It’s over. 2022 that is. Whether the pain in capital markets is over is a different, and unanswerable question, but 2023 is unlikely to play out in the same way given the dramatically different starting point in terms of rates. On New Year’s Eve 2021, the yield on the 10-year Treasury stood at 1.52%. Fast forward one year, and the 10-year is at 3.88%, not too far off the recent closing high of 4.25% at the end of October. And the upper limit of the Fed Funds rate, which began 2022 at a mere 25 basis points, now sits, seven hikes later, at 4.50%. Yet inflation, which came in at 7.1% year-over-year in December of 2021, finished November of 2022 at, wait for it, 7.1%. Granted, it did take an interesting ride to about 9% along the way.

At the risk of eliciting PTSD in some readers, those inflation prints, rate hikes, and interest rate movements resulted in the worst equity market since 2008, with the S&P 500® falling by 18.1% on a total return basis. Further, the bond market experienced its worst year ever, collapsing by 12.9% in nominal terms, and depending on what the final inflation number turns out to be, potentially around -20% in real terms. All of which left the vaunted 60/40 portfolio with a loss of about 16%. Where did I put that Pepto?

While the backdrop is much changed in some respects, 2023 begins with a few parallels. Aside from the aforementioned inflation numbers, economic growth, which accelerated in 4Q21, has, if the Atlanta Fed’s GDPNow forecast can be believed, accelerated once again in 4Q22. The current estimate is for 3.9% growth, which would not only be the strongest quarter of the year but the third straight quarter of improvement. Job openings, which came in at 10.9 million in November 2021 (and increased to 11.4 million by year-end), finished November 2022 at 10.5 million, according to the Bureau of Labor Statistics. There simply isn’t much weakness to speak of yet. However, the Fed’s efforts will certainly have an impact, albeit with a lag, and The Wall Street Journal reports that “More than two-thirds of the economists at 23 large financial institutions that do business directly with the Federal Reserve are betting the U.S. will have a recession in 2023…They cite several red flags: Americans are spending down their pandemic savings. The housing market is in decline, and banks are tightening their lending standards.” Exacerbating the global growth outlook is the fact that both Chinese manufacturing and service-sector activity recently fell to their lowest levels since the onset of COVID (Source: The Daily Shot), given that the Chinese Communist Party only recently did away with its zero COVID policy, which has unleashed a wave of the disease on a population that had heretofore been largely insulated.

Indeed, the past year has been a tough slog for investors, and perhaps more so for financial advisors working diligently to calm clients’ nerves, keep them focused on the long term, and remain committed to financial plans so carefully crafted. It hasn’t been easy for us either, but as Winston Churchill famously said, “We shall fight on the beaches, we shall fight on the landing grounds, we shall fight in the fields and the streets, we shall fight in the hills; we shall never surrender.”  On that, you have our word. Happy New Year!

What happened in the markets in the fourth quarter?

Equities: European vacation

A big hats-off to overseas markets that provided a much-needed respite from an otherwise taxing year. During the fourth quarter, large or small, growth or value, you couldn’t go wrong. The MSCI EAFE Value Index gained almost 20%, international small growth stocks advanced by over 14%, and everything else EAFE ended somewhere in between. To be fair, the sagging U.S. dollar is owed a tip of the cap as well. While international developed stocks bested U.S. equities in both dollar terms and local currency terms, their performance in the absence of the dollar’s decline was far less spectacular; EAFE in local currency returned 8.7%.

In the U.S., quality small caps (S&P 600) handily outperformed large caps, 9.2% to 7.6%, but the Russell 2000, which contains many more negative earners, trailed, generating a return of 6.2%. REITs, which have been a punching bag all year, put up a 524-basis point performance, to end the year with a 24.4% loss. Finally, outside of developed markets, China’s almost 36% rise over the final two months of the year wiped out stomach-churning losses in October, and pulled emerging market equities along for the ride, helping them to gain 9.7%.

Corporate America is facing a much more challenging landscape as we head into 2023, but despite the strong possibility of a recession, and seemingly multiple threats to margins, analysts are still expecting earnings growth of 5.5% for the S&P 500, according to FactSet. One interesting headwind to margins that we’ve mentioned before, is the reshoring of manufacturing jobs, which BofA recently said was a record year for such activity, bringing back almost a quarter of a million jobs. And while we are glad to hear of such, we’d be remiss not to point out that the offshoring of jobs was a key contributor to decades of low inflation. Sigh.

Bonds: A welcome gain

The yield on the 10-year Treasury ended the quarter about where it started at 3.9%, and the yield curve experienced a bear flattening, i.e., short rates rose while longer-term rates mostly stood still. With that as the backdrop, the broad bond market chalked up a decent quarter, returning 1.9%. TIPS did a bit better at 2.0%, and credit faired quite well with investment grade (+3.7%), leveraged loans (+3.8%), and high yield (+4.1%) all generating respectable returns. But a rising tide didn’t lift all ships, long-term Treasuries capped off a troubled year with a loss of 62 basis points for the quarter.

Despite the consistently hawkish tenor of the Federal Open Market Committee (FOMC) minutes, which among other things revealed that most Fed officials see a peak in rates of between 5% and 5.5% in 2023, with expectations for that level to hold until sometime in 2024, markets think otherwise. Futures markets are pricing the terminal rate at just under 5%, with cuts coming during the second half of 2023. Wishful or prescient thinking? We’ll see.

Commodities: Alloys allure

Most commodities added to what has been a solid year. Industrial metals (+16.4%) and precious metals (+13.3%) were the quarter’s big winners, with the former advancing on China’s reopening. Elsewhere, agricultural futures limped along (+2.4%) and energy contracts fell by over 9%. But looks can be deceiving, and under the surface, most energy components were up for the quarter; petroleum led with a gain of 7.5%. What brought the energy complex down was natural gas, which fell by 36% in warmer weather.

How are Frontier strategies positioned?

Allocation changes

Within Frontier Core Strategies, none of the asset allocation shifts that drive our trading decisions changed by more than 1.5% going into January. Trading activity was minimal and the few trades that did occur across the lineup were implemented to either make manager changes or to better align our existing exposures with our target allocations.

Within the Frontier Tax-Managed Strategies, the biggest asset allocation changes going into the month were reductions to municipal bonds, which performed quite well in the fourth quarter, in favor of TIPS, which now sport meaningfully positive real yields, and managed futures, which have struggled of late. At the trade level, however, we took the opportunity to harvest additional losses to hopefully offset gains over the remainder of the year, and those trades may or may not have aligned directly with the asset allocation changes. Further, some of the trades that were completed were to push our risk exposures closer to targets.

Within the Frontier Specialty Strategies, given how different those models are from one another, there were no common asset allocation changes to start the year. Only one of the Specialty Strategies – Focused Opportunities – experienced any trading activity, and that was to reduce global equities and add to managed futures, in keeping with the target asset allocation.

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 fourth quarter, Frontier’s more aggressive, Core strategies were within a couple of basis points of their respective benchmarks, except for Long-Term Growth, which outperformed by a significant margin on a gross-of-fee basis. The more conservative strategies underperformed benchmarks but were able to generate solidly positive performance. For the calendar year, the Balanced and Moderate Growth strategies, which sit in the middle of our offerings in terms of risk, were both slightly ahead of their benchmarks in what was a disappointing year on an absolute basis.

Frontier’s Specialty Strategies were either on benchmark (Absolute Return) or well ahead of benchmark (Absolute Return Plus and Focused Opportunities) for the quarter. Within our Tax-Managed Strategies, all strategies, except for Long-Term Growth, underperformed their respective benchmarks on a pre-tax basis, while capturing and transforming paper losses into tax assets for clients, as losses were harvested.

From an asset allocation perspective, in general, across our strategies, our overweights to international and U.S. small caps, and emerging markets, were beneficial, while our underweight to international large caps, the quarter’s best performers, hindered results. On the fixed income side, strategies that were overweight to high yield and leveraged loans benefitted, while our long-term Treasury positions posted mildly negative results for the quarter and trailed all other fixed income sectors. Managed futures funds, which we’ve been utilizing largely as a diversifying asset at a time when fixed income has failed in that role, hurt performance for the quarter, with all the funds that we utilize ending in the red.