13 Jul 2023
Predictably Unpredictable
At the end of 2022, investors felt battered and bruised after an awful year for stocks and bonds, and economists were increasingly calling for a recession. As I mentioned in our year-end commentary, the Wall Street Journal reported 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 a number of red flags: Americans are spending down their pandemic savings. The housing market is in decline, and banks are tightening their lending standards.” Fast forward six months, and the Commerce Department just revised its estimate for first quarter Gross Domestic Product (GDP) growth from 1.3% to 2.0%, the Atlanta Fed’s GDPNow estimate for 2Q GDP recently moved upwards to 2.3%, and the S&P 500® has turned in an almost 17% total return on the backs of growth stocks that have rocketed upward (the NASDAQ 100 is up 39.4%). Few were predicting that the economy and the market would take such paths as we collectively nursed our 2022 hangovers. Indeed, the market’s ability to confound never ceases to amaze.
But the Fed’s efforts, while failing to push us into a recession thus far, are having a meaningful impact. The Case-Shiller home indices fell in April from the prior year, marking the first such decline since 2012 and reflecting in part the fact that homeowners who are locked into low-rate mortgages are loath to move and see their rate double or triple. Further, inflation keeps coming down, as measured by both the Consumer Price Index (CPI) (4.1% YOY) and Personal Consumption Expenditures Price Index (PCE) (3.8% YOY), and the record streak of job gains exceeding expectations ended after a 14-month run, with 209k jobs added in June versus expectations for 240k. Despite the jobs’ “miss”, that report, along with the much stronger ADP report that reflected a gain of 497k, seem to be more than sufficient to keep the Fed on track for another hike when they meet towards month end (futures markets are currently pricing in a 92% chance for a 25-basis point increase).
With quarter-end comes the earnings parade, and the big banks are set to kick things off in the coming days. According to Yardeni Research and Refinitiv, analysts expect S&P constituents to report a third consecutive decline in quarterly earnings, with profits expected to be 8.9% lower than they were a year ago before leveling out in the third quarter and jumping by 8.3% in the fourth quarter. And while there are many potential headwinds for profitability, S&P data indicates that margins are expected to increase from 11.6% to 11.9% when the second quarter results are revealed. All of which is to say that corporate America is in solid shape, but what that may mean for equity returns in the second half is anyone’s guess.
What happened in the markets during the quarter?
EQUITIES: THE RISE OF MACHINES AND THE RISING SUN
While still a few hundred points away from the high set in January 2022, the S&P 500 clawed back another chunk of last year’s losses, gaining 9% in the second quarter and bringing the year-to-date cumulative return to about 17%. Growth sectors Consumer Discretionary (+14.6%), Technology (17.2%), and Communication Services (+13.1%) far outpaced all other sectors, but Industrials (+6.5%) and Financials (+5.3%) put up respectable numbers and helped the S&P 500 Value Index to a 6.6% return for the quarter and a 12.1% gain for the year.
The rise of real yields, which spelled doom for growth stocks last year, has seemingly been relegated to the dustbin of investor concerns, as real yields and growth stocks have been diverging since the fourth quarter. And according to JPMorgan, as of June 30th, the top 10 stocks in the S&P 500 make up a record high 31.7% of the total market cap of the index and trade at a forward Price-to Earnings (P/E) of 29.3 times earnings, well above the 17.8 multiple for the other 490 constituents. In addition, the earnings contribution of those top 10 names has fallen to 21.5% from a high of about 34%, which should give investors pause.
Overseas, Japanese stocks surpassed the S&P 500, with gains of 15.6% and 23.8% (MSCI Japan NR) for the quarter and year, respectively, in local currency terms, helped no doubt by Warren Buffet’s interest in Japanese equities. But those gains were hacked away at by a plunging currency (the Yen fell by about 8% during the quarter), leaving U.S. dollar investors up 6.4% for the quarter and 13% for the year. In contrast, while European equities greatly underperformed, advancing by only 1.8% for the quarter in local currency, the Euro’s advance added almost 1% to U.S. investors’ pocketbooks.
BONDS: REAL YIELDS MARCH HIGHER
The yield curve shifted upwards and inverted further over the quarter with the 10-year minus 2-year ending 48 basis points lower and the 10-year minus 3-month finishing 25 basis points lower. Further, 5-year real yields hit their highest level since 2009, ending at about +2% (they bottomed in 2021 at about -2%). With that as the backdrop, only high-yield bonds (1.7%) and leveraged loans (+3.3%) were able to post positive returns. Munis (-0.1%) and investment grade corporates (-0.3%) held up reasonably well, while TIPS (-1.5%) and long-term Treasuries (-2.4%) suffered steeper setbacks.
COMMODITIES: DOWN IN THE DIRT
All major commodity categories, agriculture (-1%), energy (-1.6%), industrial metals (-10.5%), and precious metals (-3.1%) were down for the quarter. Oil prices weakened despite the efforts of Saudi Arabia and other major oil exporters to drive them higher, as U.S. petroleum production, surpassing 12.5 million barrels a day, is on pace for a record-breaking year thanks in part to productivity improvements. Corn, soybeans, and wheat futures fell due to favorable weather forecasts in the Midwest and larger-than-expected Canadian production.
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, 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 continue to favor U.S. and international small caps, emerging market equities, managed futures, long-term Treasuries, and floating rate loans. 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.
Emerging market equities and international small caps continue to remain near the tops of their respective 20-year ranges in terms of expected return, while U.S. large caps and REITS are stuck near their 20-year lows.
PERFORMANCE ATTRIBUTION
For the quarter, our preference for global small caps over global large caps hindered performance, as did our overweights to emerging markets, which were hurt by the poor performance of Chinese equities. Our underweights to commodities and REITS, and our overweights to leveraged loans all boosted relative and absolute performance. Our hedging assets, managed futures funds and long-term Treasuries, went in opposite directions, as the former gained between 1.8% and 5.8%, while the latter fell by 2.4%.
Past performance is no guarantee of future returns. Performance discussed represents total returns that include income, realized and unrealized gains, and losses. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any type of securities, and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for an s investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or protect against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before investing, consider investment objectives, risks, fees, and expenses. Frontier may modify its process, opinions, and assumptions at any time without notice as data is analyzed.
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Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. The estimates, including expected returns and downside risk, throughout are calculated monthly by Frontier and will change from month to month depending upon factors, including market movements, over which Frontier has no control. They are only one factor among many considered in Frontier’s investment process and are provided solely to offer insight into Frontier’s current views on long-term future asset class returns. They are not intended as guarantees of future returns and should not be relied upon in making investment decisions.
Hypothetical expected returns have certain limitations, are discussed for illustrative purposes only and it should not be assumed that actual results will match the hypothetical expected returns referred to. Unlike actual performance, hypothetical expected returns do not represent actual trading and since trades have not been executed, the results shown may have under or overcompensated for the impact, if any, of certain unforeseen market factors. Hypothetical expected returns, whether back tested or forecasted, have many inherent limitations and no representation is being made that any account will or is likely to achieve the results expected. In fact, there are frequently material differences between hypothetical expected results and actual results achieved. One of the limitations of hypothetical expected results is that they do not take into account that material market factors may have impacted the adviser’s decision-making process if the firm were actually trading clients’ accounts. Also, when calculating the hypothetical expected returns, the adviser has the ability to change certain assumptions and criteria in order to reflect better returns. There are numerous other factors related to the markets in general or to the implementation of any specific investment strategy that cannot be fully accounted for in the preparation of hypothetical expected results, all of which can adversely affect actual trading and performance. Importantly, it should not be assumed that investors who actually invest in this strategy will have positive returns or returns that equal either the hypothetical expected results expected. In addition, performance can and does, vary between individuals.
In reviewing the performance information presented here, we recommend that you consider both the returns generated and the level of risk that was assumed in generating those results. We believe that performance information cannot be properly assessed without understanding the amount of risk that was taken in delivering that performance.
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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 | Nasdaq 100 | A stock market index made up of 101 equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock exchange. |
| European Equities | MSCI Europe Index | Captures large cap representation across the 10 Developed Markets (DM) countries in the EMU. |
| Japanese Equities | MSCI Japan NR | Designed to measure the performance of the large and mid cap segments of the Japanese market. |
| 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. |
| Leveraged Loans | S&P / LSTA U.S. Leveraged Loan 100 | Designed to reflect the performance of the largest facilities in the leveraged loan market. |
| 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. |
| 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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