If indeed equity markets advance on investor concerns, the route up the face of that mountain isn’t lacking for hand holds. Not only are fierce debates raging about the inflation picture and whether the Fed can architect a soft landing, but the entire world order is in flux, with decades of globalization now being challenged in favor of onshoring and supply chain independence.

The market is torn on the outlook; the yield curve keeps toying with inversion, and historically, once that happens (if it sticks for more than a moment), a recession follows in about 18 months on average. Given just how strong the labor market is, it is difficult to see a recession hitting any earlier than that. According to the U.S. Bureau of Labor Statistics, both initial and continuing jobless claims recently hit lows not seen since 1969, and the unemployment rate came within 10 basis points of the fifty year low it hit just before the pandemic began. Over 11 million open positions remain countrywide.

The Atlanta Fed’s GDPNow model is now projecting first quarter GDP to come in at about 0.9%, a far cry from the torrid 6.9% annualized pace witnessed in the fourth quarter. And the bond market, by way of inflation breakeven rates, is signaling expectations for inflation to average about 3.3% over the next five years, falling to 2.4% for the five-year period after that. Despite all the hand wringing, and with the acknowledgment that a lot depends on the Fed’s credibility, that 2.4% inflation rate looks awfully similar to the 2.2% average over the past 15 years. It would seem for now, market participants are believers.

What happened in the markets in the first quarter?

1. Equities: The more things change…

As if the market didn’t have enough to contend with, first quarter earnings for U.S. large caps are expected to fall quarter-over-quarter by almost 10% on an operating basis and by just over 12% on an as-reported basis, according to S&P. But despite the mounting pressures on margins, at 13.4% (est.) they remain a hair’s breadth away from the all-time high of 13.5% set in the second quarter of last year. And on a trailing twelve-month basis, S&P 500 operating and as-reported earnings have been enviable, advancing by 41% and 56%, respectively, albeit off a low base, the twelve-month period inclusive of the second quarter of 2020.

With slowing growth, rising inflation, and rising rates, equities were challenged during the first quarter. Nearly every broad equity index – domestic or foreign – was in the red. Notably, international developed large cap value stocks eked out a 0.3% return, but beyond that, risk appetites were left unsated. The ugliest part of the market was the small cap growth space, where both the Russell 2000 Growth and the MSCI EAFE Small Growth indices declined by 12.6%, trailing their value counterparts by margins of 10.2% and 8.2%, in turn. And while the market environment changed dramatically during the first quarter, ultimately, the song remained the same, the S&P 500 (-4.6%) outperformed small caps (-5.6%), international developed stocks (-5.9%), and emerging market equities (-6.9%).

Indomitable, unconquerable, unstoppable; pick your favorite synonym to describe the S&P 500 basically since the bottom of the market during the Financial Crisis of 2008-2009. But while you ponder the relative greatness of this simple “well diversified” asset, consider that at year-end the top ten stocks in the index had the same aggregate market value as the bottom 408 stocks, and accounted for 30.5% of the index, according to the folks at Horizon Kinetics. In contrast, just a few years ago in 2010, the top 10 stocks made up 18.7% of the index and their combined market cap equaled that of the bottom 255 stocks. The risk in the index continues to concentrate, which makes us wonder if there could be an immovable object somewhere in the path of this unstoppable force.

2. Bonds: Viewer discretion is advised

Hyperbole, perhaps, but the first quarter was not kind to fixed income. Losses were universal, with few places to hide, except for cash and leveraged loans, which managed to stay about flat (-0.2%). Over the course of the quarter, the Fed’s stance became increasingly hawkish, they raised rates for the first time in years, and telegraphed six more hikes for 2022. And in recent days, Fed comments about the pace of their balance sheet reduction efforts again have bond markets in a tizzy.

Worst hit were long duration Treasuries, with the 20+ year index falling by 11%. Hard currency emerging market debt (-10%) was a close second, thanks in part to the dollar’s strength, and investment grade corporates rounded out the bottom three sectors, losing 7.7%. Less interest rate sensitive high yield bonds held up better, only losing 4.8%, and the Bloomberg Aggregate Bond and Municipal indices, staples of the traditional 60/40 portfolio, were both off by about 6%. The Aggregate is now in its worst drawdown since the early 1980s.

3. Commodities: Inflation + conflict = gains

Every subcomponent of the Bloomberg Commodity Index advanced during the quarter, pushing the Index itself to a 25.6% gain. Current and proposed sanctions on Russia due to its war on Ukraine, along with upended trade routes and relations, as well as that little pre-existing inflation issue, helped push futures for natural gas (+58.5%), nickel (+56.2%) and heating oil (+54.7%) higher for the quarter. Nickel took center stage within the commodity complex, as it spiked on fears of shortages that led to a massive short squeeze, imperiling Chinese metal producer Tsingshan Holding Group Co. The company was on the hook for $15 billion momentarily when prices hit $100,000. In response, the London Metal Exchange suspended trading for a week and canceled trades worth over $4 billion, as reported by CNN. Elsewhere, investors holding gold and silver as an inflation hedge were rewarded, with gains of around 7%, but those gains were rather pedestrian given the number of commodities in double digits, from tin (+12%) up to natural gas (+58.5%), as previously mentioned.

How are Frontier strategies positioned?

Allocation changes

Frontier strategies began and ended the quarter in similar positions, with only modest modifications made along the way, as both stocks and bonds were under water. Given valuations and earnings expectations, we continue to see better long-term opportunities in out of favor equity segments, namely U.S. and international small caps, and emerging markets. In addition, we view U.S. and international large cap stocks more warily (especially the former). Despite these views, and the resulting over/under weights relative to long term allocations, U.S. large caps do dominate the absolute weightings within the equity complex for our strategies, with the exception of our most aggressive strategy, Global Opportunities.

Our fixed income expectations continue to set a very low bar, even after the recent selloff, due to low rates and both recent changes in the yield curve and expected changes over the coming year. Across the board, real return expectations remain in spitting distance of zero, making fixed income suitable mostly for risk reduction (please forgive the incongruity of that statement in light of first quarter bond performance). We maintain significant exposures to high quality bonds in our more conservative strategies, and meaningful, but not particularly large exposures to long term Treasuries within our more aggressive strategies, while mostly avoiding TIPS, high yield, and international bonds. In an effort to include lower correlated assets, given the unattractiveness of fixed income, we have held significant positions in managed futures strategies, which benefit from rising rates.

Performance attribution

As all risk assets except for commodities experienced losses for the quarter, our strategies too were in the red. Most trailed benchmarks as well, thanks to our over/under weightings within the equity complex, our modest underweights to commodities, and exposure to long term Treasuries. On the subject of Treasuries, it should be noted that at the portfolio level, using our Balanced strategy as an example, our duration risk inclusive of all of our fixed income positions was not meaningfully different from that of the Aggregate Index itself. As always, it is important to consider the sum of the parts, not the parts in isolation. Finally, one bright spot for the quarter was the performance of managed futures strategies, which, at the fund level, returned between 9.2% and 18.1%, stemming losses from other asset classes.