December 2024 Capital Markets Perspective

With election-related uncertainty behind it, markets rallied, adding to what has been a string of strong Novembers in recent years. U.S. equities and all major fixed income sectors generated healthy returns, as investors rapidly tried to discern which industries and companies would be the beneficiaries of reduced regulation, accelerating M&A activity, and changes to government spending. And while there were clear winners, fully 385 of the 500 S&P constituents ended the month in the black, indicating widespread confidence in the outlook for corporate America.

Adding to the enthusiasm for stocks and bonds was the Fed’s unanimous decision to reduce rates by another 25 basis points (bps) to a range of 4.5% to 4.75%. But the rate cut outlook is again being challenged, as inflation came in higher than in the prior four months (although as expected), real wages keep improving (+1.4% YOY), and initial jobless claims hit a multi-year low for this time of year. Even manufacturing, which has been in contraction territory, is showing signs of optimism, even as the surge in the dollar is weighing on export orders. At the time of this writing, the futures market is placing a 78% probability of another 25-bps cut at the December 18^th meeting, but after that the rate path becomes a bit more murky, evinced by Fed Governor Christopher Waller’s recent comment that, “I feel like an M.M.A fighter who keeps getting inflation in a choke hold, waiting for it to tap out, yet it keeps slipping out of my grasp at the last minute.”

Surveys show that households haven’t been this bullish on stocks for two decades. And fund managers are about as fully invested as they can be. Signs of exuberance abound, with rapid growth of leveraged ETFs and explosive gains for cryptocurrencies. But often times such indicators, rather than being affirming of market conditions, end up being contrarian. As Berkshire Hathaway’s cash position has risen to almost 30% of total assets, an all-time high, investors just might be wise to temper their enthusiasm.

What happened in the markets during the month?

EQUITIES: The Tr(i)ump(h) of Small Cap

U.S. small cap equities experienced a blistering rise during the month, gaining almost 11% as the S&P advanced by a more modest, yet strong, 5.9%. The Mag 7 all performed well, but only Tesla (+38%) and Amazon (+11.5%) managed to outperform the broad large cap index. Expectations for less business regulation and the fact that smaller companies tend to be less exposed to oversee markets seemed to be behind the frenetic advance of small caps. At the sector level, the primary beneficiaries were consumer discretionary, financials, industrials, and energy.

But not all was well in the land of equities, as concerns about the impact of tariffs on global trade and a rising dollar hurt international developed and emerging market equities, which finished lower by 0.6% and 3.6% respectively. Related, according to BofA we are at a 75-year high in terms of cumulative outperformance of U.S. equities. And that trend in favor of U.S. equities has pushed a proxy for the U.S. equity risk premium to zero for the first time since 2002. Further, based on data from Goldman Sachs, just about every valuation measure for the S&P 500® is between the 95^th and 100^th percentile, meaning very expensive, the lone exception being free cash flow yield.

BONDS: Yields Down After Spike Last Month

The yield curve shifted lower during the month across almost all durations, and the 10-Year Treasury yield ended at 4.18%, 10 bps below that of the prior month end. The overall winner among fixed income sectors was long-term Treasuries, which gained 1.8%, as inflation expectations eased slightly after climbing into the election. Credit slightly outperformed investment grade debt, with high yield up 1.14% and quality bonds returning just over 1%, and the duration of both sectors gave them a boost over floating rate notes, which advanced by 0.8%. TIPS rounded things out by gaining almost 50 bps.

While absolute yields are still attractive overall, spreads on corporates are extremely tight. Investment grade corporate spreads reached a low not seen since 1997 during the month, and high yield spreads narrowed to their lowest level since the Global Financial Crisis (GFC). That lack of spread coupled with moderating rate cut expectations, has led to strong flows to bank loans once again.

COMMODITIES: U.S. Dollar Dents Precious Metals

The fortunes of the various commodity complexes split this month, with energy and agriculture experiencing gains of 3.7% and 1.9%, respectively, while industrial (-1.2%) and precious metals (-3.8%) fell. Energy sub-components differed widely, with natural gas rising as Brent and WTI crude fell with easing geopolitical tensions in the Middle East, particularly due to a cease-fire between Israel and Hezbollah, which alleviated concerns about potential disruptions in crude supplies.

Within industrial metals, sustained demand weakness in China and lack of broader stimulus measures for the economy largely contributed to declining metal prices. And improved supply further eroded prices, with China boosting aluminum output and Indonesia delaying its plans to ban copper exports until the end of 2024.

Lastly, precious metals were negatively impacted by a surge in the U.S. dollar.

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, ETF, 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. At the beginning of December, our asset allocation models shifted exposure within certain strategies from cash, U.S. small caps, and long-term Treasuries, to TIPs, in part due to the run up in small caps and the fact that our inflation expectations exceed market breakeven rates.  

Changes to return expectations varied by asset class, with U.S. equities experiencing a decrease, while all things foreign increased modestly. Within fixed income, high yield bond return expectations declined the most, as spreads have reached levels not seen in over a decade, while those for TIPS increased. U.S. large cap return expectations continue to hover near their 20-year lows, as is the case with REITs, with all other equity classes offering substantially higher real return potential; international small caps top the list.

PERFORMANCE ATTRIBUTION

Performance for the month greatly benefitted from our overweight positioning in U.S. small caps, which was the best performing asset class by a large margin. Managed futures was the next biggest positive contributor in certain strategies, but that was highly dependent on the specific funds utilized, as the range of outcomes from the funds in which we invest went from -1.7% to +2.2%. Avoiding commodities also positively impacted absolute and relative performance, as they only eked out a small positive return. But our underweights to U.S. large caps and REITs, and our preference for floating rate loans over high yield bonds all negatively impacted performance. Further, overweights to emerging markets and international small caps were a headwind, particularly because of the currency impact of a sharply rising U.S. dollar.