10 Aug 2022
The cat bounced, but can it walk away?
Relief rally or sustainable surge? That’s the question on investors’ minds, but after a generally miserable second quarter, market participants will take whatever they can get. And they just got a lot; if 2Q was the “everything sale”, July was the “buying binge”. Except for a nominal loss in emerging market equities, all asset classes were solidly in positive territory.
On the economic front, the data continues to confound. Economists expected the job market to cool in July, thanks to the Fed’s efforts, producing about 250,000 new jobs, which would have been down significantly from the 398,000 created in the prior month. But the actual number? 528,000.[1] Even though overall economic output has declined, the supply of workers that companies require simply hasn’t kept pace with their needs. According to the Wall Street Journal, “Payrolls have grown faster during the first half of this year than during any other post-World War II period when the economy began contracting.” And with this jobs report, the unemployment rate ticked down to 3.5%, matching the pre-COVID-19 50-year low.
Adding to the discordant data, BofA recently pointed out that all six of the variables that the National Bureau of Economic Research monitors to determine when the economy falls into a recession have improved since December. Those variables are: real personal income, nonfarm payrolls, household survey employment, industrial production, real wholesale and retail sales, and real consumer spending. On that last measure, the Commerce Department reported that household spending increased by 0.1% in real terms in June, managing to slightly outpace inflation. However, while personal incomes rose, after accounting for taxes and inflation, they fell by 0.6%, which will begin to impact the ability to spend. Yes, GDP (Gross Domestic Product) has been negative in each of the last two quarters, but so far it hasn’t been because of the consumer, and it’s difficult to marry the GDP prints with the barrage of other data points indicating strength.
Unlike in the States, overseas the European Union’s statistics agency reported gross domestic product was 0.7% higher in the three months through June than in the first quarter, and 4% higher than a year earlier.
As earnings season winds down, with 72% of S&P 500® constituents reporting so far, operating earnings have increased by 7.3% vs. Q1, and GAAP (generally accepted accounting principles) earnings increased by 1.7%. However, versus 2Q21, GAAP earnings are down 3.4%, and margins, while remaining quite high at 12.4% compared to an average of 8.4% going back to ‘93, are down from 13.5% a year ago. Furthermore, according to Alpine Macro, only about 22% of S&P 500 companies have raised earnings guidance recently, which suggests executives are doing some prep work for a possible earnings recession. Understandable, given that during the quarter the employment-cost index increased at a pace nearly as high as in Q1, which was the highest on records tracing back to 2001, according to U.S. Bureau of Labor Statistics. And on an annual basis, 2Q22 over 2Q21, the increased spending on workers marked the fastest annual pace on record. Margins will likely feel that.
What happened in the markets in July?
1. Equities: Giddy up growth
Market breadth improved in July with close to 40% of S&P 500 companies trading above their respective 200-day moving averages, and almost 80% trading above their 50-day moving averages. And Growth took top honors. The S&P 500 Growth Index advanced by 12.8%, eclipsing every other index we track that doesn’t contain the word “crypto”. Growth won by market cap and growth won by geography. At the industry group level, Tech Hardware was up 17.4% and Semiconductors were up 16.1%, but interestingly first prize went to Automobiles and Components, which gained 30.4%. The only groups to post a loss were Household & Personal Products (-1.5%) and Telecom Services (-5%).
Small caps (+10%) bested large caps (+9.2%), which narrowly outpaced REITs (+9.1). Outside of the U.S., small caps also topped large caps, returning 6.6% vs. 5%. And for the first time in a while, currencies didn’t have much impact, as EAFE stocks in local currencies only returned 20 basis points (bps) more than in dollar terms (although the trend is still in place and the cumulative difference continues to grow). The one red mark on the page was emerging markets, which were off by 25 bps thanks to China, which was down 9.5% after being the only winner during 2Q.
2. Bonds: You can come out now
Bond investors emerged from their shelters in July, after quaking in fear during the first six months of the year. The Bloomberg U.S. Aggregate Bond Index gained 2.4%, with high yield bonds rallying by almost 6%, investment grade corporates gaining 3.2%, and leveraged loans advancing by 2.1%. The yield on the 10-year Treasury fell by 31 bps to end at 2.67%.
The yield curve is now as inverted as it’s been since 2000 (10-year minus 2-year), and the 10-year minus 3-month just bounced off of zero. As of a week ago, futures markets indicated a terminal Fed Funds rate of 3.3% by year end, and that there will be no additional tightening in 2023…today’s jobs report just may change that outlook.
3. Commodities: Gas pains
Commodities as a group advanced by 4.3% in July as inflationary and recessionary forces battled. Roughly half of the sub-components of the Bloomberg Commodity Index were in the black and the other half were, to state the obvious, in the red. Natural gas rocketed 53%, because, as MarketWatch reported, “Russia has been holding back natural-gas supplies in Europe, curbing the flow through the Nord Stream 1 pipeline, leading to a rally in the region’s prices and higher demand for liquefied natural gas from the U.S. Hotter-than-usual weather in many parts of the U.S. has also contributed to the rally for commodity, which is used as a power source to meet cooling demand.”
Lean hog contracts were up 12% (I don’t know, the upcoming football season?), while other gains were more muted, and sugar, coffee, and wheat fell 5.0%, 5.4%, 8.5%, respectively.
How are Frontier strategies positioned?
Allocation changes
In general, at the beginning of July, our strategies increased their target allocations to managed futures and high yield bonds by reducing allocations from investment grade fixed income. How that translated into actual trades was, in most cases, a reduction in long-term Treasuries to fund managed futures and other positions. Relative to our long-term allocations, we are overweight long-term Treasuries, emerging market equities, managed futures, U.S. small caps, international equities, and bank loans; and are underweight high-yield bonds, absolute return, commodities, and U.S. large caps. Overall, we are positioned approximately in-line with expected long-term risk targets, although our conservative strategies are situated cautiously.
Performance attribution
Given Frontier’s focus on carefully managing risk exposures, in a month that was as exuberantly “risk-on” as July played out, keeping up with long-term benchmarks was difficult; all but one of our strategies trailed for the month. However, the gross-of-fee absolute returns were solidly positive, especially given the risk profiles. Our bias toward small caps, both domestically and abroad, paid off, with the S&P 600 outperforming the S&P 500, and the MSCI EAFE Small Cap outperforming MSCI EAFE, but that wasn’t sufficient to offset underweights to U.S. large caps, REITs, and high yield bonds, all of which posted solid months. In addition, our overweight exposure to emerging markets was a headwind.
[1] U.S. Bureau of Labor Statistics
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| ASSET CLASS | INDEX | INDEX DESCRIPTION |
| U.S. Large Cap Equity | 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 |
| U.S. Small Cap Equity | S&P 600 | Measures the small-cap segment of the U.S. equity market. |
| U.S. Equity – Growth | Russell 3000 Growth | A market capitalization-weighted index based on the Russell 3000 index. The Russell 3000 Growth Index includes companies that display signs of above-average growth. |
| International Developed Equity | MSCI EAFE | An equity index which captures large and mid cap representation across 21 Developed Markets countries around the world, excluding the U.S. and Canada. |
| International Small Cap Equity | MSCI EAFE Small Cap | An equity index which captures small cap representation across Developed Markets countries around the world, excluding the US and Canada. |
| Emerging Market Equity | MSCI Emerging Markets | An Index that captures large and mid cap representation across 27 Emerging Markets (EM) countries |
| Investment Grade Bonds | Bloomberg U.S. 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. |
| Investment Grade Corporates | Bloomberg Barclays U.S. Corporate OAS | Represents the Option-Adjusted Spread (OAS) of the Bloomberg Barclays U.S. Corporate Index, which measures the investment grade, fixed-rate, taxable corporate bond market. |
| High Yield Bonds | Bloomberg US Corporate High Yield | Measures the USD-denominated, high yield, fixed-rate corporate bond market. |
| Leveraged Loans | S&P / LSTA U.S. Leveraged Loan 100 | Designed to reflect the performance of the largest facilities in the leveraged loan market. |
| REITS | FTSE NAREIT Equity REIT | A free-float adjusted, market capitalization-weighted index of U.S. equity REITs. |
| Commodities | Bloomberg Commodity | Broadly diversified index that allows investors to track commodity futures through a single, simple measure. The DJ-UBSCISM is composed of futures contracts on physical commodities. |