Canadian equities have performed well amidst a volatile market backdrop. In British Pounds, the Fund generated a total return of 3.4% in July, which was in-line with returns of the Benchmark and the TSX Composite Index.
There is a confluence of factors that have contributed to the market recent volatility. In the political sphere, we had a failed assassination attempt on a U.S. presidential candidate, a sitting President decide not to run for a second term, and a surprise election result in France. In geopolitics, tensions between Israel and its neighbouring adversaries have ratcheted higher following the assassination of a top Hamas political leader on Iranian soil. In currency markets, the Bank of Japan unleashed a massive unwind of a crowded carry-trade with a surprise rate hike. And finally, weak manufacturing and jobs data in the U.S. has stoked recession fears and raised expectations of Fed rate cuts.
These developments have spurred a massive factor rotation in recent weeks. Mega-cap growth stocks, which were market leaders in the first half of the year, have experienced outflows in recent weeks. Canadian equities have benefitted from the rotation, having outperformed the S&P 500 by 4.7% in July. There are several factors that have contributed to this outperformance, with the main driver being lower interest rates. The Bank of Canada cut short-term borrowing rates for a second consecutive meeting in July and signaled further easing ahead. We expect this tailwind to persist over the medium-term as investors redeem cash and cash-like alternatives whose yields are expected to decline over the coming months. The market is currently pricing 3 to 4 more rate cuts from the BoC before the end of the year and nearly 7 total cuts over the next twelve months.
Real Estate has been the biggest beneficiary of the recent rotation. The TSX Real Estate sector returned 10.6% in July – its best monthly return since November 2020. In addition to interest rates shifting from headwinds to tailwinds, Q2 earnings have confirmed that REIT fundamentals remain very solid. For example, Choice Properties, the Fund’s largest REIT position, reported 48.2% increases on new leases, with uplifts of 13% in its retail portfolio and 106% for industrial properties. Despite quarter after quarter of robust fundamentals, REITs are still very cheap on a historical basis. We estimate that our holdings are trading below 14x FFO on average – a 4+ point discount to where they traded before the Bank of Canada started its hiking cycle in March 2022. Canada’s population grew 3.2% in Q2 compared to the same time last year and, unlike the U.S. market, supply has not kept pace with robust demand. This should result in continued growth in rents and earnings.
A resurgence in M&A activity is sending signals to investors that confidence is building in the Canadian market. The number of deals has risen for three consecutive quarters with robust activity across multiple sectors. In the first half of the year, there has been over C$80 billion of M&A activity in Canada, with nearly C$60 billion of that occurring in the second quarter. Several of our portfolio holdings have been opportunistically acquiring assets as the M&A market thaws. Most recently, Tourmaline announced an agreement to purchase Crew Energy for C$1.3 billion in a move that strengthens its position as Canada’s largest gas producer. We expect further M&A activity to boost investor sentiment as it is generally viewed as a positive sign of growth, confidence, and potential profitability.
