Perspective :

The Download: First Quarter 2022

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Inflation & Volatility - Higher for Longer?

For the Fed to really fight inflation, they need to put the Fed Funds Rate above inflation, and they need to induce an inverted yield curve.

There are three major forces that have the potential to impact the performance of both stocks and bonds in the intermediate term future: the war in Ukraine, inflation and the Fed’s response, and the widening differences between expected returns of assets.

The War in Ukraine

While the U.S. economy was already wrestling with inflation and potential Fed tightening, the big surprise this quarter is the extent of the war in Ukraine.

The war in the Ukraine is likely to cause inflation to remain higher for longer, as natural resources from both the Ukraine and Russia have been taken offline. At the same time, most of the first world is experiencing strong economic growth, a strong labor market, supply chain issues, and general inflation. The war in Ukraine makes this inflation situation worse.

Secondly, the war in Ukraine is likely to cause volatility to remain higher for longer, as capital markets try to absorb the potential geopolitical implications of this war and the possibility of escalation or further surprises.

Finally, the war in the Ukraine will likely cause capital spending to increase. This could happen on two fronts. First off, governments around the world are likely to increase their military budgets, which is akin to fiscal stimulus. When governments increase military budgets, they borrow money that is then spent in the private sector. Secondly, geopolitical turmoil added to supply chain stress will likely cause nations to become more insulated in their global trade, and to onshore productions to their local markets. This is also a form of stimulus, as businesses will need to ramp up borrowing and to spend in the private markets. This onshoring trend could be the beginning of a multi-decade reversal of globalization and has the potential to be a driver of local economies.

Inflation and The Fed

Believe it or not, the Fed has historically kept the Fed Funds Rate at or above the rate of inflation. It is only post the Financial Crisis that the Fed has so keenly kept the Fed Funds Rate below the rate of inflation. Currently, the Fed Funds Rate is 0.25%, and inflation is 8% for the CPI-U on an annual basis. This is the widest deficit in history, and implies the Fed may need to embark on an aggressive tightening schedule to offset inflation.

However, historically, Fed tightening regimes have led to recession, as the Fed has been effective at engineering economic slowdowns by raising interest rates. When this happens, the yield curve generally flattens, with the short-end of the yield curve anticipating the Fed Funds increases, while the long-end of the yield curve anticipate the future slowdown. Few investors realize that the yield curve was inverted through most of the 70’s inflation saga. When the yield curve is flat, investors and banks alike have little incentive to borrow or lend. An inverted yield curve is a precursor to economic slowdowns and even recessions.

The yield curve has already reacted to the expected Fed Funds Rate increases, as the 2-year yield on government bonds (the market’s theoretical expectation of future Fed Funds Rates) has already reached 2.5%. On the longer end, the 10-year yield has remained strong at close to 2.5% as well, implying a flat yield curve. Now it is up to the Fed to follow through with a few 0.50% rate hikes to reassure the market that they are serious about fighting inflation.

Contrary to popular opinion, the more aggressively the Fed raises interest rates, the more likely it is that the yield curve inverts. It is possible that the bond market is settling into its new reality and could remain near these levels for the immediate future.

Large differences between asset class valuations

Currently, both stock and bond markets around the world have quickly adjusted to this new reality. Both global stock and bond markets just experienced a negative quarter for returns. As this new reality appears more long-term than many investors expected, it is likely that both stock and bond markets are likely to stay volatile for the near future.

The Fed has yet to aggressively hike interest rates, and companies have yet to report earnings that will likely be impacted by inflation. That being said, business performance as represented by margins and earnings has been historically strong. Further to this point, the latest GDP estimates reflect a slowdown, but are not implying a recession.

Economic growth and earnings are expected to remain solid. While stock volatility can remain, the economy seems resilient to the inflation shock and the threat of rising interest rates, so far.

For the last 12 plus years, U.S. large cap stocks have continued to outperform all other major asset classes. While the industry has been advocating for international stocks for quite some time, there has been little abatement of the domination of U.S. stock performance. Likely, any positioning away from U.S. large cap stocks has been a detractor to investors’ return. This has left U.S. large cap stocks at historic high valuations, and international stocks near historic low valuations. This is a classic momentum vs. valuation situation. But, when will the pendulum swing, are we closer to the end of this cycle than the beginning?

This all being said, Frontier is not bearish on U.S. stocks and bullish on international stocks, per se. A better characterization is that Frontier is “constructive” on equities overall. What does constructive imply? It means that we are actually positive on equities overall, but we do not believe that all equity asset classes will perform in the same manner. Some equity segments may turn out to be better than others, and sub asset class positioning will likely matter more than in recent history.

During a quarter when both stocks and bonds both lose money, risk management becomes difficult. Adjusting the major factor of stock and bond ratios makes little difference. However, there are several finer points of positioning that we believe can help mitigate risk.

Points of position for most of the Frontier Core[1] Strategies

  • Constructive on equities
    • Global economy remains surprisingly strong
    • Higher than target exposures to U.S. stocks
    • While our expected returns for international stocks are high, we actually hold less exposure to international stocks than targets
    • We currently hold low exposure to Europe
  • Defensive bond positioning
    • Despite holding reduced exposure to treasury bonds as a hedge against an economic slowdown, portfolio durations are below current targets
    • We have paired treasury bonds with low duration short-term corporate bond funds
    • In strategies where we hold healthy positions to bonds, we also generally hold managed futures
  • Active management
    • Be able to adjust towards our higher expected return asset classes
    • Hold relatively low beta actively managed mutual funds
    • Hold exposures to value equity mutual funds
    • Hold multi asset funds that can allocate within the fund

Overall, investors should expect relatively aggressive tightening from the Fed and continued volatility from the War in Ukraine. Furthermore, it is unlikely that we will quickly return to the go-go growth environment of the post COVID era. In terms of portfolio positioning, what got you here, may not get you there. We believe that investors need to continue to hold both stocks and bonds, but in a more cautious manner. Stock positioning could favor more defensive and quality securities, while bond positioning will depend on changes to the yield curve and yield spreads. Finally, we believe that active risk management will be important, as volatility could remain higher for longer than most investors expect.

[1] As of February 2022 Frontier’s Globally Diversified Strategies were renamed Core Strategies

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ASSET CLASS INDEX DESCRIPTION
U.S. Stocks Represents U.S. large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ.
International Stocks Large and mid-cap equities across developed markets in Europe, Australasia and the Far East, excluding the U.S. and Canada.
Treasuries Publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value.
High Yield Bonds Domestic non-investment grade corporate bonds. Floating-rate and convertible bonds and preferred stock are not included.
Managed Futures Managed futures refers to an investment where a portfolio of futures contracts is actively managed by professionals.

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