12 Oct 2021
Inflation-loving assets take center stage
With the year-over-year changes to the consumer price index coming in at 5.3% (July), 5.2% (August), and 5.7% (expected for September based on the Cleveland Federal Reserve’s Inflation Nowcast), assets that many investors have come to rely on to at least partially hedge inflation risks had their moment in the third quarter. Commodities, TIPS, REITs, and leveraged loans outperformed all other broad asset classes.
Inflation wasn’t the only thing on investors’ minds; there were myriad risk-off inducing concerns to choose from during the quarter: downward estimates to GDP (Gross Domestic Product), Evergrande’s potential default, electricity shortages in China, a more hawkish tone from the Fed regarding tapering and rate increases, falling renomination odds for Chairman Powell, a rising dollar, heightened regulatory scrutiny of Big Tech, and a debt ceiling fight in D.C. That enough?
On the GDP front, third quarter estimates have gone from a bit over 6% at the beginning of August, based on the Atlanta Fed’s GDPNow estimate, to just 2.3% on October 1st. COVID-19 related headwinds and supply chain issues, best exemplified by the 73 vessels anchored and awaiting entry into the Long Beach and Los Angeles ports on September 19th, with another 37 drifting nearby (according to the Marine Exchange of Southern California) can be thanked in part for the dramatic downward revision.
But there was also much to celebrate for Corporate America during the quarter. According to S&P’s Howard Silverblatt, “…earnings were up 9.7% over Q1 2021 and 94.2% over a COVID-19-depressed Q2 2020; sales came in up 5.5% from Q1 and 21.7% year-over-year; and margins increased 13.55% (the average from Q1 1993 is 8.07%).” While an increasing number of corporate executives are mentioning inflation, hiring problems, and wage pressures during earnings calls, for now at least the landscape remains quite conducive to profit generation. And with business investment – nondefense capital goods ex-aircraft – for August revised upward to another all-time high that should boost productivity going forward and help ease the supply chain bottlenecks…eventually.
What happened in the markets in the third quarter?
- Equities: Emerging Market Misfortunes
While eyes were on China, which, according to S&P was off by 16.7% for the quarter, Brazil suffered the biggest loss among developing markets, returning -20.3%. Nevertheless, given China’s weight in the indices, it was clearly the driver of the disappointing performance for emerging markets, which saw the MSCI Emerging Market Index return -8.1% for the quarter. The U.S. dollar didn’t help the performance of overseas assets either. While the MSCI EAFE Index, fully hedged, was up 1.5%, outperforming all other broad based equity indices, in dollar terms it was down 0.5%. International small caps, on the other hand, held up reasonably well, gaining 0.9% (MSCI EAFE Small Cap Index).
In the U.S., while growth stocks took a punch to the gut in September as interest rates rose, they still outperformed for the quarter. The Russell 1000 Growth Index added 1.2%, outpacing the S&P 500 Index (+0.6), the Russell 1000 Value Index (-0.8%), and both the S&P 600 Index (-2.8%) and the Russell 2000 Index (-4.4%).
At the sector level, Financials and Communication Services led the way, returning 2.6% and 1.5%, respectively. On the other side were Materials and Industrials, each losing about 3.9% for the quarter, after suffering particularly bad outcomes during the month of September.
- Bonds: Reaching a TIPping Point?
The yield on the 10-year Treasury swung from 1.45% at the beginning of the quarter, to a closing low of 1.19% hit on multiple days in July and August, and ended at 1.52%, which was close to the high over the period. That pathway resulted in early gains for the Bloomberg U.S. Aggregate Bond Index that were erased in the final month, resulting in a 0.05% return for the quarter. Investment grade corporates performed slightly worse, while the Bloomberg US Corporate High Yield Index gained 0.9%, with CCC and lower grade paper performing even better. The S&P/LSTA Leveraged Loan 100 Index was up 0.98%, and even long-term Treasuries posted a positive return of 0.5% for the quarter (they were down about 3% in September based on the Bloomberg US Treasury 20+ Yr).
But back to inflation concerns, the Bloomberg US Treasury TIPS index was the winner within the fixed income complex for the quarter, gaining 1.8%. For the protection afforded against unanticipated inflation, holders of 10-Year TIPS are now assured of a -0.9% annualized real return for the next decade, with shorter dated maturities offering even lower real yields.
- Commodities: A Cruel Winter Ahead
Natural gas prices have been on a tear, with the Bloomberg Natural Gas Futures Index gaining 59% during the quarter, with most of the gain coming in September. Heating oil and Brent crude also experienced high single digit gains. And with OPEC (Organization of the Petroleum Exporting Countries) and Russian oil producers deciding to moderate production increases, oil recently hit its highest price in at least three years. According to the Wall Street Journal, U.S. producers are only slowly ramping up production. They report that, “…the last time that domestic crude prices were so high, there were roughly 1,100 more rigs drilling for oil than the 428 at work last week, according to oil-field-services firm Baker Hughes.”
The Bloomberg Commodity Index advanced by 6.6% for the quarter, again, helped by energy prices. Large positive moves were also seen in cotton (+25%), coffee (+19%), and aluminum (+19%). Interestingly, silver and gold, which many investors gravitate toward as inflation hedges, were down (silver fell by about 16%), very likely negatively impacted in part by a rising dollar.
How are Frontier strategies positioned?
Allocation Changes
At the asset allocation level, once again there were essentially no material changes made going into September. Among the few trades that were completed, there wasn’t a common theme. A couple of trades were manager driven, and the others were initiated to modestly impact the risk/return profiles of the strategies. Going into October, our positioning remains tilted against U.S. and international large caps, due to low future expected returns, in favor of U.S. and international small caps and emerging markets. To be clear, these tilts are relative to the long-term allocations that serve as references or policy portfolios against which we make over/underweight decisions; the overall weightings to large caps still eclipse that of small caps in all but our most aggressive strategies. Long-term Treasuries, always a “popular” topic of conversation, continue to play a material role across most of our strategies as a hedge against adverse outcomes, should the ever-growing list of concerns mentioned at the outset of this commentary change the direction of the current of a sea of richly valued assets.
Performance Attribution
For the third quarter, all of our strategies were close to their respective benchmarks (i.e. either slightly above or slightly below), save for the most aggressive strategies, which did trail. Our relative positioning, that is, the over or underweights to the long-term allocations were, in most cases, headwinds. As pointed out above, while our large cap exposures exceed our small cap exposures in total, we were underweight the former and overweight the latter on a relative basis. Same story for emerging markets vs. U.S. equities. And the surge in commodities and REITs was generally a negative as well, as we were underweight to those asset classes. However, on the plus side, even with asset class movements getting the best of us over the past few months, the fact that most of our strategies were very close to benchmark we believe reflects good performance from our actively managed mutual funds, which as our clients know, we count on for solid security selection, as well as additive short term tactical decisions that we avoid, as we focus on the longer term.
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Nominal GDP measures a country’s gross domestic product using current prices, without adjusting for inflation. Contrast this with real GDP, which measures a country’s economic output adjusted for the impact of inflation.
Real Return – The annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external factors
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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 |
S&P 600 |
Represents US large company stocks. It is a market-value-weighted index of 600 stocks that are traded on the NYSE, AMEX, and NASDAQ |
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. |
MSCI EAFE Small Cap |
An equity index which captures small cap representation across Developed Markets countries* around the world, excluding the US and Canada. |
MSCI Emerging Markets |
An Index that captures large and mid cap representation across 27 Emerging Markets (EM) countries |
Russell 2000 |
Measures the performance of the small-cap segment of the U.S. equity universe. |
Russell 1000 Growth |
Measures the performance of the large-cap growth segment of the U.S. equity universe. |
Russell 1000 Value |
Measures the performance of the large-cap growth segment of the U.S. equity universe. |
Bloomberg Commodity |
This is a 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. |
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. |
Bloomberg U.S. Corporate High Yield |
Measures the USD-denominated, high yield, fixed-rate corporate bond market |
Bloomberg U.S. Treasury 20+ Year |
Measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with 20+ years to maturity |
Bloomberg U.S. Treasury US TIPS |
Represents inflation-protected securities issued by the U.S. Treasury. TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers |
Bloomberg Natural Gas Futures |
Reflects the natural gas segment of the commodities market and measures the performance of the commodity future contracts. |
S&P / LSTA U.S. Leveraged Loan 100 |
Designed to reflect the performance of the largest facilities in the leveraged loan market. |