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Michelle Khalili: It's great to be here again for another conversation on capital markets. My name's Michelle Khalili, and I'm the Head of Global Equity Capital Markets and Corporate Finance Advisory at Scotiabank. On this episode of Market Points, we're focusing our discussion on how the macroeconomic environment could influence equity capital markets in the second half of 2024, and into 2025. We'll also get into how the U.S. Election is impacting investor sentiment and how the tech sector is driving the market.
I'm joined by my Scotiabank colleagues today. Derek Holt, Vice President, Scotiabank Economics.
Derek Holt: Good to be here.
MK: Great to have you. John Cronin, Managing Director and Head, U.S. Equity Capital Markets.
John Cronin: Thanks, Michelle. Good to be here.
MK: Welcome, John. Matt Sheehan, Managing Director and Head, Canadian Equity Capital Markets.
Matt Sheehan: Thanks, Michelle. Look forward to our discussion.
MK: Same here. Looking forward to it. And Pete Gordon, Director, Equity Capital Markets.
Peter Gordon: Thanks for having me, Michelle.
MK: First, let's consider the major factors driving market performance year to date. Market expectations for the pace of interest rate cuts have adjusted, and investors know that interest rates could remain higher for longer. Markets, especially in the U.S., have remained pretty resilient. So, what happened?
Let's get into it. Derek.
DH: Thanks very much, Michelle. We've seen evidence of that in the first half performance of this year in terms of the drivers of market activity. We came in, go back to last fall, there was a lot of concern in the bond market about the pace of debt issuance in the United States. The U.S. 10-year yield had risen to about 5%. What kind of uncertainty would that raise for equity premiums and discount rates? And that was a temporary surge and though we've since come off of that peak. It was temporarily driven by the replenishment of the Treasury General account of the Federal Reserve, after the debt ceiling fracas last year. It front loaded a lot of debt issuance and once the market cleared out all that supply, the bond market settled down a little bit, and it could then return to focusing upon when the Federal Reserve would begin cutting interest rates. It was a little bit too aggressive at the start of this year.
The markets were pricing between 150 and 175 points worth of cuts by the end of this year if we go back to January pricing. In part fed by some comments by some of the Fed officials, Governor Waller, for example, who said that maybe March is a live meeting. Once we got past that, the markets began to reassess and this led to the third driver of the market performance so far this year. They reassessed that rate path and trimmed their rate cut expectations because the U.S. economy and the global economy was looking more resilient than feared. And that's good news to the bad news of delayed rate cuts. And so, in terms of the sources of that outperformance, we've had, somewhat embarrassingly for the economics profession, about six or seven quarters in a row in which the U.S. economy has significantly outpaced expectations, and I think that's reflecting an uncertain debate over why that may be. Why is the U.S. Economy more rate resilience this time around than in past cycles? And to me, the consumer is a significant part of that. The lowest debt to income ratios in the household sector in about 23, 24 years. There's still a record low debt service burden, debt payments as a share of after-tax incomes, still a very high mountain of excess cash holdings, and still very resilient job markets. And so, there's still that tendency to keep spending. And so, the equity markets have looked at this and said, okay, we can tolerate delayed, tamped down, pushed out rate cuts, as long as everything else is holding together quite nicely.
And I think that's almost the nice delicate balance that we've been in ever since.
MK: Thanks for those insights, Derek. Matt, how did the markets react, and how do you see it impacting our business?
MS: I'd say it was probably a relative toss up, in terms of expectations for whether the Bank of Canada moved in June or July.
Now that we have seen the first cut from the Bank of Canada, and a pretty strong commitment for further cuts throughout the year, we expect the Canadian equity capital markets to continue to benefit on a flow of funds basis. There's still a lot of cash on the sidelines that needs to be put to work, and that should benefit the market.
I think it's worth noting that, from Hugo St. Marie, our equity strategist in his last investor survey, he noted that in Q4 and Q1, we saw the largest consecutive inflow into equity markets that we have since the beginning of 2021. So that's a pretty material shift in terms of a flow of funds perspective.
When we think about it, as it relates directly to the Canadian ECM landscape, the simple view is when you see a peak in rates, it's typically a great time to buy equities. If we look out over history, the average return in any given year in an equity market is roughly 11%, in the year following a pause by a central bank, specifically the Fed, you usually see that outperformance look towards 19% and then 2 years out, that moves to over 30%. So that expectation is there, and we are seeing people put money into equity markets because of that expected outperformance. That should benefit valuations, and as valuations improve, cost of equity gets better for our issuance clients, and we expect them to become incrementally more active.
At the sectoral level, the Canadian market has historically had a significant contribution for what are often referred to as the bond proxy sectors - the REITs, the utilities, the telcos. These groups on average have contributed on average upwards of 8.5 billion in issuance in any given year. That for the last 2 years has only been 2 billion. So, as these sectors get the benefit of rate declines and what that will do to valuations and their ability to be more active, we expect those sectors will become incrementally more active.
On the flip side to the positivity that we expect in the ECM market, because of rate declines, is the big question about the Canadian dollar. As the Canadian dollar potentially depreciates versus the U.S. Dollar, if the Bank of Canada deviates too far from the Fed, that can hurt the purchasing power of Canadian companies. So, if Canadian companies are out there looking to either buy assets domestically or expand internationally, and their purchasing power is impacted by the Canadian dollar, that could possibly have follow on impacts to the Canadian ECM market.
In general, I'd say net-net, we expect it to be positive for Canadian ECM issuance. Especially in the near term.
John, the Fed decision day in June, attracted a lot of attention as it usually does. What were your takeaways from that?
JC: A lot of the same themes here in the U.S. The market is trading very well with the S&P being at an all time high and investors are still leaning towards two cuts before year end, despite a decidedly mixed dot plot from the Fed. The Fed is being cautious in their communication, but it's hard to ignore the recent inflation data with CPI being at the lowest point in three years. The market sees that and is factoring that into expectations. Investors will continue to focus on inflationary signals, but right now it's full speed ahead and the markets are reflecting that. And the deal markets are reflecting that with, with a good amount of issuance and recovery so far this year, and we anticipate that's going to continue.
MK: Now, Derek, how do you view the likely path forward for interest rates in the U.S. compared to Canada?
DH: Yeah, great question. I'd start off by acknowledging that we have a lot of people listening to this who have seen many rate hike and rate cut cycles and, in many respects, the way in which we're proceeding here is somewhat typical.
Everybody's waiting for somebody else to dip their toe in the pond and you go first, and I'll be right behind you and let's see how it goes. And then once they all start going, they reach a critical mass, and then we start to go down together. And I think we're approaching that stage. And so, transitioning to what it means, having already seen cuts at the ECB, the Bank of Canada, the Swiss National Bank, and number of LATAM central banks, I think we're approaching that point for the Canadian and U.S. Central banks going forward. We have, another 75 points worth of rate cuts from the Bank of Canada this year, and a similar amount of rate cuts in 2025. So down to a policy rate of about 3.25%, from the peak of 5% and for the Federal Reserve from a peak of 5.5%, we expect 50 points worth of cuts this year. And then more of the cutting to unfold next year when we expect about 150 points worth of cuts down to a policy rate of Fed funds rate of about 3.5%.
And so, the way in which the market is translating that, it positions the U.S. Treasury curve as cheap relative to Canada. Discount rates relatively too high in the United States compared, to say Canada, on a go forward basis. The market is just waiting for those first signs that the Fed has enough confidence to dip its toe in the pond and begin that process. And once they do see that, I think you're going to see a bit of a pile on effect into twos, fives, some of the benchmark , treasury yields, and also probably driving down some of the discount rates like a B AA proxy for the corporate bond yield that would feed into the equity markets. And I think we can have a fair amount of confidence in that narrative going forward.
For the United States we're expecting cooling growth. In fact, I have greater confidence in cooling economic growth than I've had in the past 2.5 years. Fiscal policy is turning toward a drag effect. The U.S. dollar should be a bit of a drag effect upon the net trade side of the picture.
We're also dealing with tightened credit conditions that carry lagged effects upon growth. And so, from that supercharged pace of growth, we're expecting to come down to something in line with the long run average potential. At the same time that the supply side is improving through population growth, as well as productivity gains in the U.S. economy.
So cooler demand growth pick up and supply side of the economy, that should be reinforcing in terms of weaker inflation, at the same time that the lagging effects of cooling rent pressures upon the key inflation gauges should also help cool down some of the inflation numbers. So, by the rest of this year, we're expecting the Federal Reserve to see that evidence and to have enough confidence to begin cutting interest rates.
For Canada, I think the curve is probably reasonably fairly priced right now in terms of discount rates going forward. I think the market is saying, okay, we know you have mortgage resets in Canada, we know that you have some competitiveness challenges going forward, but you've got some other things offsetting that, and further traction in terms of, some disinflationary pressures in the economy.
That's not to say we don't have uncertainties going forward. I mean, we have a lot of housing shortages, we have very strong immigration, we still have stimulative fiscal policy in Canada by contrast to contractionary fiscal policy in the U.S. And the United States wage gains are being paid for by productivity. In Canada, wage gains are in excess of weak productivity growth. And so with that kind of a mixture, I still think that we have to be careful, but we can start that experimentation phase toward no longer being in nosebleed territory on policy rates and starting to take out some of the excessive restrictiveness that exists, in money markets. And I think you'll see more of that kind of traction over the rest of this year and on into next year.
It won't be a straight line, but I think we can look to that on a trend basis.
MK: Interesting. Thank you, Derek. I'd like to stay with you for a minute, but let's turn our attention to elections. Elections have already impacted markets this year in places like Europe, Taiwan, Mexico, India. Could U.S. elections unsettle market sentiment? What should investors be looking for?
DH: Yeah, great question, Michelle, and I've been at this long enough to know better than to try to predict election outcomes, to be totally frank. I'm waiting for the results. We have not incorporated the outcome into our forecast in any detailed granular fashion, because the potential policy development in the aftermath could be quite different depending upon who wins the election and critically, what shape Congress takes in terms of the new Congress when it takes effect in January. That could also affect the ability to push through any agenda into a new presidential term.
I do worry about a couple of things, however.
For one, that the bond market is a very different beast now than it was eight years ago. When we were talking about aggressive tax cuts and fiscal debt issuance, it was at a time when the U.S. 10-year yield was about 185, and now it's been well over 4%. And so, in that context, the market is much more attuned to inflation risk and the supply of treasuries and further debt issuance, and I don't think we can be quite as cavalier in saying that the tax cuts will pay for themselves, and so that's one uncertainty.
I think trade policy is another uncertainty going forward, with both presidential candidates and on both of these fiscal policy and trade matters. On trade policy, I'm inclined to believe the tariff plans when I see them, I think there's a lot of bellicose rhetoric and hubris that's out there. It could be that some of the art of the deal mentality and to threaten people and to try to extract better deal terms, but I do think that we have to be very careful on the trade policy side of the picture from a market standpoint. But there are a lot of things that the U.S. economy and the world economy have as advantages this time around.
MK: Now, I'd like to consider how election years typically impact ECM issuance. John, over to you.
JC: Sure, Michelle, and it is going to be an interesting election for sure. We've got two candidates with very different economic plans and policy views in a race that's pulling very tight.
It's typical that you would see some risk mitigation ahead of the election by issuers. And in this case, we don't see this year being any different. If you go back and you look historically at the four months leading up to an election, those same four months - July, August, September, October, tend to be more active than in non-election years. And so, we would anticipate that's going to be the same here. Now, when you look at 2024 year to date, while it is a pickup, certainly in activity over 2023, we're still lagging the 10-year average. So, it'll be interesting to see how much of a pickup we see in the next four months, but it's reasonable to expect that we will.
In terms of how we advise clients around these windows, I think it's important to watch volatility, especially as we get closer to the election. However, with the VIX currently at 13 and the market at or near all time highs, it's hard not to advise clients that taking risk off the table is a good idea if you can afford to be opportunistic. Given the historic issuance trends, we do think that issuers will take advantage of that, but it will depend as well on a positive overall market backdrop.
Matt, what's your thought there?
MS: I really think you hit the nail on the head. It's really not about elections, it's about that future volatility event. So, the elections are there, they're visible and they represent that risk of future volatility and I think you mentioned the resiliency in the market. I think that can't be overstated. We started the year with the market looking for 7 rate cuts from the Fed and now we're looking at 1, maybe 2. And despite that, you have markets hitting all time highs. Our advice to clients, is if you have a good use of proceeds and an acceptable cost of equity, move sooner rather than later and take that risk off the table.
John, what we've been talking here is about the opportunistic issuances. What about IPOs? IPOs take a lot more time to plan and you have to be very thought out about when you access the market. Pete, do you want to talk about your recent IPO survey?
PG: Yeah, absolutely. Thank you.
Recently, we've been out to talk to a number of investors and there's a number of different learnings from this. Ultimate outcome here is that investors are looking for transactions to come to market at reasonable valuations, relative to comps, strong allocations to a mix of different accounts that aren't necessarily all filled to cornerstone accounts and a healthy amount of float, which will allow them to build positions in the aftermarket.
Now, just to get into a couple of the details of the IPO survey, majority of respondents said that they see a significant recovery in the market, in 2025, with potential for a significant recovery after the U.S. Elections. Interestingly, no one said that they saw a significant recovery until the elections were over with.
Secondly, in terms of risk to the IPO market, the majority of respondents said that the biggest risk was weak IPO and aftermarket pricing. So, in other words, not necessarily trading well in the aftermarket or being priced at the right discount relative to comps. However, the second biggest risk was still interest rates and inflation, which shouldn't be a surprise to anyone.
Interestingly, no one saw that global conflict with the U.S. Election was the primary risk to the IPO market. And from speaking to a number of different investors, the rationale behind this is that we've already had a Biden, we've already had a Trump election, and we can more or less understand what either outcome could look like.
And lastly, just on liquidity, the majority of respondents thought that cornerstone investors should be less than half the deal at launch. In other words, they shouldn't necessarily take up the entire IPO. And they would like to see a mix of investors coming into the transaction. And the majority of respondents said that they'd like to see float represent around 20% of the transaction. The feedback that we're getting from investors is that they would like to build positions in the aftermarket and in order to do so, you need to bring a transaction that has the requisite amount of float.
And then, the last part of the survey is we asked investors to rank what sectors they are most interested in. Not surprisingly, tech came out on top, followed by healthcare, and then the remaining sectors were consumer, energy transition, real estate and retail. However, we would expect that tech will likely lead us out of the IPO markets going forward.
MS: Thanks for that, Pete. This is where I would typically jump in and say a lot of intelligent things about the Canadian IPO market, but the reality is we haven't seen an IPO in almost two years. One relevant point in that survey that I would strongly agree with is that as companies as we do see the IPO market return, float in trading liquidity is going to be a paramount important to investors.
MK: Pete, I'd just like to take a moment and talk about the importance of the tech sector.
There are certainly concerns that the U.S. Market could be too concentrated, driven by the leading tech companies and high level of interest on artificial intelligence.
PG: It ties into what we were talking about earlier with the IPO industry survey because the majority of respondents said that the sector they're most interested in seeing IPOs from is the tech sector.
When you look at the companies that are most likely to come to market in the near term and you compare that to say the profile of tech companies that have gone public in the past, they're actually about double the size. So, the names at the front of the pipeline are much larger and they're much more scaled.
The other part that shifted is the request for profitability. So, investors would like to see at least a quarter or two of companies exhibiting the ability to get profitable, and really the definition of that is durable revenue, and the investors would like to see that as a part of an IPO, at least visibility into profitability.
MK: Thanks very much, Pete.
Again, Derek, John, Matt, this has been a great discussion, and while certainly we have to acknowledge there will be some challenges going into the back half of 2024 and into 2025, there's going to be windows of opportunity, and there's certainly a lot of positive elements to consider.
Certainly, looking forward, we've got an easing policy environment. We're also in the current period of muted volatility. And finally, we've got funds flowing into the equity markets. We've had great demand for recent equity issuance in Canada and the U.S. and it'll certainly give us some momentum going into the back half of 2024 and into 2025.
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