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Monthly Update | August 2019

21 August 2019

Geremy van Arkel, CFA® | Principal

JUST ANOTHER SLEEPY SUMMER MONTH

Geremy van Arkel, CFA® | Principal

The terra firma beneath our feet is starting to feel a bit uncertain. In the last 18 months, some seismic rumbling has been rolling through capital markets – an undercurrent that is hard to read or characterize, but easy to feel. In February of last year, markets were rattled by the end of the tax cuts; in the 4th quarter it was the Federal Reserve Bank (Fed) tightening; and in May, a slowing of the general economy. Now, in August, that old trade war is bubbling back up again.

Last month, we all sat and waited on the Fed. Everything was quiet and slow, except for the steady drumbeat from the media, pontificators, and even Trump tweets calling for the Fed to cut interest rates. And we had to wait until the last day of the month for the big reveal.

Nevertheless, July as a distinct time period was a meager but solid month for the “everything bubble.”  Once again leading the way, the large cap U.S. stocks, as represented by the S&P 500®, gained about 1.4% for the month, while the Russell 2000 Index of U.S. small cap stocks gained about 0.6%. International stocks experienced some headwinds from a stronger U.S. dollar which gained about 2% or more against major currencies. While most international stock markets showed progress in local terms, a strong U.S. dollar led to a slight loss for U.S. investors. The MSCI EAFE Index of international developed stocks and the MSCI Emerging Markets Index both lost about 1% for the month. Bonds, too, held their ground, with most bond indexes returning about their coupons for the month.

Just when it looked like we had a drama-free month in the bag, on the last day the Fed caved and cut the Federal Funds Rate by 0.25%. The gesture felt seemingly harmless, and to many, mainly symbolic. It was meant to make us all feel assured that the Fed is ready to keep the balloon afloat. Besides, what difference could 0.25% make anyway?

The common logic of this rate cut was flawed from the get-go. The thinking behind the move went seemingly something like this: “The Fed should lower interest rates because the economy is faltering, but a rate cut will be a good thing for stocks, since stocks like low interest rates.” We now know how that ended. The Fed gave in to public opinion, despite what appeared to be a healthy economy and staggeringly strong capital markets. The consequence? Equity markets did not like the rate cut at all.

Lowering the Fed Funds Rate was also intended to alleviate the stress of high, relative short-term interest rates, and an inverted yield curve. The problem with an inverted yield curve is that it is restrictive to lending and is effectively like running a tight monetary policy. Lending is based on the idea of borrowing short-term savings to lend long-term. Thus, lenders will not lend if the borrowing rate is below the savings rate, because in that scenario, they simply can’t make money. Further, an extended inverted yield curve has preceded all modern era recessions, which can’t be a good thing.

A More Inverted Yield Curve

Not to be outdone, the spotlight abruptly shifted from the Fed to the on-again-off-again trade war. Just when we thought trade tensions were simmering down, up they went again with renewed threats of tariffs on Chinese imported goods. The combination of the Fed rate cut – signaling that maybe the economy really is weak – and renewed trade war fears knocked capital markets into a tailspin in early August. As each month passes, we find the global landscape further apart politically and on the goal of mutually beneficial coordinated globalization.

The combination of a lowered short-term borrowing rate and an unpredictable trade war signaled to investors that either something really is wrong, or that the Fed and central government have lost their bearings. Given this choice of two poor outcomes, investors ran to the safety of treasuries in a manner that has never been witnessed before. By now, we should all know that the real interest rates in the economy are controlled by investors buying or selling bonds. This frantic buying of treasury bonds drove bond prices up and interest rates down to near 50-year lows.

The net result of all this drama appears to be a material move lower for interest rates. I guess the Fed achieved its goal after all.

Despite this recent bout of volatility, returns year-to-date have been relatively outstanding. The S&P 500® Index has gained a little over 20%, and the MSCI EAFE Index is still up more than 12.5%. Astonishingly, during this latest blast off of asset prices, interest rates are down, way down. The Barclays U.S. Government Long Index of long-term treasuries has defied all skeptics and pontificators and gained slightly more than 11% year-to-date. As if that wasn’t enough, over the last year the long-term government bonds have outperformed the S&P 500® index. Who would have predicted that?!

While the Fed’s rate cut and the trade war may have stolen the media spotlight for the month, there has been very little coverage of the U.S. earnings season. S&P 500® earnings are expected to decline by 2.7% during the quarter, and international stock earnings are experiencing a similar decline. This, to us, is an important point that should not be overlooked.

The foundation of the last decade’s low volatility bull market in asset prices have been low interest rates and the corresponding increase in borrowing; improving employment; coordinated mutually beneficial global growth; and ever-increasing asset prices, which are driving a real wealth effect. This has been a perfect virtuous circle for rising asset prices. Equity investors are betting that this environment will continue, and Central Banks around the world are keenly aware of their real goal: to keep this ball rolling.

Yet sometimes if things can’t get any better, they don’t. If asset prices flatline, employment is at its peak, earnings are declining, and central governments are no longer on the same page, the only things left to provide stimulus are low interest rates and borrowing. Paying peak prices for peak earnings is always a tricky proposition because trees don’t grow to the sky indefinitely. This is probably why bond investors are ever more willing to pay up for low yielding safety. If you add in the unpredictable trade war, it is easy to see why so many investors are spooked and why capital markets volatility has spiked.

A growing, loud rumble and a general lack of faith in the bull market’s foundation are causing a slow shaking of the capital markets’ board. The chips have ended up on two colors, equity hope, and treasury bond pessimism.  Simultaneously, we have near record high prices in both stock and bond markets, which also means near-record-low interest rates. The capital market outlook is just as divided as our current political environment. One camp is willing to pay high valuations to bet on equities and continued growth, while the other is so adamant that the near-term outlook will be blight that they are betting on the deflation protection of treasuries, with or without any yield. The possible outcomes are that either someone will be spectacularly right or catastrophically wrong, or the “divided at the extremes” is the new normal. It does feel like capital markets are trying to tell us something.

The material change for the month seems to be that investors have accepted the fate that the low interest rate environment is here to stay – at least for the foreseeable future. The questions now are whether the consumer and governments will continue to borrow and if the investors manage to hang in there and keep asset prices steadily rising through this shifting foundation.

JULY 2019 STRATEGY REVIEW

Gary A. Miller, CFA® | Founding Principal

 

Boring. July’s financial market activity was boring. Not much movement in the major asset classes during the month, and none of the major asset classes having monthly returns that differed from 0 by as much as 2%. A perfect example of boring was in the 10-year Treasury note. Its yield ended June at 2.01% and ended July at 2.02%. Boring. US large company stocks were one of the biggest winners in the month, as the S&P 500®returned 1.4%, while international developed markets stocks, as measured by the MSCI EAFE Index, lost 1.3%. And the Bloomberg Barclays Aggregate Bond Index gained 0.22%, right about its yield. Boring. Of course, the beginning of August has been anything but boring, but that is a story for another day. (Though a sneak preview would say that stocks were extraordinarily volatile while Treasuries staged a huge rally … we shall see).

The July performance of Frontier Asset Management’s Globally Diversified strategies was, well, “boring.” All strategies posted modestly positive returns that hovered around their Globally Diversified benchmarks. The more aggressive strategies gave back a little return due to their conservative posturing but made up for it with the added value performance of their mutual fund holdings. The more conservative strategies gained or lost little due to either asset allocation or fund manager selection. Longer term returns continue to be benchmark-beating for all strategies over nearly all time periods

Frontier Asset Management’s unconstrained Alternative Strategies were more of a mixed bag in July. Absolute Return continued to outperform conservative hedge funds, as measured by the HFRX Absolute Return Index, but Absolute Return Plus and Focused Opportunities trailed the broader hedge fund universe. Focused Opportunities continues to struggle due to its over-reliance on emerging markets stocks. Performance of Frontier’s Alternatives Strategies continues to look favorable relative to the hedge fund universe and other alternative strategies available in mutual fund formats over longer-term horizons.


Past performance is no guarantee of future returns.  Performance discussed represents total returns that include income, realized and unrealized gains and losses. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees and expenses. All calculations of performance are by Frontier.
Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice.  Frontier obtained some of the information provided herein from third party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Data sources for funds and indices are Morningstar, the Hedge Fund Research Institute and BarclayHedge. Other sources include: National Geographic.
Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance.  References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries or financial instruments of any kind.  This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice.
Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.
Hypothetical expected returns have certain limitations, are shown for illustrative purposes only and it should not be assumed that actual results will match the hypothetical expected returns shown. Unlike actual performance, hypothetical expected returns do not represent actual trading and since trades have not been executed, the results shown may have under or over compensated for the impact, if any, of certain unforeseen market factors. Hypothetical expected returns, whether back-tested or forecasted, have many inherent limitations and no representation is being made that any account will or is likely to achieve the results shown. In fact, there are frequently material differences between hypothetical expected results and actual results achieved. One of the limitations of hypothetical expected results is that they do not take into account that material market factors may have impacted the adviser’s decision-making process if the firm were actually trading clients’ accounts.  Also, when calculating the hypothetical expected returns, the adviser has the ability to change certain assumptions and criteria in order to reflect better returns. There are numerous other factors related to the markets in general or to the implementation of any specific investment strategy that cannot be fully accounted for in the preparation of hypothetical expected results, all of which can adversely affect actual trading and performance. Importantly, it should not be assumed that investors who actually invest in this strategy will have positive returns or returns that equal either the hypothetical expected results reflected, or any corresponding benchmark presented.  In addition, performance can, and does, vary between individuals.
In reviewing the performance information presented here, we recommend that you consider both the returns generated and the level of risk that was assumed in generating those results. We believe that performance information cannot be properly assessed without understanding the amount of risk that was taken in delivering that performance. The performance information presented here covers different time periods. We present performance information for short time periods because we understand that clients and potential Investors are interested in this information, however, we recommend against making any investment decisions based on short-term performance information. For any investment products mentioned herein, a complete description of their investment objectives, along with details of the risks and fees involved is contained in their respective prospectus and statement of additional information, which is available on their websites and should be read fully.
It is generally not possible to invest directly in an index*. Exposure to an asset class or trading strategy or other category represented by an index is only available through third party investable instruments (if any) based on that index.
INDEX
INDEX DESCRIPTION
S&P 500®
Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ
MSCI All Country Index ex-US
The MSCI ACWI ex-USA is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI ex-USA consists of 44 country indices comprising 23 developed and 21 emerging market country indices.
Barclays US
Aggregate Bond
Measures the performance of the U.S. investment grade bonds market. The securities must have at least one year remaining to maturity, must be denominated in U.S. dollars and must be fixed rate, nonconvertible and taxable.
Barclays Capital Long U.S. Treasury
Includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value
Benchmark Composition. The Benchmarks for the Long-Term Growth, Growth & Income, Balanced, Conservative and Capital Preservation strategies are combinations of the Wilshire 5000 Total Market Index, MSCI All Country World ex US Index, Bloomberg Commodity Index, HFRX Global HF Index, Barclays US Aggregate Bond Index and 3-Month T-Bills.
The blends of the indices are currently:
Capital Preservation Bench
Conservative Bench
Balanced Bench
Growth & Income Bench
Long-Term Growth Bench
Wilshire 5000
10%
15%
30%
45%
50%
MSCI AC World ex US
0%
5%
15%
20%
30%
Bloomberg Commodity
15%
15%
10%
10%
10%
HFRX Global HF
25%
25%
20%
15%
10%
Barclays US Agg
40%
40%
25%
10%
0%
3M T-Bills
10%
0%
0%
0%
0%
Benchmarks for the Global Opportunities, Focused Opportunities, Absolute Return Plus, Absolute Return and Short-Term Reserve strategies are the MSCI World, S&P500®, HFRX Global HF, HFRX Absolute Return and Barclays Capital 1-5 Year US Treasury Indices, respectively. In the case of indices that include foreign securities, index returns are still presented on a total return basis but will be net of foreign taxes on income generated by these securities.
Frontier’s ADV Brochure is available at no charge by request at info@frontierasset.com or 307.673.5675.
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Geremy’s Thoughts