What was likely to be a difficult task to begin with, that is, the unwinding of quantitative easing and the start of a rate hike campaign to tame inflation, just became significantly more challenging thanks to Russia. The Fed stands in an unenviable place at present. The myriad ways in which Putin’s war on Ukraine will affect the global economy are just beginning to be understood, and the landscape is changing rapidly, but for starters of course, we have oil. West Texas Intermediate crude oil has gone from $92 the day prior to the invasion (February 23rd) to $124 as of this morning, March 8th. While the U.S. was a net exporter of oil in 2020 and 2021, and Russian crude only makes up about 3% of our imports, according to the Energy Information Administration, replacing those imports is not easily achieved in the short run, and Europe’s dependency is far greater.

Even inclusive of energy markets, Russia’s economic footprint is small – its GDP (Gross Domestic Product) based on purchasing-power-parity as a share of the world’s total is only about 3.1% (Source: International Monetary Fund) — but it is a large exporter of grains and certain metals, like palladium and aluminum, and the impact on those markets is already being felt. Further, the unparalleled sanctions that have ceased or at least slowed multiple modes of travel across Europe and Asia, will have ripple effects across an already strained global supply chain. Inflation will likely only increase in the near term.

On a cheerier note, the job market continues to impress. While the market expected about 440,000 jobs to be added in February, the actual number came in at 678,000 and the unemployment rate fell to 3.8%, according to the Labor Department. Further, the previous jobs numbers for December and January were both revised higher. On the surface that may stoke greater inflationary fears, but the downside to the report is that wage growth is not keeping up with inflation; the dreaded wage-price spiral has not yet made an appearance. Perhaps that will help Powell and Co. to sleep a bit sounder.

What happened in the markets in February?

1. Equities: David fares well against Goliath

Indicators of market breadth, e.g. the percentage of stocks in the S&P 500® trading above their 200-day moving averages and the number of NASDAQ stocks hitting 52-week lows, continued to deteriorate during the month. Large growth stocks, whether measured by the NASDAQ 100 or the Russell 1000 Growth, sold off, returning -4.5% and -4.3%, respectively. But investors ran for shelter, perhaps surprisingly, into U.S. small caps, which saw the S&P 600 gain 1.4% and the Russell 2000 Value advance by 1.7%. As we pointed out recently in one of our market commentaries, small caps had been trading at about the biggest discount to large caps since the Tech Bubble, so that combined with the fact that small caps may be less exposed to global trade disruptions could help explain the outperformance.

Overseas, smaller and cheaper were also themes that worked, albeit only on a relative basis, as everything was in the red. The MSCI EAFE returned -1.8%, while its smaller sibling was down by 1.3%. Within emerging markets (-3%), all eyes are on Russia these days, with Barron’s reporting on March 2nd that shares in Sberbank, the country’s largest bank, had collapsed by 99% since mid-February, and their largest oil companies Rosneft and Lukoil both suffered equally disastrous outcomes. But at least going forward, emerging market investors won’t have to worry about Russian exposure anymore, as both MSCI and FTSE Russell announced that they would drop Russia from their indices, as the market had become “uninvestable”. Stranded assets will of course be something that will plague emerging market investors for some time.

2. Bonds: The rate rollercoaster ride

The yield on the 10-year Treasury began the month at 1.79%, reached 2.05% by mid-month, and ended back at 1.83%, barely above its starting point. And the yield curve continued to flatten throughout the month, and in the days since month-end, with the spread between the 10 and 2-year sitting at only 23 basis points (bps) as of March 7th.

In an environment that was shaped by a tug-of-war between inflation concerns and geopolitical risk, almost all bond categories finished in negative territory. The Bloomberg U.S. Aggregate lost 1.1%, high yield was down 1% (although CCC & lower paper was actually up by 0.6%, most likely due to the improving prospects for energy companies), investment grade corporates were off by 2%, and long-term Treasuries fell by 1.6%. The only major fixed income category that turned in a positive return was TIPS, which gained 85 bps. And as could have been expected, the biggest loser for the month was emerging market debt, with hard currency debt, as represented by the JPM EMBI Global Diversified Index, down by 6.7%. Local currency debt did a bit better, with the JPM GBI-EM Global Diversified off by 5%.

3. Commodities: The war premium

Commodities rallied across the board as tensions grew and bombs flew. Wheat futures gained the most (+22%), as both Russia and Ukraine are big exporters of the amber grain. But a mix of agricultural (e.g. soybeans +11.9% and corn +10.3%), energy (e.g. heating oil 11.3% and petroleum 10.6%), and metals (e.g. aluminum 11.7% and nickel +9.0%) were all up strongly for the month.  In addition, spot prices for gold and silver rallied by +5.8% and +8.3%, respectively, serving in their traditional hedging/haven roles. In aggregate, the Bloomberg Commodity Index advanced by +6.2%.

How are Frontier strategies positioned?

Allocation changes

Changes made to our asset allocation models at the beginning of February were modest, with shifts occurring primarily within our more conservative strategies. Minor increases were made to cash, floating rate loans, and absolute return strategies, funded by decreasing allocations to U.S. large cap stocks, investment grade bonds, and commodities. Within our equity positioning, while U.S. large caps carry the largest absolute weightings (except within Global Opportunities) our over and under weights relative to our long-term allocations continue to favor tilts to U.S. and international small caps, as well as to emerging market equities.

Within the fixed income complex, while most of our exposure is to high quality bonds, we do continue to maintain long-term Treasury exposure and mostly avoid high yield bonds, given the hedging properties of the former and the low return and higher risk profile of the latter. We are also overweight to managed futures funds in most of our strategies, which can provide meaningful diversification and hopefully better return potential than what is available for most fixed income categories.

Performance attribution

Within the equity allocations across our strategies, favoring U.S. and international small caps over large caps was beneficial, as U.S. small caps (S&P 600) were up 1.4%, while the S&P 500 was down almost 3%. Likewise, international small caps outperformed their large cap brethren by 50 basis points. Our emerging markets exposure was a negative in absolute terms – down 2.99% – but it was no worse than the S&P 500. Lastly, our underweight to REITs provided a relative boost, as REITs fell 3.1%.

Turning to fixed income, our overweight to long-term Treasuries negatively impacted performance, while our underweight to high yield had essentially no impact, as junk bonds were in line with the performance of high-quality bonds. Finally, our underweight exposure to commodities hurt absolute and relative performance, as commodities were the best performing asset class for the month. However, our managed futures positions generated solid monthly returns in part due to their exposure to commodities. The funds that we utilize to gain exposure to managed futures returned between 2.2% and 3.1% for the month.