A Rock and A Hard Place
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?
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.
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.
Past performance is no guarantee of future returns. Performance discussed represents total returns that include income, realized and unrealized gains and losses, but gross of advisory fees. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types 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.
Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice. Frontier obtained some of the information provided herein from third party sources believed to be reliable, but it is not guaranteed, and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. Frontier’s use of external articles should in no way be considered a validation. The views and opinions of these authors are theirs alone. Reader accesses the links or websites at their own risk. Frontier is not responsible for any adverse outcomes from references provided and cannot guarantee their safety. Frontier does not have a position on the contents of these articles. Frontier does not have an affiliation with any author, company or security noted within. Frontier reserves the right to remove these links at any time without notice.
Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries or financial instruments of any kind. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice. Frontier does not directly use economic data as a part of its investment process.
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 in 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.
Nominal GDP measures a country’s gross domestic product using current prices, without adjusting for inflation. Contrast this with real GDP, which measures a country’s economic output adjusted for the impact of inflation.
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|ASSET CLASS||INDEX||INDEX DESCRIPTION|
|U.S. Large Cap Equity||S&P 500||Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ|
|U.S. Large Cap Growth||Nasdaq 100 / Russell 1000 Growth||Measures the performance of companies with higher price-to-book ratios and higher forecasted growth values.|
|U.S. Small Cap Equity||S&P 600||Measures the performance of the small-cap segment of the U.S. equity market.|
|U.S. Small Cap Value||Russell 2000 Value||Measures the performance of the large- cap value segment of the US equity universe.|
|International Developed Equity||MSCI EAFE||An equity index which captures large and mid cap representation across 21 Developed Markets countriesaround the world, excluding the U.S. and Canada.|
|International Small Cap Equity||MSCI EAFE Small Cap||An equity index which captures small cap representation across Developed Markets countries* around the world, excluding the US and Canada.|
|Investment Grade Bonds||Bloomberg U.S. Aggregate Bond||Measures the performance of the U.S. investment grade bonds market. The securities must have at least one year remaining to maturity, must be denominated in U.S. dollars and must be fixed rate, nonconvertible and taxable.|
|Investment Grade Corporates||Bloomberg Barclays U.S. Corporate OAS||Represents the Option-Adjusted Spread (OAS) of the Bloomberg Barclays U.S. Corporate Index, which measures the investment grade, fixed-rate, taxable corporate bond market.|
|High Yield Debt||Bloomberg US Corporate High Yield||Measures the USD-denominated, high yield, fixed-rate corporate bond market.|
|Long-Term Treasuries||Bloomberg US Treasury 20+ Year||Measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with 20+ years to maturity.|
|TIPS||Bloomberg U.S. Treasury TIPS||Represents inflation-protected securities issued by the U.S. Treasury. TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers|
|Hard Currency Debt||JPM EMBI Global Diversified||An unmanaged, market-capitalization weighted, total-return index tracking the traded market for U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.|
|Local Currency Debt||JPM GBI-EM Global Diversified||Comprehensive emerging market debt benchmarks that track local currency bonds issued by Emerging market governments.|
|Commodities||Bloomberg Commodity||This is a 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.|