What Happened in Q3 2023

Date postedOct 18, 2023

What happened

After a strong first half of the year, most major markets experienced a decline in the third quarter. Higher-than-forecasted GDP and substantial employment numbers leading to higher interest rates all contributed to a challenging market environment.  Global inflation rates continued to trend downward from their previous highs, with some countries experiencing a slight upward shift in inflation, mainly due to housing costs and energy price increases. Economists and forecasters increased the likelihood of a hard landing in the US and across global economies, with public markets reflecting this with weak performance as assets were repriced. In the private space, aggregate fundraising within private equity, infrastructure, and real estate remained low, reflecting the current economic conditions and higher rates. Private credit also saw a slowdown, but to a lesser extent, given the favorable lending environment. 

While still positive for the year, US equities saw a pullback during the quarter as the enthusiasm over a soft landing diminished and the reality of rates staying “higher for longer” set in. The information technology sector was the weakest sector over the quarter, with most of the “Magnificent Seven” (Apple, Alphabet, Meta, Amazon, Microsoft, Nvidia, and Tesla) posting negative returns and taking the market with them. Specific to the S&P500, these “Magnificent Seven” stocks provided most of the index’s total return YTD, with the S&P500 returning 12.8% vs. the S&P500 Equal Weight Index returning only 1.6% in Canadian Dollar terms, further indicating high concentration within the index. Energy and commodities were some of the only safe havens during the quarter, rising sharply amongst oil production cuts from Russia and Saudi Arabia.

The US markets slightly outperformed their global counterparts, partly due to the strength of the US dollar, with the MSCI ACWI declining by 1.2% (in Canadian terms) over the quarter. Major equity markets in Japan and the UK showed positive local currency returns over the quarter, in part due to Japan’s better-than-expected GDP growth and the UK’s relatively large tilt towards energy. Emerging markets posted negative returns over the quarter, primarily impacted by continued weakness in China’s economy and concerns around the real estate sector.

Global bonds also struggled over the quarter, as bond market participants grew more confident that rates are approaching their peak in the hiking cycle and shifted their focus to how long rates will stay at restrictive levels. Fiscal instability within some major markets, specifically the US, Canada, and the Eurozone, continued to concern bond investors, explicitly surrounding the size of their fiscal deficits. This was reflected across the yield curve, with long-term rates rising faster than short-term rates, indicating potential future turbulence in the economy ahead.

While the private markets saw a reduction in fundraising activity over the quarter, private managers are sitting on quite a bit of dry powder. Private real estate values remain rich, with office and industrial real estate showing increasing vacancies and residential and multi-family showing decreasing vacancies. Private equity exits remained at a standstill, but the IPO market started seeing signs of life over the quarter. As mentioned, private credit continued to see increased demand as traditional lending conditions continued to drive borrowers to seek alternative sources of financing.


Strategic Income Pool

The quarter witnessed a robust performance in the Strategic Income Pool, recording an impressive gain of approximately 3%, significantly surpassing its benchmark, which experienced a decline of 3.8%. Notably, the substantial gains were driven by various holdings in the pool, particularly in US residential credit and private debt.

Private debt has been a focal point of industry discussions throughout this fiscal year, and for good reason. Amidst the most rapid rate increases seen in the past four decades and the Federal Reserve's commitment to a "Higher for longer" interest rate policy, private credit has emerged as an attractive investment. While the concern with higher rates revolves around borrowers facing increased interest payments and potential defaults, it's crucial to highlight that our portfolio's private debt investments predominantly consist of senior secured 1st lien loans. In case of default, these loans are strategically placed at the highest level of capital stack, serving as a safeguard to mitigate potential risks.

Furthermore, it is imperative to underscore that our managers actively engage with borrowing companies, meticulously analyzing their financial statements and steadfastly upholding established covenants. This vigilant oversight serves the dual purpose of continually evaluating the financial health of these businesses and proactively addressing any potential downsides. Given these efforts, the risk-adjusted returns derived from this asset class remain highly appealing.

Regarding allocation, the pool experienced an uptick in private credit and music royalties’ exposure. Apart from expecting further capital calls from managers, we forecast additional increases to private credit as we strategically reallocate more funds to this promising asset class.


Real Asset Pool

The real asset class registered a 0.7% return for the quarter, showing a year-to-date increase of 4.5%. The relatively modest performance in the quarter can be attributed to the predominantly flat performance of the pool's agriculture and private infrastructure holdings. Nevertheless, the distinctive features of the real asset pool, marked by remarkably low volatility and correlation to public markets, function as a robust safeguard during periods of uncertainty.

Looking ahead, we anticipate a "harvesting" phase for some of the pool's holdings in the upcoming quarters, potentially yielding incremental returns. While certain holdings within the pool are expected to contribute significant alpha over the next several years, their current value has not yet fully materialized. The managers overseeing these holdings actively engage in value-added initiatives, laying the groundwork for substantial future value. Acknowledging the inherent time dynamics of assets like private infrastructure and real estate is crucial, emphasizing the necessity for a longer-term outlook when dealing with this asset class.


Strategic Growth Pool

The portfolio demonstrated noteworthy performance in the quarter, recording a notable gain of 4.2%. This strong growth can be attributed to various factors, with the resilience of the US economy in the first half of the year being a significant contributor. It's worth highlighting that the positive effects of the robust US economy on the portfolio took some time to materialize, as is typical with the lag effect associated with private equity investments. Consequently, the gains are now evident in the portfolio's overall performance. It's important to acknowledge that, despite the strong performance exhibited by many pool components, the venture capital exposure within the pool performed poorly. This aligns with the broader trend observed in this asset class over the past year.

Towards the end of the quarter, we observed an uptick in capital calls from our managers, indicating their identification of attractive opportunities to acquire assets at discounted prices and to enhance businesses within the current challenging economic landscape.

For our primary investments, opportunities have arisen due to the high cost of capital, placing additional financial strain on businesses. Faced with these pressures, businesses often explore options such as partial equity sales or complete acquisitions. Private equity firms are well-positioned to intervene in such scenarios, implementing strategies to improve cost efficiency, enhance revenue, and generate higher returns.

Conversely, in our secondary investment strategies, we find ourselves in a buyer's market. The surge in private equity allocations by pension plans in 2021 and 2022 has created a scenario where many of them need to rebalance their portfolios. To maintain their desired asset allocation, divesting holdings on the secondary market becomes necessary, often at a discounted rate. We are pleased to report that several secondary managers have surpassed expectations this quarter, setting the stage for a robust year of returns.


Canadian Equity Pool

The Kinsted Canadian Equity Pool faced challenges in the quarter, experiencing a decline of 4.1%, trailing its index by 1.5%. Although the relative performance in the quarter was subpar, the pool's year-over-year results were within 0.5% of its benchmark. The pool's consistent alignment with the TSX in the longer term underscores the effectiveness of its investment strategy and the steadfast adherence to a proven investment process.


Global Equity Pool

The initial half of the year saw a surge of optimism in the public markets, driven by expectations surrounding artificial intelligence and the outlook for a soft economic landing without experiencing a recession. However, as Q3 unfolded, this enthusiasm decreased, leading to a decline of -3.40% in the MSCI ACWI for the quarter and a further drop of -4.14% in September.

As highlighted in our previous quarterly commentaries, strategic adjustments were initiated in the global equity pool to substantially reduce relative volatility compared to its benchmark. The implementation of these changes is now largely complete, including the introduction of several new managers into the pool.

Our tactical positioning continues to be defensive, with approximately 15% of the pool allocated to a US Equity Value manager. Additionally, we continue to hold around 15% in cash, a position upheld throughout the year. Our conviction remains unwavering despite the possibility of being early in predicting an impending recession. We anticipate that as market conditions deteriorate, our cash holdings will provide valuable opportunities for strategic investments.

Explore Kinsted's Q4 positioning and perspective as we kick off the quarter. Click to learn more.


Food for thought: Over the past 80 years, a recession has occurred in the US every time the unemployment rate has risen by 1/3 of a percentage point.

Explore Kinsted's Q4 positioning and perspective as we kick off the quarter. Click to learn more.