21 Oct 2022
Divergence
Just past the halfway mark for the month, stocks and bonds have decoupled, with healthy gains for developed market equities and continued losses for most fixed income sectors. Quality U.S. small caps, represented by the S&P 600®, have surged by 6.6% through the 18th, and are the best performing asset class that Frontier utilizes within strategies. Long-term Treasuries on the other hand have led on the downside, returning -3.4%. Exactly why equities and bonds have moved in different directions of late isn’t exactly clear, as the inflation picture, the Fed’s stance, and expectations for overall economic growth and earnings have given investors much to wrestle with. Regarding economic growth, economists surveyed by the Wall Street Journal now place the odds of a recession within the next 12 months at 63%.
That expectation is no doubt influenced by comments from members of the Federal Reserve questioning the impact that rates hikes have had to date. As reported by the Wall Street Journal, and echoing similar statements from other Fed members, PIMCO alum Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, commented earlier this week that absent actual progress on lowering core inflation, he did not see why he would favor stopping rates at 4.5 or 4.75 percent next year. “We’re not even sure that the problem is not getting worse, I’m not ready to declare a pause until we at least have that confidence,” he said.
Complicating matters, U.S. manufacturing output rose in September to its highest level since 2008 and capacity utilization matched its highest level in decades. Capacity utilization above 80% is generally considered inflationary.
Returning to markets, as we’ve noted previously, the strength of the U.S. dollar has done a number on international holdings this year, and that trend has continued in October. The MSCI EAFE Index is up 2.7% in dollar terms, but in local currency terms, it’s risen by 3.2%, bringing the year-to-date outperformance of the local currency index to a whopping 13.4%. But according to the BofA Global Fund Manager Survey, the most crowded trade is now considered to be long-dollars, which may portend a top of sorts. It should be noted that the strength of the U.S. dollar not only provides Americans with greater purchasing power while vacationing overseas, but also when purchasing foreign assets. Combining that purchasing power with what are already compelling valuations – case in point European stocks that are trading as cheaply as they have in a decade – helps explain why many strategists expect higher long-term returns for international and emerging market equities than for U.S. equities.
Within fixed income markets, high yield issues have continued to outperform, generating a 1.5% return so far this month, while investment grade corporate issues, which are more sensitive to rate changes, have bled another 1% or so. Because investment grade bonds have so underperformed year-to-date, while interest in high yield has been growing, on a spread basis, junk’s appeal is reduced.
With the whiplash that equity markets have inflicted upon on investors this year, its understandable that investor sentiment surveys are exceedingly bearish, but its also worth remembering that when all the news is bad, assets are priced as such, and future performance can be rewarding to those willing to invest while being eyed by a bear.
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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.
| ASSET CLASS | INDEX | INDEX DESCRIPTION |
| Quality U.S. Small Cap Stocks | S&P 600 | Measures the small-cap segment of the U.S. equity market. |
| International Developed Market Stocks | MSCI EAFE Index | Designed to measure the equity market performance of developed markets outside of the U.S. & Canada |
| High Yield Bonds | Morningstar U.S. High Yield Bonds | Measures the performance of USD-denominated high-yield corporate debt. It is market-capitalization weighted. |
| 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. |
| 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. |
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