07 Aug 2023
Skies are blue, birds are chirping
Both consumer and investor confidence jumped in July, reflecting accelerating economic growth and decelerating inflation. Second quarter GDP (Gross Domestic Product) came in at 2.4%, well above expectations for 1.8% growth, and above the first quarter print of 2%, with both consumers and businesses doing their part. And currently, the Atlanta Fed GDPNow estimate for the third quarter sits at an astonishing 3.9%. Add to that the fact that the Personal Consumer Expenditures (PCE) dropped from 3.8% in May to 3% in June, between 187,000 and 324,00 new jobs were just added (Labor Dept. vs. ADP), and initial jobless claims at 227k hover near the monthly average from 2019 just before the pandemic hit, and you’ve got yourself a pretty rosy environment.
The good news doesn’t stop there. Productivity, which has languished since spiking in early 2020, grew at a seasonally adjusted 3.7% annual rate in the second quarter, according to the Labor Department, real wages recently broke free from the gravitational forces that kept them in negative territory for the last few years, and consumers continue to enjoy the excess savings they accumulated between 2020 and 2021. All as the Fed hiked yet again in July, taking rates to a range of 5.25% to 5.50%. The increase in rates thus far, if you can believe it, not only hasn’t hurt businesses (see “Equities” below) but has failed to dent the consumer. The latter is explained by the fact that the share of household debt that is adjustable has been estimated by Moody’s Analytics to be only 11%. If that is indeed the case, then rates could keep going up, and most Americans would hardly be phased (assuming they don’t run a balance on their credit cards, where rates, dare I say, approach the level of “usury”).
The task list of “things to worry about” continues to shrink. But with that, the proxy for the equity risk premium, that is, the forward earnings yield on the S&P 500®, less the yield on the 10-year Treasury, also continues to evaporate, reaching levels not seen since 2008. And according to Bloomberg, the cost of puts on the S&P 500 has also reached the lowest level since at least 2008. If that isn’t a contrarian signal, we don’t know what is, but at this point, surprises fail to surprise.
What happened in the markets in July?
EQUITIES: INVESTOR PREFERENCES BROADENED
The S&P 500 may have logged its fifth straight monthly gain, a nothing-to-sneeze-at 3.2%, but for the first time in a long time, investors enjoyed greater prosperity investing in virtually everything else. China’s rebound propelled emerging market equities to a 6.2% gain, U.S. small caps advanced by 5.5%, and international small caps marched higher by 4.4%. In aggregate, value stocks outperformed their sexier growth siblings across market caps and oceans, with energy, financials (particularly banks), and materials leading the way. However, Value wasn’t universally rewarded, as healthcare, which makes up more of the Russell 3000 Value Index than the Growth Index (approx. 16% vs. 11%), was the worst performing sector, and the more straightforward value sectors, utilities, and staples, huddled together toward the bottom of the performance heap as well.
With 78% of S&P 500 companies reporting, the 2Q earnings season is winding down, and thus far, 77% of those companies that have reported have beaten on earnings, and 66% have beaten on sales, with margins holding up well at 11.5%, down only slightly from first quarter’s 11.6% level. Helping to explain the S&P’s levitating margins, SocGen’s Albert Edwards recently stated in a research note that “Treasurers [of U.S. companies] had time to arrange long-term fixed financing, and pay off old higher rate loans so that they are now paying much less in interest than when fed funds was pegged at zero.”
BONDS: CREDIT PAYS OFF
The yield curve flattened ever so slightly during the month, with the 10-year minus 2-year increasing by 15 basis points and the 10-year minus 3-month inching upward by four basis points. The yield on the 10-year increased by 0.16% and the bond market as a whole pulled back by 0.1%, largely thanks to long-term Treasuries, which lost 2.2%. But there were places to make money in fixed income; in fact, just about all sectors were up. TIPS gained 0.2%, investment-grade corporates advanced by 0.4%, leverage loans returned 1.1%, and high-yield bonds jumped by 1.5%.
COMMODITIES: ENERGY SURGES
The string of positive economic surprises and oppressive heat waves during the month helped the energy complex to an 11.9% gain. AP News reports that “…refineries are typically designed to operate between 32 and 95 degrees Fahrenheit. “They don’t like temperature extremes because they’re inherently dangerous places… So they dial back the production for safety purposes, but that then constrains supply.”
Commodities as a group were up 6.3% for the month, with gains in industrial metals (+6.9%), precious metals (+4.0%), and agriculture (+2.6%). Everything except soybeans (-0.4%) and natural gas (-4.6%) was in the black.
How are Frontier strategies positioned?
ALLOCATION CHANGES
Due to the complexities of attempting to generalize about allocation changes across our Core, Specialty, Tax-Managed, Multi-Asset Income, 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. and international 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.
Emerging market equities and international small caps continue to remain near the tops of their respective 20-year ranges in terms of expected return, while U.S. large caps and REITs remain near their 20-year lows.
PERFORMANCE ATTRIBUTION
Our equity preferences all paid off for the month, as emerging markets and global small caps outperformed U.S. and international large caps. Our underweights to REITs were also beneficial, but our underweights to commodities hindered results, given the rally. On the fixed income side, our exposures to leveraged loans and high yield bolstered absolute returns, but our underweight to junk bonds hurt relative returns. Both long-term Treasuries and managed futures, which are used in part to hedge risk, faltered, hurting overall returns.
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 type 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 s 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. Frontier may modify its process, opinions, and assumptions at any time without notice as data is analyzed.
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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. The estimates, including expected returns and downside risk, throughout are calculated monthly by Frontier and will change from month to month depending upon factors, including market movements, over which Frontier has no control. They are only one factor among many considered in Frontier’s investment process and are provided solely to offer insight into Frontier’s current views on long-term future asset class returns. They are not intended as guarantees of future returns and should not be relied upon in making investment decisions.
Hypothetical expected returns have certain limitations, are discussed for illustrative purposes only and it should not be assumed that actual results will match the hypothetical expected returns referred to. 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 overcompensated 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 expected. 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 expected. 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.
Frontier provides model strategies to various investment advisory firms and does not manage those models on a discretionary basis. The performance and holdings of model strategies may vary from strategies managed by Frontier.
Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
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| ASSET CLASS | INDEX | INDEX DESCRIPTION |
| U.S. Large Cap Equity | S&P 500 | Represents US large company stocks. |
| U.S. Small Cap Equity | S&P 600 | Measures the small-cap segment of the U.S. equity market. |
| U.S. Growth | Russell 3000 Growth | A market-capitalization-weighted equity index that seeks to track 3000 of the largest U.S.-growth traded stocks. |
| U.S. Value | Russell 3000 Value | A market-capitalization-weighted equity index that seeks to track 3000 of the largest U.S.-value traded stocks. |
| International Developed Equity | MSCI EAFE Small Cap | An equity index which captures small-cap representation across 21 Developed Markets countries around the world, excluding the U.S. and Canada. |
| Emerging Market Equity | MSCI Emerging Markets | Captures large and mid cap representation across 24 Emerging Markets (EM) countries. |
| Chinese Equity | MSCI China | Captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g., ADRs). |
| Investment Grade Corporates | Morningstar US Corporate Bond | Measures the performance of fixed-rate, investment-grade USD-denominated corporate bonds with maturities over one year. |
| High Yield Bonds | Morningstar U.S. High Yield Bonds | Measures the performance of USD-denominated high-yield corporate debt. It is market-capitalization weighted. |
| TIPS | Morningstar US TIPS | Represents inflation-protected securities issued by the U.S. Treasury. |
| Leveraged Loans | S&P / LSTA U.S. Leveraged Loan 100 | Designed to reflect the performance of the largest facilities in the leveraged loan market. |
| Long-Term Treasuries | Morningstar US 10+ Yr Treasury Bond | Measures the performance of fixed-rate, investment-grade USD-denominated Treasury bonds with maturities greater than ten years. |
| 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. |
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