Q3 2024 - Market Review
ECONOMIC COMMENTARY
Equity markets advanced for the fourth quarter in a row as of September 30th. That being said, the leadership slipped away from the US tech sector for a few reasons. First, the AI story became more nuanced as observers started to question valuations. Second, the Bank of Japan’s decision to hike its discount rate from 0-0.1% to 0.35% in late July caused a partial unwinding of the carry trade[1],[2] which impacted stocks which had been enjoying the most positive momentum. Third, the growing certainty of a Federal Reserve rate cut in September lifted many lagging sectors that are sensitive to interest rates due to high indebtment such a REITs and Utilities. Against this backdrop, the MSCI All Country World Index[3], the S&P 500 Index, and the S&P/TSX Composite gained 4.89%, 5.78%, and 10.54%, respectively, during the quarter. Despite the pullback that affected AI stocks, the US equity market rally was broad, as nearly 80% of the S&P 500 constituents posted positive returns and nearly 75% exceeded the index performance during the quarter[4]. This contributed to the outperformance of US equity markets relative to Asian and European markets. Separately, emerging markets, which had been underperforming with somewhat surprising consistency in the past few years posted a strong quarter. To this point, the MSCI Emerging Markets Net Total Return Index returned 8.72% in US$ terms. The emerging markets rally was almost entirely driven by the performance of Chinese equities which rebounded in excess of 20% in the 2nd half of September. More on this further.
There was a moment of panic in early August. In fact, the CBOE VIX index even reached the dreaded level of 60. As we didn’t see any single, major, previously unknown negative situation working its way in the system, we chose not to make any portfolio adjustments. We note that the CBOE VIX index dropped back to 15 before the end of the month and markets recovered.
Fixed income markets were revived by softening labor markets and decelerating inflation headlines during the quarter. This led an increasing number of central banks, globally, to initiate or pursue a monetary policy pivot. To this point, the Bank of Canada, the European Central Bank (“ECB”), the Swiss National Bank (“SNB”), Sweden’s Riksbank, and the US Federal Reserve all lowered monetary policy rates at least once during the quarter. As such, the ICE Bank of America Global Government Bond Index and the ICE Bank of America Global Corporate Index gained 3.79% and 4.83%, respectively, during the quarter, and turned firmly positive for the year. Furthermore, the ICE Bank of America Global High Yield Index, which is more sensitive to credit risk developments than to interest rate developments, returned 4.88%: a sign that market participants have confidence that central banks globally will manage to orchestrate a soft landing. The Canadian fixed income market performed in line with the global fixed income markets as the ICE Canada Broad Market Index posted a return of 4.54% during the quarter.
There has been a lot of appetite for cash and other ultra-short duration strategies lately since the yield to maturity on longer dated fixed income instruments, even riskier ones, is lower than the yield to maturity on shorter dated and often less risky instruments. That being said, we want to take the opportunity to reiterate, as we wrote in last year’s 3rd quarter letter[5], that counterintuitively, as central banks continue to ease towards their neutral policy rate, cash and short-term fixed income assets are likely to underperform longer dated instruments, as any reduction in policy rates is likely to disproportionately benefit longer dated instruments.
EASTWINDS
The biggest surprise in the quarter came from China on September 24th, just a few days before the celebration marking the 75th anniversary of the founding of the People's Republic of China. To this point, Beijing announced a massive monetary stimulus package and suggested that a sizeable fiscal package would soon follow. The main features of People Bank of China’s (“PBOC”) policy moves include a 0.20% reduction on the reverse repo rate[6], a 0.50% reduction in the mortgage rate, a 0.50% reduction in the bank’s reserve requirement ratio[7] and, last but not least, a novel 1 trillion Yuan lending facility (≈ 150 billion US$) for non-bank financial institutions[8] to buy stocks. The last move was specifically designed to stabilize the ailing stock market.
Whilst details around the fiscal policy move remain to be seen, the monetary piece alone is almost on par with the cumulative gradual monetary easing adjustments that the PBOC has done in the past year. Moreover, the aggregate monetary easing adjustments made from early 2023 through September 24th dwarf the monetary easing engineered by the PBOC at the onset of the Covid-19 pandemic and during the 2015 sell-off. This implies that the politburo finally admitted that the economy was in a more precarious state than it had been at any point in the prior 10 years and that it was not going to recover on its own. As such, it is legitimate to ask if this massive announcement was designed to spur growth or simply to avert a depression.
Assuming that the government follows through with a comparable fiscal stimulus package, this could be sufficient to boost Gross Domestic Product (“GDP”) growth back above 5% for 2024, according to Capital Economics Chief Asia Economist, Mark Williams[9]. It is worth noting that Goldman Sachs and Citigroup had, as recently as September 16[10], lowered their expectations to 4.7% for the year. It is important to note that, at the time of writing (October), China’s Finance Minister has yet to confirm the upwards to 2 trillion Yuan special government bond issuance that the market has come to expect. For this reason, mainland China equity indices, which had rallied by as much as 30%, have retraced more than half those gains in the days following the re-opening of the markets after a week’s break.
We do not have a view on the Chinese equity market. We have always found it too policy dependent and, by corollary, unpredictable. As such, we much prefer participating in this segment via hedge funds which emphasize alpha-driven, non-directional trading strategies as opposed to speculative, directional strategies. That does not mean that mainland China equities cannot climb further. After all, we have recently been reminded that it does not take much for a market to spike when stocks are dramatically under owned, and sentiment cannot fall further. But markets could also stagnate further. After all, it is not obvious to me how quickly confidence can be restored after a 4-year long real estate crash destroyed the savings of a generation and the application of the “common prosperity” reform hurt some of the most widely held stocks.
Nonetheless, more relevant to us is where will the side effects of China’s dual policy adjustments be felt because China remains the 2nd largest economy in the world. As the government has yet to reveal how the various stimulus pieces will be deployed, visibility remains low. For instance, will the government favor domestic consumption (which would be better for South Korea), domestic industrial capital formation (which would be better for exporting countries such as Australia and Indonesia or regions like South America), or digital investment (which would likely favor Taiwan)? It is hard to say, but we highlight that all these markets have responded positively, at least modestly, so far.
IS THE VENTURE CAPITAL DOLDRUM OVER?
The Venture Capital segment of the capital markets draws much attention. After all, this is one of the segments that has delivered the highest returns over the past three decades. Since early 2021, however, venture capital has been experiencing a prolonged downturn. To be specific, here is a summary of what the data collected by Pitchbook[11] and by Crunchbase through early October suggests:
Investment activity: North American Venture volume (in US$) was down 10% quarter on quarter (“QoQ”) in Q3-24 as OpenAI’s widely expected 6.6 billion round closed early in Q4-24. More importantly, volume had been climbing in Q1-24 and Q2-24 from the multi-year lows of Q4-23. In Europe and Asia, however, funding volume continued to decline sequentially in Q3-24, to reach 4-year and 10-year lows, respectively. Artificial Intelligence (“AI”) startups are capturing an increasingly large portion of aggregate investment volume (nearly 40%) while other sectors are proving less popular;
Exit activity: Overall venture capital exit volume is on track to reach roughly 100 US$ billion this year. This would be similar to the 2022 and 2023 exit volume, but it would be the lowest volume since 2016 and would equate to roughly 15% of the 2021 exit volume. The number of exits is also tracking close to 10-year lows. Exits through Initial Public Offerings (“IPOs”) remain challenged. This year, there have only been 4 noteworthy venture capital exits through IPOs[12] and their performance has been mixed, at least relative to small capitalization stocks. Similarly, corporate mergers and acquisitions have been subdued and have been showing few signs of recovery, with deal volume in US$ and deal count tracking lower than either 2022 or 2023;
Fund raising: The exit drought hampers fund raising efforts. The industry, as a whole, is on track to raise between 75 and 100 billion US$ in 2024. While more capital may be raised than last year, it would still be barely 50% of the capital raised in 2021 or 2022. The number of distinct venture capital funds being raised, however, is tracking towards roughly 500, which would represent a decline of 40% from last year and nearly 70% from 2021 and 2022. We highlight that the environment is particularly challenging for smaller funds and first-time funds as the proportion of total volume captured by established managers is at a 10-year high;
Liquidity: The median Distribution to Paid-In capital (“DPI”) for venture capital funds raised between 2019 to 2022 is 0.0x and that of those raised between 2015 and 2018 is only 1.0x. Moreover, the average annual distribution, as a percentage of net asset value (“NAV”) for seasoned funds, has been barely above 5% as compared to an historical average that exceeds 15%. This leaves investors facing a cash flow deficit (distributions less contributions) exceeding 40 billion. Overall, industry dry powder now exceeds 300 billion US$, an all-time record. The two thirds of it comes from funds raised between 2020 and 2022. At the current pace, it could take nearly 2 and a half years to deploy it: a strong indication that funds are either struggling to find good opportunities or that they are not comfortable with the price;
Valuations: The Venture Capital backed IPO index price-to-sales ratio has declined from an average of 12.6x in 2021 to 4.9x this year. This is closer to the more reasonable pre-2020 average. The median and average discounts to the last round have improved to 31% and 24%, respectively, from nearly 50% in early 2023. While the multiple of sales may have bottomed and the discounts to last financing round have improved, the supply and demand imbalance in the industry persists.
All things considered, the venture capital industry seems to have stabilized, and there are green shoots of recovery. Nonetheless, we believe that there are broader challenges that may not be fully priced in. These include the following: first, we have gone from a globalizing world to a multi-polar world in which building redundancies may be more rewarding than maximizing efficiencies. Second, governments globally seem to have become more preoccupied about cross-border data flow and ownership. The European Commission’s recent decision to ban its staff from using TikTok or Apple’s censorship in China over security concerns may only be preludes of what comes next. Lastly, we wonder if the General Partner (“GP”) skillset that has worked in a pre-pandemic, near infinite low cost of capital will be sufficient. More tools may need to be developed.
With that in mind, our view is that while the next couple of venture capital vintages (2025, 2026) will probably turn out better than the 2020-2022 vintages, they will probably not be as good as the pre-2020 vintages. Because of that, this is not our preferred space for new commitments and for investors intent on making incremental commitments in the space. Therefore, we advocate leaning towards larger, established managers with a demonstrated exit track record.
COUNTDOWN TO IMMORTALITY
I promise that this quarterly letter is not going to turn into a book review column, but I want to make an exception here to touch on Ray Kurzweil’s new book, “The Singularity is Nearer: When We Merge with AI”, published earlier this year[13]. For some context, Kurzweil is a prominent inventor, futurist, and author, known for his pioneering work in artificial intelligence more than 40 years ago. As an inventor, Kurzweil is known for several groundbreaking inventions, including the first assisted reading machine for the visually impaired, which converted printed text into speech, and one of the first music synthesizers to accurately replicate the sounds of real instruments. These inventions earned him the National Medal of Technology and Innovation and entry into the National Inventors Hall of Fame. As a futurist and author, Kurzweil gained fame when he published “The Singularity is Near”[14] in which he argued, among other things, that computers would attain human level intelligence before the middle of the 21st century.
Prompted by the advent of ChatGPT and other advancements in the field of artificial intelligence, Kurzweil argues that the moment when artificial intelligence reaches human level intelligence will happen before the end of the current decade. Kurzweil is an unapologetic optimist but, given the pace at which the revolution is occurring, his prediction is not as outlandish than it would have seemed a few years back.
Still, the chapter that caught my attention the most is about nanotechnology. In this chapter, Kurzweil envisions a future (some 20 years from now) where advances in nanotechnology enable the repair and enhancement of human biological systems at a cellular level. This includes the use of nanobots to monitor and repair damaged tissues and organs, to fight diseases, and even to reverse the aging process. Kurzweil argues that these developments could significantly extend human lifespan and, more importantly, quality of life. This could lead to scenarios where individuals maintain youthful vitality for... ever.
Leaving aside concerns about overpopulation, resource allocation, and inequality, it is not difficult to imagine that these technologies could have an even bigger impact on life-expectancy improvement than the impact that the broad adoption of modern medicine has had since the early 1900s. If so, it would totally reshape long-term economic growth projections and force everyone to rethink the retirement age concept, which has remained essentially unchanged since it was introduced. This, it turn, would force us to make dramatic adjustments to our long-term capital markets assumptions.
Dimitri Douaire, M. Sc., CFA
Chief Investment Officer
[1] A strategy that involves borrowing in a country with low interest rates and investing the proceeds in assets that promise a higher expected return. An unwinding of a carry trade occurs when participants decide to sell the assets purchased and reimburse the sums borrowed.
[2] In an August 2nd article titled “JPY: Peeling back the carry trade onion”, ING’s Chief Economist CIS, Dmitry Dolgin, and Global Head of Markets & Regional Head of Research for UK and CEE, Chris Turner, argued, looking at data from the Bank of International Settlements, that cross-border loans originating in Japan should be the most relevant for the carry trade and that they amounted to 157 trillion Yen (1 trillion US$ equivalent) as of March 31.
[3] Local currency returns unless specified otherwise
[4] Source: Bloomberg
[5] https://www.patrimonica.com/all-news/q3-2023-market-review
[6] The reverse repo rate is the rate at which the PBOC borrows from commercial banks. A reduction in the reverse repo rate indirectly injects liquidity in the monetary system because it augments the incentive for commercial bank to lend instead of depositing it with the PBOC.
[7] The reserve requirement ratio is the percentage of deposits or assets that banks must keep in cash. A reduction in the reserve requirement ratio increases commercial banks’ lending capacity.
[8] Examples of non-bank financial institutions include insurance companies and brokers.
[9] Source: Reuters
[10] Idem
[11] Pitchbook, NVCA Venture Monitor Q2-2024
[12] Astera Labs, Reddit, Rubrik & Ibotta
[13] Kurzweil, Ray, “The Singularity is Nearer: When We Merge with AI”, (2024)
[14] Kurzweil, Ray, “The Singularity is Near: When Humans Transcend Biology”, (2005)