09 Nov 2022
Higher for longer
The Federal Reserve’s efforts to cool the U.S. economy and achieve price stability have yet to bear fruit. After two consecutive quarters of negative annualized growth, the economy grew at an inflation-adjusted annual rate of 2.6% in the third quarter, which is above the 2.3% average over the last decade[1]. Further, most of the jobs-related data continues to show strength. The Bureau of Labor Statistics reported that U.S. employers added 261,000 jobs in October; that was down from 315,000 in the prior month, but ahead of the 205,000 expected by economists surveyed by The Wall Street Journal. Job openings recently increased by almost a half-million, going in the opposite direction of expectations, initial jobless claims remain muted, and continuing claims are well below levels witnessed between the last two recessions. Add to that the fact that wages keep rising rapidly and consumers keep spending, and it seems clear that rates will likely continue to increase and should remain elevated for a considerable period. Futures markets are telegraphing a terminal Fed Funds rate now in excess of 5%, with the peak expected in July of next year. However, given that Chairman Powell has said that he believed, “…over-tightening carries a smaller penalty than going too slowly” those rapidly changing estimates may prove to once again be too low. Welcome to higher for longer.
Not only is the job market on steady footing, albeit with a notable uptick in layoff announcements from several big tech companies, but economists at the Federal Reserve recently estimated that American households had roughly $1.7 trillion of excess savings remaining in the second quarter of the year, far above the $99 billion in the first quarter of 2020.[2] That pile of cash is, as could be expected, held mostly by higher-income households, but even the bottom quartile groups are much better off than in the pre-COVID days. That helps explain why corporate revenues have thus far held steady. FactSet reports that, “The blended revenue growth rate for the third quarter is 10.5% today [for the S&P 500®], compared to a revenue growth rate of 8.7% at the end of the third quarter. If 10.5% is the actual growth rate for the quarter, it will mark the seventh straight quarter that the index has reported revenue growth above 10%. All eleven sectors are reporting year-over-year growth in revenues, led by the Energy sector.”[3]
The energy sector isn’t just ahead on top line but is also responsible for keeping overall earnings on the plus side. With about 87% of firms reporting so far, S&P states that operating earnings are estimated to come in at +12.6% quarter-over-quarter, but only by a modest +1.4% year-over-year (and GAAP earnings are down 4.8% YOY). Without the energy sectors’ bounty, operating profits would be in the red for the S&P compared to a year ago. Looking ahead, analysts expect a decline in earnings of -1.0% for Q4, but earnings growth of 5.6% for the full calendar year (FactSet)³. Neither the consumer nor the corporate world is showing signs of significant stress at the present, which is at odds with overall economic sentiment as we head into the mid-term elections.
What happened in the markets in October?
1. Equities: China & Big Tech aside, October was stellar
Every major equity category enjoyed healthy gains during the month except for emerging markets, thanks to China, which plummeted by almost 17% on fears about Xi Jinping’s tightening grip on the Chinese Communist Party. Emerging market equities fell by 3.1%, but ex-China they were up 3.2%. U.S. small cap stocks were the biggest winners overall, advancing by 12.4%, with small value stocks doing even slightly better. Smaller names within the S&P 500 also fared well, with the equal weighted S&P (+9.8%) outperforming the market cap weighted version (+8.1%) by 170 basis points. Microsoft, Alphabet, Amazon, Tesla, and Meta were all in the red for the month, with Meta losing over a third of its value, helping to explain the outperformance of the equal weighted index. Overseas, international developed markets also rang up solid returns, with large names gaining by 5.4% and smaller companies advancing by 4.2%. As was the case in the U.S., value names outperformed growth overseas. And for the first time in a while, the U.S. dollar did not materially impact the returns earned by U.S. investors in foreign markets.
2. Bonds: The hits just keep on comin’
With yields rising rapidly across the curve (28 bps on the 2-year and 27 bps on the 10-year) bonds served as a punching bag once again. Corporates were down about 1%, besting the broader investment grade index, which fell by 1.29%, and long-term Treasuries, which took another stomach-churning drop of 5.6%. There were a few bright spots, however. Because Treasury yields were driven higher due to inflation expectations, while real rates fell, TIPS managed to add 1.2%. Junk bonds advanced by 2.8% on continued economic strength, and rate sensitive leveraged loans benefited from the rise in short rates, gaining 1.6%.
Bank of America noted in a research piece that so far, it’s been the worst year for the 10-year Treasury since 1788[4], suggesting (maybe) that things can only get better from here. And that might be what BofA’s clients are thinking as well, seeing as they’ve been behind strong inflows to bonds in recent weeks. Morningstar has also reported a surge in flows to long term government funds during the quarter, and JPMorgan’s Treasury Investor Sentiment Index is in positive territory for the first time in almost two years. All welcome news to a battered bond market.
3. Commodities: “Black Gold” again outshines the real thing
While heating oil, petroleum, Brent crude, and WTI crude futures all posted double digit gains, both gold futures and gold spot prices fell. Based on spot prices, it was the seventh straight monthly decline for gold, which according to Deutsche Bank, is a record losing streak not seen since 1869. The almost 2% loss brings the year-to-date number to -10.3%. Incidentally, the gains in oil and oil related products were related to the announcement by OPEC+ that it would cut production by the largest amount since the beginning of the pandemic. Elsewhere within the commodity complex, agricultural futures as a group were up slightly (+1.1%), and industrial metals were off a bit, returning -0.6%.
How are Frontier strategies positioned?
Allocation changes
At the asset allocation level, the most consistent changes going into November were small (+1% or so) increases to emerging market equities, influenced by the fact that we are at all-time highs in terms of expected returns for the asset class, according to our models going back to the inception of Frontier. All other changes were strategy specific. Considering our Core Strategies, the asset allocation changes did result in the addition of emerging market exposure to a couple of the portfolios, but overall trading in our non-taxable series was minimal. Within our Tax-Managed Strategies, we continued to engage in tax loss harvesting, which accounted for the majority of trading for the month.
Overall positioning remains in favor of U.S. small caps, emerging market equities, international small caps, managed futures, and long-term Treasuries. Our more conservative portfolios are overweight floating rate loans as well. We are generally underweight U.S. large cap stocks, international large caps, 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
October was a solid month for Frontier strategies on an absolute and relative basis. All of our Core Strategies were either ahead of benchmark or on benchmark, with the exception of Balanced, which trailed slightly. Within our Specialty Strategies, all were ahead of benchmark for the month. One of the primary tailwinds was the strong outperformance of small caps, especially quality small caps. Aside from that exposure, the outperformance was attributable more to manager/fund specific performance, as many of our tilts at the asset allocation level worked against us, such as our managed futures and long-term Treasury overweights, and the underweights to U.S. large caps.
[1] The U.S. Bureau of Economic Analysis.
[2] https://www.federalreserve.gov/econres/notes/feds-notes/excess-savings-during-the-covid-19-pandemic-20221021.html#:~:text=By%20the%20third%20quarter%20of,%241.7%20trillion%20by%20mid%2D2022
[3] https://insight.factset.com/sp-500-earnings-season-update-november-4-2022
[4] https://www.marketwatch.com/livecoverage/stock-market-today-10-28/card/what-s-next-for-bonds-after-10-year-treasury-note-s-worst-performance-since-1788–eH3SxR2FBNRnycUF4e2r
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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. |
| Emerging Market Equity | MSCI Emerging Markets | An Index that captures large and mid cap representation across 27 Emerging Markets (EM) countries |
| 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. |
| 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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