09 Mar 2023
Positive correlations, negative results
January’s jubilation gave way to February’s malaise (everything was down) as the now familiar theme of “market starting to believe the Fed” played out. The 10.8 million job openings in January may have been down from the 11.2 million reported by the Labor Department[i] in December but remain significantly elevated relative to the 7 million job openings in February of 2020. And the openings-to-unemployed ratio continues to hover around two. What’s a Fed chairman supposed to do in such an environment? Evidently, the answer is to stay the course. Futures markets are now pricing in a terminal rate for Fed Funds of almost 5.7% and have given up on the idea of cuts for the second half of the year.
With fourth-quarter earnings essentially in the books (97% of S&P companies have reported), operating earnings fell by 1.7% quarter-over-quarter and by 5.8% for the 122 months ending in December 2022 vs. December 2021 (source: S&P Global[ii]). But those pesky GAAP earnings, which must be based on accounting principles if you can believe it, fell by 12.8% and 13.1% over those same periods. Operating margins are anticipated to be around 10.8%, well above the long-term average but off materially from the peak of 13.5% achieved in 2Q21. Corporate America continues to fare well in the inflationary environment we find ourselves. Of course, that is typically cheered by investors, but the specter of even higher interest rates is taking its toll on sentiment.
Across the pond, core inflation in Europe is still rising, thanks largely to the pricing of services, and is approaching 6%, even as total inflation declines (source: Wall Street Journal and Eurostat[iii]). But the interest rate environment over there isn’t as foreboding, with futures markets suggesting that overnight rates will top around 4%, well below our Fed Funds. According to Citi’s Economic Surprise Index[iv], European economic data continues to surprise on the upside, which might help explain why the MSCI EAFE Index in local currency terms was the only equity index that we track that posted a gain for the month, however small.
What happened in the markets in February?
EQUITIES: LOTS OF RED
After a startlingly strong run by Chinese equities over the prior few months, February was a time to take some gains, which contributed to a more than 10% sell-off for the MSCI China Index. With that, emerging markets were down about 6.5% in total, with China accounting for almost 2% of the overall decline. Pickings were slim for U.S.-based investors, with all broad-based equity indices in the red in dollar terms for the month. Growth stocks outperformed regardless of market cap, despite typically being more sensitive to rising real rates; the Russell 3000 Growth was down a modest 1.2%. Quality small caps (S&P 600) likewise faired okay, also losing 1.2%. But the pain was more severe for all other equity classes, with international developed stocks, both large and small, off by about 2.1% in dollar terms, and U.S. value stocks (Russell 3000 Value) falling by 3.5% on recessionary concerns related to the possibility of over-tightening by the Fed.
BONDS: LEVERAGED LOANS STAY ABOVE THE FRAY
Exhibiting the hoped-for positive correlation to rising rates, leveraged loans managed to add 12 basis points of return to investor portfolios for the month. But that was the only bright spot in fixed income land, as the duration champs that are long-term Treasuries declined by 4.8%, and investment grade corporates, also not lacking in rate sensitivity, fell by 3.1%. The continued strength in economic data helped high-yield bonds shrug off some of their recession fears, enough to overcome some rate-related forces and post a 1.3% loss. TIPS were down 1.4% even as both 5-year and 10-year inflation breakeven rates increased during the month.
COMMODITIES: RISING RATES AND THE ADVANCING DOLLAR LEAD TO LOSSES
Industrial metal prices foretold of the oft-cited and repeatedly incorrect economic slowdown, with aluminum (-10.6%), zinc (-11.1%), tin (-15.4%), and nickel (-18.2%) all taking it on the chin. Precious metals also suffered as rates increased and the dollar advanced, with spot silver down 10.7% and gold falling by 5.6%. Within the agricultural complex, favorable U.S. weather conditions contributed to declines in wheat (-8.2%), corn (-6.7%), and soybeans (-3.5%). Energy futures were also in the red, in part due to high inventory levels of the underlying for many key contracts, especially natural gas in both the U.S. and Europe.
How are Frontier strategies positioned?
ALLOCATION CHANGES
Beginning this month, due to the complexities of attempting to generalize about allocation changes across our Core, Specialty, Taxable, 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. Those summaries describe in detail what trade activity occurred by strategy and why.
We will continue to use this section to describe the overall positioning of our Core Strategies relative to their long-term asset allocations, which serve as policy portfolios guiding our dynamic allocation decisions. Currently, our Core Strategies remain in favor of U.S. and international small caps, emerging market equities, managed futures, long-term Treasuries, and high-yield bonds. Our more conservative portfolios are also overweight floating-rate loans. We are generally underweight U.S. and international large-cap stocks, 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
While all of Frontier’s strategies posted negative returns for the month, given that all but two of the asset classes in which we invest were down, our more conservative strategies, i.e., Capital Preservation, Conservative, and Conservative Multi-Asset Income, were able to generate favorable relative performance, while strategies in the middle to the higher end of the risk spectrum, as well as our Specialty strategies, underperformed on a gross-of-fee basis. Our Tax-Managed Strategies largely fell in line with our Core Strategies in terms of relative performance.
From an asset allocation perspective, our overweight to managed futures and floating rate loans were generally rewarded, as was our overweight to U.S. small caps and underweight to REITS and commodities. However, our emerging market and long-term Treasury positions hindered results.
[i] https://www.bls.gov/news.release/jolts.nr0.htm
[ii] https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overview
[iii] https://www.wsj.com/articles/eurozone-inflation-eases-but-core-measure-hits-record-high-3903b283?mod=Searchresults_pos3&page=1
[iv] https://thedailyshot.com/2023/02/28/the-market-is-finally-coming-to-terms-with-no-fed-rate-cuts-in-2023/
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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 | S&P 600 | Measures the small-cap segment of the U.S. equity market. |
| International Developed Equity | MSCI EAFE | An equity index which captures large and mid cap representation across 21 Developed Markets countries around the world, excluding the U.S. and Canada. |
| Chinese Equity | MSCI China | Captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). |
| Emerging Market Equity | MSCI Emerging Markets | An Index that captures large and mid cap representation across 27 Emerging Markets (EM) countries |
| U.S. Growth | Russell 3000 Growth | A market-capitalization-weighted equity index that seeks to track 3000 of the largest U.S.-growth traded stocks. |
| U.S. Value | Russell 3000 Value | A market-capitalization-weighted equity index that seeks to track 3000 of the largest U.S.-value traded stocks. |
| 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. |
| 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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