fund generated a return of +0.1%, while the benchmark returned -2.2%. We have positioned the fund to have a shorter duration than the benchmark. This positioning benefitted our unitholders in August.

The bond market seems to be searching for direction and trying to decide if inflation or recession is the bigger risk. On July 27th, the Federal Open Market Committee (“FOMC”) in the United States raised the Fed funds rate by 0.75%. However, comments made in the press release and at the press conference by FOMC Chair Jerome Powell were deemed “dovish” by the market and the bond market rallied (interest rates went down/bond prices went up). The following Friday, strong employment data in the U.S. caused the market to fear that more interest rate increases were likely, and the bond market sold off. The following week, U.S. inflation data was slightly lower than forecast and the bond market rallied yet again. As August wore on, the bond market generally drifted lower.

We believe central banks in Canada and the United States are very focused on reducing inflation. Consequently, central banks will continue to increase short-term interest rates through at least late 2022 and will be reluctant to reduce interest rates. In early August, markets were pricing in four interest rate increases from the FOMC, followed by three interest rate cuts before the end of 2023. In our opinion, this bordered on irrational exuberance.

In a speech on August 31, Loretta J. Mester (President of the Federal Reserve Bank of Cleveland and a FOMC voting member) said of interest rates that “I think we’re going to have to move them up … above 4% and probably need to hold them there next year,”. Similarly in an August 30 speech, John C. Williams (President of the Federal Reserve Bank of New York and FOMC Vice Chair) said that the possibility of interest rates cuts in 2023 was “very unlikely”.

The yield curve is relatively steep in the extreme short end, but flattens in the 2-5 year range. Based on this yield curve, moving from 2 year (4.99%) to 5 year (5.05%) only adds 6 basis points in yield, but should increase interest rate sensitivity (which could be a proxy for volatility) by 150% all else equal. That is not a worthwhile trade-off in our opinion. Consequently, the duration of the fund is approximately 1.91.

Figure 1: Bloomberg Canada BBB+, BBB, BBB- Yield Curve

We have positioned the Kipling Strategic Income Fund to have a shorter duration than the benchmark (1.91 vs. 5.34) and to have a higher yield-to-maturity than the benchmark (7.1% vs. 4.4%). In an environment where all interest rates move higher, the fund should outperform the benchmark due to its’ shorter duration and higher yield-to-maturity. In an environment where interest rates are unchanged, the fund should outperform due to its’ higher yield-to-maturity. In an environment where all interest rates move lower, the fund should underperform. However, the underperformance should be mitigated by the higher yield-to-maturity and should still be positive as all bonds would increase in value (all else equal). We think this is the best way to position the fund in the current environment.