Equity Commentary: As at March 31, 2024*

The rise in equity prices has certainly been impressive. U.S. equity markets ended the first quarter of 2024 at all-time highs despite two of the MAG 7 stocks being negative year to date – highlighting an improvement in overall breadth. Additionally, core inflation has now surprised to the upside for two consecutive months and that in turn has reduced the number of implied U.S. Federal Reserve (“Fed”) interest rate cuts for 2024 by half since the start of the year. We’d note that there are several structural themes playing out across equity markets, including AI, cloud computing, biotechnology, GLP-1 drugs, onshoring, commercial aerospace, infrastructure, electrification, data centre power, to name a few. The opportunity set has been improving for active managers. There has also been an increase in dispersion between stocks with correlations among stocks lower than average, which made for a great backdrop for stock pickers.

Sectors that contributed to absolute performance:

Information Technology

Information Technology was the top contributor to absolute performance across our long positions. The sector compounded its Q4 2023 strength with the best performing subsector being semiconductors, led by Nvidia Corporation, followed by internet stocks.

We remained cautiously optimistic on the outlook for Information Technology as an improved interest rate environment could lead to increase confidence and spending as well as ongoing multiple expansion. In Software, enterprise budgets generally appeared more optimistic as we began 2024, and AI revenue is likely to begin scaling into 2025. Semiconductor stocks exposed to AI remain winners, although we think there may be some near-term processing of the recent moves, while cyclicals may begin to perform better as inventory corrections near an end.

Financials

Financials also added value across our long positions. To start the year financials lagged the broader market in Canada while trading in line with the broader market in the U.S. In the sector, Insurance (both property & casualty and life) has led gains, while the more credit-sensitive banks have lagged. We continue to be a little more cautious about banks, especially in Canada, as revenues are slowing and credit losses are trending higher. In Canada, we believe we are headed for a period of more rapid deleveraging that will hold back growth and profitability for the banks’ domestic banking businesses. Among financials, we favour less credit-sensitive companies with good idiosyncratic growth tailwinds, irrespective of the macroeconomic backdrop.

We remain very bullish on life insurance: we believe there is a structural rerate opportunity provided by a higher rate regime than 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.

Sectors that detracted from absolute performance:

Utilities

Utilities was the only sector with negative performance across long positions. Higher bond yields have led to underperformance of the Utilities sector relative to broader index. Within utilities we prefer strong balance sheets that can self-fund growth, favourable regulatory jurisdictions, and have no large rate cases outstanding.

With regard to independent power producers, we favour names that have no large project risk and are able to self-fund growth.

Small Cap Spotlight

We would like to highlight our position in Lumine Group Inc. (Lumine) – Lumine is a Vertical Market Software (VMS) acquiror that was an operating group within Constellation Software Inc. (CSU) before being spun out during 2023. Their strategy within CSU continues to be a focus on acquiring, strengthening and growing businesses in the Communications and Media industries across the globe. It is acquiring mission critical software for large enterprises in their targeted industries, improving the margins of them, and using the cash flow to grow the business and acquire additional businesses. We believe that this strategy has a very long runway of acquisitions that can deliver outsized returns on capital. Since being an independent public company, Lumine has made a string of acquisitions, including corporate carveout transactions that deliver high Internal Rates of Return, and we expect this to continue as they execute their plan. Given its spinout to be an independent company which allows it to advance its acquisition pace at an unencumbered pace, historical evidence of strong execution and long runway of opportunities available to it, we have a positive view on shares.

Outlook and Opportunities

While global GDP has no shortage of soft spots, the resilience of the U.S. economy has most investors in a “soft landing” camp, even though some classic recession indicators remain (i.e. a still-inverted yield curve). We do not believe this is a particularly opportune time to embrace equity risk with newly committed capital, as investors must continue to grapple with Fed rate cut expectations being “pushed out” by fixed income markets. This lack of potential tailwind for valuations is but one risk and though equity performance seems to have broadened from the narrow leadership of mega-cap tech, earnings expectations still seem anemic. We continue to question whether investors can “have their cake” (maintain/expand stock valuations) and “eat it too” (see earnings expand to drive stocks even higher). To the extent we believe the market rewards momentum uniquely, we are not outright bearish, yet we continue to be cautious with respect to sectors or themes in equity markets which bear momentum but are also “crowded” trades.

Overseas, while headline economic data remains weak in most areas, there are reasons to be more optimistic for the second half of this year. In Europe, we are seeing inflection points in several areas including real wage growth, consumer confidence, and inflation expectations. This will likely lead to stronger consumption in most countries, leading us to close our underweight in domestically exposed consumer plays. In Asia, we are seeing a good follow through on inflation in Japan with the most recent wage negotiation pointing to continued upward pressure. This is a positive development in Japan as it will allow the Bank of Japan to normalize its rate policy and hopefully drive a sustained cycle of higher investments and better growth. Japan is our largest overweight on the global side as Japanese stocks remain attractive despite its strong performance over the past year with many companies still trading at below book value and companies are being incentivized to increase their return to shareholders.

(*) Annualized performance

Source: Picton Mahoney Asset Management