12 Dec 2022
Cart before the horse?
Investor enthusiasm for an end to the rate hike cycle was palpable in November; “The Market” just can’t wait for this to be over. But with every single asset class that we utilize in the portfolio construction process solidly in positive territory for the month, we suspect there is more than a little wishful thinking baked into expectations.
On one hand, NY Fed president John Williams said on Fox Business News that to get the PCE from 6% down to 2% is going to take a couple of years[1]. And with the upward revision to 3Q Gross Domestic Product (GDP) (2.9% vs. 2.6% originally)[2], the latest payroll number coming in 32% above expectations (263k vs. 200k), the prior month’s payroll number revised upward by 23k, initial and continuing jobless claims moving lower[3], and inflation adjusted consumer spending increasing by a seasonally adjusted 0.5% from the prior month (the biggest gain since January)[4], his comment is understandable. Yet, the futures markets are pricing in rate cuts for the second half of 2023[5]. For that to be true, one needs to believe that a recession is a foregone conclusion.
Granted the consumer has remained resilient, buoyed by an abundance of excess savings5 and strong wage growth³ (albeit less than the level of inflation), which has kept debt loads manageable; household debt service as a percentage of disposable income remains near a multi-decade low5. But JPMorgan estimates that excess savings will disappear by mid-2023, hastened by the fact that the personal savings rate just hit its lowest level since 2005 and is flirting with a 50+ year low. If savings do dry up, that will impact corporate revenue growth, and thus earnings. While earnings estimates[6] for 2023 have continued to come down, week after week, they don’t appear to reflect the kind of recession that would necessitate rate cuts on the backside of 2023. Something’s got to give.
What happened in the markets in November?
1. Equities: The Chinese see-saw
What goes down must go up? After a 17% decline in October, Chinese stocks rocketed upward by almost 30% in November, far outpacing every other major market, and helping emerging market stocks to a 14.8% gain. International large cap stocks also performed well, advancing by 11.3%, as did international small caps, which returned almost 10%. Roughly 500 basis points of the return to international large caps came thanks to a decline in the U.S. dollar, which until recently had presented a formidable headwind. From a style perspective, value outperformed growth within the U.S. but overseas the reverse was true. And based on market cap, small names underperformed, but still advanced by 4.2%, bringing their quarter-to-date return to 17.1%; it’s been a remarkable run, reducing year-to-date losses to a manageable 10%, besting all major asset classes except commodities (+19%) and municipal bonds (-8.8%). As Barron’s recently pointed out, small caps are cheap on a number of measures, and “…have higher proportional exposure than large-caps to inflation beneficiaries, like energy…[are] more domestic and more tied to capital spending, which is a plus if U.S.-based manufacturers continue moving factories home.” We concur that the outlook for U.S. small caps is brighter than for large caps, which have dominated for so many years.
2. Bonds: Treasuries exact their revenge (at least a little)
The changes in sentiment and flows to bonds and bond funds that I mentioned last month were well timed; the bond market advanced by 3.7% as the 10-year Treasury yield moved from 4.1% to 3.7%. Long-term Treasuries shot up by 7.1%, leading investment grade corporates (+5.1%), municipals (+4.7%), high yield (+2%), and TIPS (+1.9%). Leveraged loans added 1.6% and have served as a haven thus far, weathering the rate hikes with only a 1.1% loss year-to-date. That’s not to say that loans aren’t without their fair share of risk, but the positive correlation with rates that they’ve exhibited has been welcome in an otherwise bleak landscape for fixed income.
3. Commodities: Pedal to the metal
Industrial metals (e.g., tin, nickel, zinc) experienced the largest increases for the month (+14.5%), as traders apparently were betting on a recovery in China, linked to loosening covid lockdown restrictions. Precious metals also performed well, with gold futures up 6.7%, platinum gaining 12.1%, and silver advancing by 13.5%. But oil and related products sold off slightly on concerns about the health of the global economy. Agricultural products were flat as a group, although wheat futures tumbled by almost 12% due in part to the continuation of the Black Sea export corridor agreement, which allows Ukraine access to world grain markets.
How are Frontier strategies positioned?
Allocation changes
Across the Frontier strategies, the common asset allocation shifts going into December were modest reductions in high quality bonds and managed futures, to allow for additions to floating rate loans and/or high yield bonds, depending on the strategy.
Overall positioning remains in favor of U.S. small caps, emerging market equities, international small caps, managed futures, and long-term Treasuries. Our more conservative strategies are overweight floating rate loans as well. We are generally underweight U.S. large cap stocks, international large caps, REITs, commodities, 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 differ.
Performance attribution
For the month, Frontier’s more aggressive, Core Strategies not only generated significant absolute returns, but also outperformed benchmarks on a gross-of-fee basis. Our more conservative strategies underperformed benchmarks by a meaningful amount but were still able to generate solidly positive performance. Frontier’s Specialty Strategies outperformed benchmarks by a large margin. Within our tax managed lineup, most strategies did trail benchmarks for the month, but again, delivered strong absolute performance, and in many cases generated tax assets for clients, as losses were harvested.
While all asset classes were in positive territory, overweight exposures to emerging markets and international small caps were the most impactful, especially from funds with higher weights to Asian equities. Allocations to long-term Treasuries, which have been painful this year, were highly additive to overall performance for the month, as they outperformed all other fixed income exposures. Overweights to U.S. small caps negatively impacted performance, as did allocations to managed futures funds. Managed futures, which are utilized primarily for their diversification benefits and are able to invest both long and short across stocks, bonds, commodities, and currencies, were in the red, as just about anything short lost money for the month.
[1] https://www.foxbusiness.com/politics/inflation-americas-problem-take-until-2025-resolve-ny-fed-president
[2] U.S. Bureau of Economic Analysis
[3] U.S. Bureau of Labor Statistics
[4] Commerce Department
[5] Federal Reserve
[6] Yardeni.com
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Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country’s economic health.
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. |
| 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. |
| Chinese Equity | China Shanghai Composite | Measures the value of all stocks (A-shares and B-shares) traded on the Shanghai Stock Exchange. |
| Emerging Market Equity | MSCI Emerging Markets | An Index that captures large and mid cap representation across 27 Emerging Markets (EM) countries |
| Investment Grade Corporates | Morningstar US Corporate Bond | Measures the performance of fixed-rate, investment-grade USD-denominated corporate bonds with maturities greater than 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. |
| Municipal Bonds | Morningstar US Municipal Bond | Measures the performance of fixed-rate, investment-grade USD denominated tax-exempt debt issued by U.S. state, U.S territory, and local government entities with maturities greater than one year. |
| 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. |
| 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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