Equity Commentary: As at September 30, 2024

Having been somewhat cautious at the onset of the quarter and with a U.S. Federal Reserve (Fed) seemingly committed to sitting on the sidelines while a soft-landing narrative cemented in the minds of market participants, we grew cautiously optimistic that deteriorating economic datapoints would at least level, if not turn positive at the margin during the period. The crux of the Fed position related to the inflation dynamic, where goods appeared to be in outright price deflation, yet core services inflation remained uncomfortably high, and firm in its footing. This “sticky situation” for the Fed, as we called it, almost required services inflation to roll over to offer the central bank a green light to cut rates. Yet, the longer the world’s largest economy went without monetary easing, the greater the odds of recession.

Market sentiment did not seem quite as sensitive to this conundrum, it seemed, as our bias to be buyers on pullbacks offered only brief opportunities to do so in August. It was a violent risk-off episode, but not supremely compelling buying opportunities in retrospect. For much of the quarter, equity valuations remained high, positioning of market participants was stretched on the long side, and various signs of late-cycle speculation had returned to the market. As vigilant as we were, we were pleased to deliver alpha in pockets of dislocation across markets.

Sectors that contributed to absolute performance:

Financials

In the third quarter of 2024, Financials outperformed the broader market as the market gained greater confidence that inflation was under control and that there was a higher probability of a soft landing, combined with 50 basis points of rate cuts in both Canada and the U.S. Banks were a key beneficiary, performing well as the market gained more optimism regarding credit and net interest income trajectories once the rate-cutting cycle had commenced. Relative outperformers in the previous quarters have begun to lag and underperformed in the third quarter, including Canadian property and casualty insurance companies and money centre banks, after the market began to re-risk companies that are rate-cut beneficiaries. We remain a little cautious on banks in the near term, especially given their recent strength, because credit metrics continue to deteriorate, and revenue trajectories seem quite muted in the near term. In Canada, we believe we are headed for a period of more rapid deleveraging that will likely hold back the growth and profitability of the banks’ domestic banking businesses.

Among financials, we favour less credit-sensitive companies with good idiosyncratic growth tailwinds, irrespective of the macroeconomic backdrop. We are bullish on life insurance: we believe a structural rerating opportunity could be provided by a higher rate regime, compared with the zero-interest-rate policy that followed the global financial crisis. Additionally, many of the life insurance companies we like have built large capital-light wealth/asset management businesses that will likely continue to benefit from numerous secular tailwinds and strong growth. We are also positive on alternative asset managers, because they seem to continue to raise significant third-party capital and will likely be able to deploy it into the next cycle; they also generally have long-term secular tailwinds for growth as they increase penetration in the retail channel.

Industrials

Recently, we’ve seen industrial stocks tick up as fears of an outright industrial recession have waned. Erring on the side of conservatism, we have maintained our short exposure to more expensive multi-industrial/ staffing names, while also hedging cyclical long positions in broader secular themes. We are confident that the businesses we like – including those with cyclical exposure – will continue to meet our long-term return thresholds.

We continue to look for out-of-favour companies with a history of outsized growth, catalyst-driven idiosyncratic rerating angles and/or opportunities to improve structural returns on invested capital. Lately, we have been focusing on hazardous waste names exposed to growing infrastructure spending and onshoring. We also remain bullish on the industrial leasing complex over the long term. We have hedged the cyclicality of rentals with less attractive names that have similar exposures. We have been looking into certain airlines, but are not buying aggressively quite yet, despite their cheap valuations. More recently, we’ve also gained conviction regarding a couple of lumber-based product manufacturers and distributors. Finally, the merger and acquisition environment for serial acquirers seems quite favourable. Accordingly, we have shored up weightings in companies with a strong track record of acquisition and ample cash on hand.

Sectors that detracted from absolute performance:

Health Care

Health Care slightly detracted from performance. Through the third quarter, Health Care has outperformed the S&P 500 Index. As hopes for rate cuts have inched higher, investors have warmed up incrementally toward risk-on subsectors within Health Care, while weakness and volatility in momentum names and year-to-date winners have increased incrementally. Especially among large biopharmaceuticals, there has been a broadening out of performance; we have seen a notable bid for defensive value, while quality growth has underperformed.

Biotechnology funding took a pause in August, compared with the first half of 2024; however, there is a typical seasonal weakness in summer funding, so we do not interpret this as a meaningful sign of deterioration in biotechnology fundamentals. Elsewhere, continued strength in medical utilization and procedure growth has generated outperformance in the providers and medical technology subsectors, particularly for names with margin expansion opportunities and innovative product cycles in attractive markets.

We anticipate further broadening of performance in the near to medium term as inflation eases and the interest rate path becomes clearer – assuming recession risks remain low. Lower rates could drive interest and capital toward the riskier growth areas of Health Care, and we are incrementally more bullish on biotechnology and related end markets. Longer term, we continue to favour names with quality growth and positive estimate revisions through innovative product cycles, as well as strong base businesses with defensible moats and opportunity for margin expansion. More tactically, we remain highly selective among catalyst-driven names where risk/reward is favourable.

Small Cap Spotlight

We would like to highlight our position in NFI Group Inc. (NFI) – NFI is a leading manufacturer of transit and coach buses in North America and the UK as well as abroad, and also offers an aftermarket parts business that’s supports all the largest transit agencies in North America. After years of difficult operating environment and burdened by high debt levels, NFI has displayed some positive changes that we believe will lead to better years ahead. Due to supply chain issues and rapidly increasing costs of parts, NFI had to endure multiple years of negative manufacturing margins delivering buses they had contracts for prior to inflation issues. However, they have now worked through this backlog and are now delivering buses with higher embedded pricing and margins which will likely benefit free cash flow dramatically going forward. In addition, given the tough operating conditions for the industry as a whole, multiple competitors who had been constraining pricing have now exited the bus manufacturing market, leaving NFI with a leading position on new bids and facing less price competition on new wins. All of this can lead to a better operating environment for NFI, which could also lead to debt paydown to more tolerable levels over time. While some lingering supply chain issues will still cause variability in results, we believe the broader positive changes will benefit the company and will result in solid performance from the company.

Outlook and Opportunities

Going into September, the U.S. Federal Reserve had to choose between stimulating a slowing U.S. economy and remaining firm in its fight against potential inflationary forces lingering on the supply-side. The central bank chose the former and as of the time of writing, further rate cuts have been priced-in to interest rate markets, some of which could be larger or come sooner than earlier expected. We believe the decision to cut rates this soon could stoke inflation moving forward given the structural issues in housing and labour supply, as well as challenging supply-side dynamics in certain key commodities. This, in turn, could have implications (i.e. shorter cycles, traditional 60/40 portfolio underperformance and lower cash returns) which investors need to remain conscious of in relation to portfolio construction. To wit, these dynamics are likely a meaningful shift from the generally benign environment which allowed traditional balanced portfolio constructs to thrive for most investors’ memories up to very recently.

On equity markets, as expected, the reaction to lower short-term interest rates was a burst of risk-on sentiment and as we are not as outright bearish relative to our last update (when economic indicators were deteriorating more broadly), we have taken the opportunity to increase cyclicality in equity portfolios at the margin. That said, we do remain cautious toward ebullient sentiment, but we believe the balance of probabilities remains constructive on a medium-term forward-looking view.

(*) Annualized performance.

Source: Picton Mahoney Asset Management

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