Second Quarter 2024 Capital Markets Perspective

Semis again stole the show in equity markets, with fixed income generating solid gains and commodities losing ground in what is becoming an increasingly uncertain economic environment in a world experiencing its fair share of political chaos.

While the June jobs number exceeded expectations, the unemployment rate did inch up to 4.1%, as the participation rate for the prime-age workforce (25-54 years old) continues to rise. Average hourly earnings came in at 3.9% year-over-year, which is in line with expectations and ahead of inflation. Further, S&P Global reported that “The early PMI data signal the fastest economic expansion for over two years in June, hinting at an encouragingly robust end to the second quarter, while at the same time inflation pressures have cooled. The PMI is running at a level broadly consistent with the economy growing at an annualized rate of just under 2.5%.”

KKR’s quarterly update pointed out that we just experienced the quickest rebound in jobs of the last four recessions. It took about 28 months to get back to peak, whereas, in contrast, it took 76 months after the 2008 recession. But the interest rate environment, among other things, is definitely taking a toll on corporate America. S&P Global data indicate that thus far this year, we’ve already seen the highest number of bankruptcies – 275 – since 2010. And the inventory of new single-family homes continues to climb as sales have slowed due to high prices and high mortgage rates.

The economy has repeatedly surprised to the upside, market participants have consistently gotten the interest rate picture wrong, and the stock market has grinded ever higher, but the Fed’s efforts are bearing fruit. The entire point of the rate hike campaign was to slow growth. And just as we are beginning to see that happen, U.S. investors are as “all in” as they’ve ever been, with household stock allocations hitting an all-time high, per a report from Ned Davis Research. That could very well be a good thing if the Fed is able to pull off an extraordinary feat (to the chagrin of an army of vocal Fed critics), but when the market is reliant on an ever-smaller number of names to keep it going, as was the case at the end of the Tech Bubble, that should give investors pause.

What happened in the markets during the quarter?

EQUITIES: SEMIS HIT THE AFTERBURNER BUTTON

While it was an excellent month for U.S. large cap growth stocks and emerging market equities, just about everything else ended in the red. The S&P 500® Growth Index gained about 7% while its value counterpart fell by 65 basis points (bps). In addition, small growth and value, international growth and value, and China all ended lower. The market’s obsession with semiconductors would seem to be bordering on the excessive, as that industry group was up another 9.9% for the month and has gained 71% year-to-date, absolutely dusting every other industry; the next best-performing industry group is Media, which has gained 28% YTD.

According to JPMorgan, the U.S. concentration in global equity indices is at an all-time high, ending at 64% of the MSCI All Country World Index as of the end of the first quarter. And yet, in any given year, approximately 33 of the best 50 performing stocks are listed overseas. In addition, the U.S. share of global GDP stands at an estimated 15.5% when measured on a purchasing power parity basis, based on data from the IMF’s World Economic Outlook database. There are plenty of reasons for investors to look abroad, but at present, nobody cares, and the strength of the U.S. dollar isn’t helping.

Turning back to semis, in particular NVIDIA, which I’m sure everyone not holding at least an equal-weighted position in the stock is tired of hearing about, I’ll add a few more gems. According to Alpine Macro, the percentage of sell-side buy recommendations on NVIDIA in about 2015, well before the stock’s meteoric rise, was about 30%, and that number just kept climbing, mirroring the stock’s run, peaking at over 95%, before settling back to about 90% recently. Analysts chased the stock the entire way, as NVIDIA eclipsed the total market caps of both the U.K. and France this year. And BofA’s global fund manager survey revealed that 69% of portfolio managers now believe the Magnificent 7 to be the most crowded trade. The fundamentals are undoubtedly strong, but this increasingly seems like a game of chicken.

BONDS: GAIN ACROSS THE BOARD

The yield curve shifted lower from 1-month out to 30-years, and the rate on the 10-year Treasury fell by 15 bps to end at 4.36%, setting up a solid month for all fixed income sectors. Duration was the clear winner, with long-term Treasuries advancing by 1.7%, followed closely by munis at 1.5%. From there, decent gains were had by all, with high yield gaining about 1%, TIPS higher by 0.8%, and leveraged loans returning 0.4%.

According to BofA’s global fund manager survey, U.S. commercial real estate is seen as the most likely source of a credit event, and as mentioned last month, there are cracks beginning to show. To repeat, for the first time since the financial crisis, a AAA-rated tranche of a commercial mortgage-backed security experienced a credit loss. The era of “extend and pretend” may be coming to an end; many office building property owners are likely going to default…something that some of the active managers that we utilize in portfolios have begun taking advantage of.

COMMODITIES: THE BEAR RETURNS

The Bloomberg Commodity Index fell by 1.5% in June, with the majority of its sub-components losing ground. S&P Global reports that more than half of all commodities are now in bear market territory, defined as being at least 20% below their 252-day highs. This is likely connected to some extent to the property market woes in China. In 2022, China consumed about 58% of all metals, 55% of all coal, and over 50% of all concrete globally. But as their residential home prices continue to fall, with supply swamping demand, those numbers will likely continue to fall from their lofty heights. The one bright spot for the month was the Energy complex, which gained 4.1% on advancing oil, heating oil, and petroleum.

How are Frontier strategies positioned?

ALLOCATION CHANGES

Due to the complexities of attempting to generalize about allocation changes across our Core, Specialty, Multi-Asset Income, Tax-Managed, ETF, and Faith-Based Strategies, and the additional difficulties of properly conveying how those asset allocation changes flow through to trade level activity, we are instead directing clients to our monthly trade summaries, which describe in detail what trade activity occurred by strategy, and why.

Focusing on our Core Strategies relative to their long-term asset allocations, which serve as policy portfolios guiding our dynamic allocation decisions, we favor U.S. small caps, emerging market equities, managed futures, floating rate loans, and cash/short term bonds. We are generally underweight U.S. and international large cap stocks, REITs, commodities, and both high-yield and high-quality bonds at the asset allocation level, but differences between the asset allocations and actual exposure at the fund level can and will occur. At the beginning of July, our asset allocation models registered modest decreases in U.S. large caps and emerging markets in favor of short-term bonds.

Return expectations for emerging market equities and international small caps remain near the tops of their respective 20-year ranges. Expectations for TIPS, managed futures, and T-bills are likewise high relative to history, and leveraged loans continue to offer the highest expected returns within the fixed income space. Expectations for U.S. large caps remain near their 20-year lows, as is the case for REITs and commodities.

PERFORMANCE ATTRIBUTION

The largest positive contributor to both absolute and relative performance for the month was our emerging market exposure, as those stocks outperformed all other broad-based asset classes. Avoiding commodities was also additive. But our underweight to U.S. large caps again detracted, although, on an equal-weighted basis, the S&P 500 was in negative territory, so from one angle, being underweight large caps was somewhat validated. Our small cap exposures in the U.S. and overseas also hurt performance, as both asset classes ended in the red. Lastly, our managed futures exposure was detrimental both on an absolute basis and a relative basis when compared to the traditional diversifiers of long-term Treasuries and high-quality bonds, which both performed well.