Quarterly Capital Markets Podcast

Warren Estey:

Hi. I'm Warren Estey, Head of Investment Banking at BMO Capital Markets, and this is our quarterly Capital Markets podcast.

Speaker 2:

Welcome to Markets Plus where leading experts from across BMO discuss factors shaping the markets, economy, industry sectors, and much more. Visit bmocm.com/marketsplus for more episodes.

Warren Estey:

We're going to cover a lot of ground today and to help me do that, I'm joined by two colleagues, Eric Benedict, who's Global Co-Head of Equity Capital Markets, and Ian Lyngen, who is our rate strategist and host of the popular podcast, Macro Horizons, which you can get weekly on any of your favorite podcast apps. Check it out. All right, let's get into it. Eric, give us your view on the state of the equity markets right now.

Eric Benedict:

Thanks, Warren. Thanks for having me. And hello everyone. I would say surprisingly strong despite uncertainty around interest rates, geopolitical events, you have the S&P 500 up 20% combined with low volatility leading to a resilient equity market that is poised to rally even further into year-end. The 18% gain for the index for the first nine months of the year puts it in the 84th percentile for performance, which typically leads to an additional six percent rally in the fourth quarter. Most importantly though, participation levels both from a performance and fundamental perspective have broadened significantly the past two months, which is a significant positive, especially as we think about the new issue market.

With the 10 largest market cap stocks having dominated performance the last two years, starting the third quarter of 2024, we've seen the rest of the index outperformed by 700 basis points. In addition, 339 S&P 500 stocks have outperformed the broader index, the highest level we've seen in 22 years. Lastly, while valuations are arguably full, we're seeing next 12 month EPS growth rates for the index X to top 10 suggesting double-digit growth rates, the highest we've seen in three years. So while we see periods of price consolidation as investors digest macro events, markets feel supportive. Net net, we are operating in a soft landing market outlook. Expect this environment to hold until the Fed gets offside with market expectations around economic reports and/or Q3 and Q4 guides change the fundamental outlook as it relates to earnings growth. But things feel good.

Warren Estey:

Okay, love that. So with that macro backdrop, how would you characterize capital markets activity year to date?

Eric Benedict:

I would say accelerating and on a path to normalization. We're by no means back to, I would say historic average levels of issuance. That said, 2024 has been markedly better than what we saw in 2023 and coming out of 2022. Just by the amount of capital raised, we've seen a 51% increase in IPO proceeds raised in '24 versus 2023. Follow on proceeds are up 36% versus '23. And the convertible market, given we had elevated interest rates in the impact on unsecured debt, borrowing costs up 41%. So across the board we are seeing levels consistently higher than 2023. I would caution however, as we think about the five-year average from an IPO perspective, we're still running 35% below sort of the five-year average there. So again accelerating, but on the path to normalization.

Probably the most important thing we've seen in the equity markets, new issue markets, this year has been the performance of large IPOs. So if you look at billion dollar IPOs in 2024, they're up on average 31%. That's versus 21% for all IPOs. So typically larger IPOs have been more of a challenge to get done just given the sheer size and the amount of capital to get done. But again, we are seeing an outperformance from a larger cap, larger IPO perspective, and we expect that to be critically important as we look forward to 2025 in terms of the size of the IPO backlog and the composition there.

Warren Estey:

And how do sponsors play into all of those metrics or how would you characterize their activity year-to-date? We've heard consistently that monetizations haven't been at the level that I think anyone would like, but how would you characterize it?

Eric Benedict:

When I think about the sponsors and their levels of activity in the markets, call it really a tale of two cities. So from an IPO perspective, to your point, very quiet. So only about 5 billion of sponsor IPOs are priced in 2024. That's only, call it, sub-20%, 18% of the U.S. IPO market when that number should be typically closer to 40%. However, and again this gets back to our point around accelerating new issue activity and what we expect for 2025 and '26, sponsors have been a lot more active monetizing existing holdings that have already gone public over the last three to five years.

Now you could argue that the market's been closed since '21, '22. But clearly what we see in the markets around valuations, individual securities trading up, we've seen sponsors be north of 40% of all secondary proceeds or follow-on proceeds sold in 2024. That's a significant increase than what we would typically see. And we've seen a lot of repeat issuers. For example, we've seen certain sponsors monetize the same company, their holdings, three or four times over the last 12 months. What that is telling you is, one, valuations are probably at a point where sponsors are going to be consistently monetizing and capital to their LPs. And two, they're sort of in a hurry.

Warren Estey:

So taking all of that, taking the macro environment and taking the activity, any trends you'd highlight or lessons learned?

Eric Benedict:

Yeah, I think the key trend, and this I think will be a significant positive for both corporates and investors and sponsors, is that when we look forward to the new issue markets and the IPO market more specifically over the next two to three years, it's really going to mirror an IPO market that preceded the COVID activity of 2122. And again, some of this seems fairly straightforward, but when we think about the IPO market, the consistency in what can get done, despite market conditions, it gets down to really best in class management teams, best in class, I would say corporate strategy, whether that's growth, whether that's capital structure, whether that's positioning relative to the public comps that are out there. And again, I think in '21, '22 period, a lot of companies listed without the ability to perform in the equity markets. They missed earnings, they missed estimates, they had upside down capital structures. Clearly that led to very negative price performance.

What we're seeing in '24, and to my earlier point around the billion dollar is performing, is investors are more discerning, but they want to put capital to work across larger, more scaled, more visibility from a financial reporting perspective. Like I said, getting back to sort of the basics of what makes a good public company. So again, I think that trend, Warren, is going to be here and here for a while.

Now we have the healthcare, life sciences, capital hungry asset class, that sector, which can comprise, call it, 20% to 30% of the IPO market. That will be consistently, I would say present. But again, those are, I would say, more earlier stage asset classes or asset plays that a certain subsect of investors that are always going to be attracted to.

Warren Estey:

Okay, I appreciate that perspective. That's great. So Ian, give us your view of the recent Fed decision to start with a 50 basis point cut and what that portends through year-end.

Ian Lyngen:

Well, I think it's a fascinating moment for monetary policy. We have a Fed that has kick started a normalization campaign with a arguably larger than expected 50 basis point rate cut. Now it follows intuitively that the market has subsequently priced in roughly 50/50 odds of another half point move in November and then subsequently December. Our base case scenario is that it does ultimately come down to the economic data and that will leave attention focus squarely on the evolution of the employment landscape and whether or not the unemployment rate stops rising at 4.2 or if we see that long awaited acceleration to 4.4, 4.5 at which the Fed will look brilliant for having started the cutting campaign with a half point move as opposed to it feels like at the moment the Fed has somewhat gotten ahead of the cycle.

Warren Estey:

Got it. So how does this end? What's the end game? When do we ultimately get to neutral?

Ian Lyngen:

Neutral is going to be a moving target that we won't know until we actually pass it. And I think that that's important context when we think about what the Fed is attempting to message. What they're attempting to achieve is a very rare soft landing. The unemployment rate hasn't spiked. We continue to see the US consumer on relatively strong footing. GDP remains well into positive territory and inflation has finally started to moderate. The issue at hand is that monetary policy impacts the real economy with a lag. So for all intents and purposes, the Fed is cutting now for the second half of 2025. Said differently, the Fed is going to have very little control of what is about to occur in the real data over the course of the next several months. The one thing that the Fed can influence is the overall state of financial conditions. And we have seen this feedback loop consistently where the Fed begins cutting, equity markets rally, financial conditions ease.

Now, the risk that this creates is that as we have seen over the course of the last couple of weeks, the market is effectively easing for the Fed. And there's a big difference between cutting rates back to neutral and shifting into actual easing territory. So as the equity market eases financial conditions, there will be a point in which the Fed needs to push back against that narrative. And I think that that's going to define the first half of next year.

Warren Estey:

Okay. So given all that and given the fact that your views are potentially different than the Fed's views, give us your sense of the broad economic outlook.

Ian Lyngen:

I'm very much in the camp that there is another leg of this cycle yet to be realized. When we look at the pace of consumption, the aggregate numbers are fine. But the aggregate numbers are masking the fact that the bottom two quartiles of households are beginning to struggle. We have seen an increase in delinquencies, we've seen an increase in credit card utilizations, all of which suggest that once the pendulum of optimism swings toward the downside, that we could see a more significant pullback by the US consumer. And when that occurs, that's when firms take a hard look at the size of their labor force and one would expect more significant pain on the labor side. And to some extent, that's been our base case scenario for the last 12 months. And so the fact that it hasn't come to fruition and the Fed, along with other major central banks with the exception of the Bank of Japan, is cutting rates really speaks to this idea that they're attempting to stick the landing.

Warren Estey:

So one of the great things about your chair is that you get to think about Fed policy, you get to think about economics, but part of all that is that you've got to think about the broad geopolitical landscape as well. So what's your current view? There's a lot going on.

Ian Lyngen:

That's very, very much the case. It's interesting, we tend to use the phrase geopolitical as overseas activities, but at this moment, geopolitical can probably most aptly be defined as focused on the presidential election in the U.S. And I think it'll be very interesting to see how the composition of Congress, in addition to who takes the White House, plays out in November. Our base case scenario is regardless of who takes the White House, the biggest impact on the real economy and the Treasury market will occur in the event that there's a sweep in either direction. That will leave the winning candidate and their party with the assumption that they have a mandate to increase spending. Whether that's in the form of tax cuts or other programs remains to be seen and is largely party dependent. At the end of the day, however, if we find ourselves in a scenario where there is some mix in Congress, then there will be a lower likelihood of major initiatives and as a result we would expect that it would be less of an event for the U.S. rates market.

Shifting overseas, however, I've been very surprised that a lot of the geopolitical uncertainties associated with the Middle East have yet to translate into significant price action in one direction or another. Recall that the developments in Ukraine were largely associated with an increase in inflationary risk and a run-up in energy prices. We haven't seen the same price action linked to the Middle East. What we have seen is we have seen increased growth concerns from other regions. China, in particular, is very much on the radar when we think about pockets of risk for the broader global growth profile. Easy for me to say.

Warren Estey:

So Eric, Ian mentioned the election. How will the election affect the equity markets from your perspective?

Eric Benedict:

It's a great question. Typically what we've seen during election cycles is a very modest slowdown in issuance both from a follow-on and an IPO perspective. If we take a look at 2016, 2020, call it about a third, about 30% of issuance, happens in the months of September, October and November, with September and October typically being more active than November. Now there's a number of different considerations in around holidays and so forth that can drive windows from an IPO perspective. But typically we've seen very little slowdown.

Now you could argue 2020 you would've had more of a slowdown. I think that was counteracted by the increase in the acceleration of activity coming out of COVID. So you could argue that issuance levels were artificially high. So maybe that helped ensure against a slowdown, given some of the noise around the 2020 election.

I think Ian's points in and around timing of economic activity and what's happening with the consumer is an important one. And I think what we saw coming out of some of the data readouts in August was a marketed change in the sense of urgencies from issuers to get ready to go, whether it was the end of '24 or the first half of '25. So again, I think the election, to Ian's point, depending on the outcome, and hopefully it's a smooth transition or non-transition, I think those are the kind of activities that would probably impact issuance. But based on timing discussions, based on activities we're seeing in the market even today, we're not expecting a significant slowdown from an issuance perspective.

Warren Estey:

Okay. Last question. Top few macro concerns. Ian, you want to go first?

Ian Lyngen:

Sure. The number one concern that I have is that the U.S. economy faces another round of reflation, comparable to what we saw at the beginning of this year, comparable to what we saw at the beginning of this year, there are enough indications that there could be pockets of sticky inflation that then translate into an environment where the Fed is cutting rates but inflation is creeping and higher. That will create a very meaningful policy conundrum for Powell. And I think from a macro perspective, that's a risk that's very much on our radar and would translate through to higher rates at a moment when, generally speaking, the market expects yields to be falling over the course of the next 12 to 18 months.

Warren Estey:

Eric, you want to venture one?

Eric Benedict:

I think interest rates, when I look at the IPO backlog, and we talk a lot about sponsors, there are $20 plus billion IPOs that want to come in let's call it the next 12 to 18 months. And it could be more than that. That's significant. So sponsors own a number of very large and for the most part, high quality assets that are too big for the M&A market. They're just too large to be sold to either another sponsor or to a strategic.

Now what does that mean? It means they have to go public if they want to get liquidity for their investors. One of the things that has been a trend, and I think the sponsors have been super disciplined, and the closing of the IPO market over the last couple of years has probably been a benefit to those assets because they've been forced to delever, forced to think thoughtfully around margins and growth and the different takes that you see there. So we're on a path right now for some large assets to come public that should be public. But if you're in a interest rate environment that is actually increasing or has a little bit of uncertainty around it versus our expectation that borrowing costs are coming lower, that could significantly curtail those assets being able to go public.

Warren Estey:

Yeah. Okay. Look, why don't we wrap it there? That was great. We covered a heck of a lot of ground in a few short minutes. Eric, Ian, thank you for joining me today. And we hope that the listener found this value-add informative. Thanks for listening.

Speaker 2:

Thanks for listening. You can follow this podcast on Apple Podcasts, Spotify, or your favorite podcast app. For more episodes, visit bmocm.com/marketsplus.

Ian Lyngen:

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