13 Nov 2023
Relentless rise in rates takes its toll
October was not kind to investors, as every major asset class in which we invest was in the red, save for commodities, which eked out a 27-basis point gain. Credit the steady rise in the 10-year Treasury yield, which briefly surpassed 5% on October 19th, for the carnage in capital markets. On the plus side, the rise in rates has widely been viewed as doing the Fed’s job for them and has effectively squashed any chance for hikes in the coming months, despite Chairman Powell’s refusal to declare victory. Futures markets only put a 5% chance of a hike in December and a 9% chance in January, and the probabilities go down from there.
And why the continued rise in rates? Both economic strength and an increase in the term premium, or the extra compensation that investors demand for holding longer-dated investments have been widely cited. On the economic front, third-quarter real Gross Domestic Product (GDP) didn’t disappoint, coming in at a seasonally adjusted 4.9% rate, which was more than double that of the second quarter, according to the Commerce Department. Not one of the components of GDP was materially negative, with consumer spending, inventories, and government spending accounting for the large gain. Further, real personal spending accelerated at the end of the quarter, coming in at 0.4% for the month of September (a 4.7% annualized rate), surprising to the upside. This is at the expense of yet another decline in the savings rate, which means that the mighty consumer could be getting winded. However, with still solid, albeit cooling job gains and an estimated 9.6 million job openings at the end of September, it’s probably too soon to call a time of death on the shopping frenzy.
Across the pond lies an entirely different situation. The European Union’s statistics agency recently reported that GDP for its 20 members fell by an annualized 0.4% during the quarter. Given that reality and the fact that Eurozone Consumer Price Index (CPI) has fallen to 2.9%, the European Central Bank kept rates unchanged at its last meeting and the market does not foresee any additional increases. In fact, deep cuts are being priced in for 2024 and 2025.
What happened in the markets in October?
EQUITIES: NOWHERE TO RUN TO, NOWHERE TO HIDE
If you were invested in equities during the month, you felt the pain, but how much depended on where you had exposure and to what extent. Small caps in the U.S. and overseas got whacked the hardest, losing 5.7% and 5.9%, respectively, as investors worried about the adverse impact of higher interest costs. While large companies have been earning more interest income than they’ve been paying in interest expense, the same is not true for smaller companies, which have seen their financing costs spike.
International developed markets fared better, but still lost over 4%, while emerging markets declined by 3.9% and U.S. large caps fell by 2.1% as earnings season began to wind down. On that note, with about 64% of companies reporting, operating earnings were up 1.1% from the prior quarter, and on a trailing 12-month basis they are about 5% higher than they were at this time last year. However, while the earnings recession has ended, corporate earnings guidance has been weak, and analysts’ earnings downgrades have exceeded upgrades for seven weeks in a row. According to JPMorgan, only about 25% of S&P 500 companies have been revising earnings per share (EPS) guidance higher.
BONDS: DARKEST BEFORE THE DAWN?
The fallout from rising rates was widespread. The only fixed-income category that held up was leveraged loans, which shed 1 basis point. Long-Term Treasuries suffered mightily, falling by almost 5%, while core bonds were down 1.6% and investment grade corporates returned -1.9%. High yield bonds, which are less interest rate sensitive, retreated by 1.3% as spreads widened by about 42 basis points.
Towards the end of the month when rates peaked, Greek 10-year bonds were yielding less than their U.S. counterparts. If you recall the PIIGS crises, that one should be a bit of a shocker. I’ll add that at month end, TLT, which is in its 37th month in drawdown, was trading at a price last seen in 2007. Indeed, battle scars abound among fixed income investors, but as the Fed is likely done with rate hikes and inflationary indicators are heading in the right direction, perhaps, as Barron’s recently wrote, “It’s Time to Stop Crying About Bonds and Start Buying Them”.
COMMODITIES: “MY PRECIOUS” METALS
While commodities as a group finished slightly in positive territory, as always there was a wide range of outcomes below the surface, because, as surprising as it may be, wheat and platinum have little in common. Industrial metals (-4.1%) and energy contracts (-2.7%) were the losers. Oil was hit especially hard, with spot Brent Crude off by 8.3% despite the conflict between Israel and Hamas, on signs of increased production by OPEC and the United States. On the plus side, precious metals served in their typical global-chaos-safety-net role, gaining 6.3%, and the agricultural complex advanced by 2.4%, with all its sub-components except cotton in positive territory.
How are Frontier strategies positioned?
ALLOCATION CHANGES
Due to the complexities of attempting to generalize about allocation changes across our Core, Specialty, Tax-Managed, Multi-Asset 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, which describe in detail what trade activity occurred by strategy, and why.
Focusing on our Core Strategies, relative to their long-term asset allocations, which serve as policy portfolios guiding our dynamic allocation decisions, we favor U.S. and international small caps, emerging market equities, managed futures, floating rate loans, and cash/short-term bonds. We are generally underweight U.S. and international large cap stocks, REITs, commodities, and both high-yield 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 occur. At the beginning of November, our asset allocation models did shave a bit off equity and managed futures exposures in favor of high-quality bonds.
Return expectations for emerging market equities and international small caps continue to remain near the tops of their respective 20-year ranges. Expectations for TIPS, managed futures, floating rate loans, and T-bills are likewise high relative to history and are also above their year-ago levels. U.S. large caps remain near their 20-year lows, while REITs, which previously shared the same unenviable position have seen their outlook creep higher.
PERFORMANCE ATTRIBUTION
For the month, and focusing on our Core and Tax-Managed Strategies, our conservative to moderate risk-level strategies outperformed their respective benchmarks, while our more aggressive strategies were either on-benchmark or trailing. As for what helped or hurt absolute and relative returns is generally true across all Frontier’s strategies. Specifically, managed futures funds were the star performers in an otherwise bleak landscape; three of the four funds that we utilize in portfolios were in positive territory for the month when just about everything else was down. Bank loans were also additive, performing much better than other fixed income asset classes, while U.S. and international small cap exposure was highly detrimental to performance. Related, our underweight to large caps, compared to their long-term allocations and related benchmarks, was a negative.
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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 | Russell 2000 | A small-cap U.S. stock market index that makes up the smallest 2,000 stocks in the Russell 3000 Index. |
| 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 |
| International Developed Equity | MSCI EAFE | An equity index which captures small-cap representation across 21 Developed Markets countries around the world, excluding the U.S. and Canada. |
| Emerging Market Equity | MSCI Emerging Markets | Captures large and mid cap representation across 24 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 over 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. |
| REITS | FTSE NAREIT Equity REIT | A free-float adjusted, market capitalization-weighted index of U.S. equity REITs. |
| 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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