Is it safe to look?
Ugly hardly describes the second quarter. Of the 91 indices that we track at present, covering all manner of equities, bonds, commodities, currencies, and yes, even cryptocurrencies, exactly eight ended the quarter in positive territory. Four of those indices represented related energy contracts (heating oil +25%, petroleum +14%, Brent crude +10%, and WTI (West Texas Intermediate Crude Oil) +9%), two were agricultural contracts (coffee +1.9% and soybeans +1.5%), one was an equity index (MSCI China +3.4%), and one was a fixed income index (3-month T-bills +0.3%). So if your gas tank was full at the beginning of the quarter (and you didn’t drive), you loaded your cupboards with Folgers, your refrigerator with tofu, and you held a portfolio of cash and Chinese equities, congratulations! For the rest of us, a short memory and a glass-half-full attitude given the new and improved opportunity set is highly recommended.
The proximate cause of the wrenching losses was an inflation landscape the likes of which we haven’t seen in about four decades, leading to as hawkish a Fed as we’ve experienced over the same period, resulting in a seemingly schizophrenic market that alternated between worrying about the Fed being behind the curve and one that will push us into recession should it prevail over inflation. It is indeed a strange time when there are still close to two job openings for every single unemployed person, and yet some believe we are already in a recession. But there are legitimate reasons to worry. Consumer spending in the first quarter was revised down from a healthy 3.1% annual rate to 1.8%, and household spending in May advanced by only 0.2%, below the consensus estimate of 0.4%, according to the Commerce Department and the Wall Street Journal. Further, consumers are as despondent about the economy as they’ve been since the 1950s when the University of Michigan began producing its sentiment index. All of which helps to explain the Atlanta Fed’s GDPNow estimate for the second quarter, which as of July 7th reflected a contraction of 1.9%.
Yes, there are reasons to be glum. But on the bright side, the market has certainly been ahead of sell side analysts in discounting likely future economic realities. Both FactSet and S&P report that S&P 500® earnings expectations continue to show growth throughout the remainder of the year, quarter-over-quarter, and year-over-year. If the wisdom of crowds is proven correct, then perhaps the brunt of the selloff is behind us. Further, the expectation for the end-of-year Fed Funds rate has been coming down, and stands at around 3.3% currently, as has the terminal Fed Funds rate, which suggests that the pain in fixed income markets may too have peaked. Interestingly, if the consensus estimate on the terminal rate for Fed Funds is correct, research from Deutsche Bank indicates that this would be the first time that the real Fed Funds rate (i.e. after inflation) would fail to reach positive territory during a hiking cycle.
What happened in the markets in the second quarter?
1. Equities: The inclusive pain cave
The beginning of the Tour de France comes at an opportune time, as equity investors need a reminder that we are capable of bearing more pain than we may believe, and we can still emerge victorious on the other side…though it may take a while. During the quarter, market breadth evaporated, all of the previous highfliers crumbled (NASDAQ 100 -22.3%), and value stocks “day in the sun” meant losing only 12.2% (Russell 1000 Value). In local currency terms, international developed stocks performed the best, returning -7.8%, but of course U.S. investors don’t earn returns in the local currencies of overseas markets, we earn returns in translated U.S. dollars, for which we can thank for an almost doubly painful return of -14.5% for the MSCI EAFE Index. Emerging market equities held up a bit better at -11.5%, thanks again to China (which is now in a very different monetary stance than the U.S. and Europe), and all things growth or spelled with the letters R-E-I-T, well, don’t ask. Valuations have likely gotten better, which portends more positive outcomes for the future, but just how much improvement has been had will be seen as we enter earnings season here shortly.
2. Bonds: Correlation extends its mean streak
Taxable investors could be tempted to give a moment of thanks for munis, which managed to slide by only 3% in an avalanche that took all other fixed income investments much further down the mountain, burying more than a few along the way. Leveraged loans, which had been holding up nicely, surrendered about 5%, TIPS lost over 6%, investment grade corporates were off by over 7%, junk bonds gave back almost 10%, and long-term Treasuries returned (or failed to return?) about -13%. Over the past 20 years, long-term Treasuries have exhibited a negative correlation to the S&P 500 of about 0.3, but over the past year that correlation aggressively moved to a positive 0.5. The same phenomena was true across fixed income instruments, although not as strongly. On a positive note, in recent weeks it’s been apparent that on growth scare days, which seem to be outnumbering inflation scare days, fixed income is again playing its traditional role. Fingers crossed.
3. Commodities: The diversification savior, not
The hero in this year’s otherwise tragic story – commodities – finally succumbed to the everything sale. The Bloomberg Commodity Index returned -5.7%, despite the aforementioned gains in oil and oil related. Industrial metals fell by about 26%, as they are highly sensitive to economic slowdowns, and had their eyes not only on the U.S. and Europe, but also on a Chinese economy that is rebounding more slowly than previously expected. Lead, copper, zinc, nickel, aluminum, and tin futures all declined by over 20%. Agricultural products fared better, but most were still in the red, with corn, wheat, cotton, and cocoa all down double digits. And those precious metal hedges, silver and gold? Futures contracts on the two metals returned -19.4% and -7.6%, respectively. There was little diversification to be found this quarter within the commodity complex.
How are Frontier strategies positioned?
At the beginning of June, in general our strategies increased their target allocations to managed futures by reducing allocations from investment grade fixed income. Certain strategies also experienced increases in high dividend equities, and to high yield bonds, which have been getting more attractive. Relative to our long-term allocations, we are overweight long-term Treasuries, managed futures, U.S. small-caps, emerging market equities, and bank loans (the latter only within our more conservative strategies); and are underweight high-yield bonds, absolute return, commodities, and U.S. large-caps. Overall, we are positioned approximately in-line with expected long-term risk targets, although our conservative strategies are situated more cautiously than normal.
While losses were widespread for the quarter, all of Frontier’s Core Strategies were ahead of their respective benchmarks on a gross-of-fee basis; however, our Specialty Strategies did trail. On the plus side, allocations to managed futures funds were beneficial, as was our bias toward high quality small cap stocks, since the S&P 600 not only outperformed the Russell 2000 by a little over 300 basis points (bps), but also outperformed the S&P 500 by about 200 bps. Our underweight exposure to REITs was also additive on a relative basis, as was our emerging market exposure. For our Tax-Managed Strategies, municipal bonds helped, as they outperformed investment grade taxable bonds (i.e. the Bloomberg U.S. Aggregate Bond Index) by about 175 bps. On the downside, our international small cap exposure, especially from our growth-oriented funds, was detrimental to performance. In fact, our growth funds, both domestic and international, were universally sources of pain during the quarter. Lastly, long-term Treasuries also hurt, as they underperformed the Aggregate.