A quarter to forget
The quarter ended on a sour note, thanks to the Federal Reserve’s preferred inflation gauge, the core Personal Consumption Expenditures Price Index, or PCE, coming in at 0.6%, ahead of economists’ expectations. Despite 150 basis points (bps) of rate hikes during the third quarter, 300 bps of hikes year-to-date, and early efforts to shrink the Fed’s balance sheet, inflation remains stubbornly high at home and overseas, where the EU (European Union) statistics agency recently reported 10% trailing one-year inflation for the Eurozone.
And then we have jobs. Initial jobless claims hit 190k for the week ending September 24th, which was the lowest level since the spring (and before that, the year 1969)[1]. As reported by DealBook and others, there is speculation that employers, having struggled for the past few years to staff up, are reluctant to reduce headcount; better to take a hit to margins and be prepared to emerge from the other side of what many believe will be a mild and short-lived recession. Further, employers added 315k jobs in August, and the unemployment rate, which ticked up to 3.7% remains well below the average of 5.8% over the past three decades¹. On the bright side (from an inflation perspective), the Fed got a peek at what it ultimately wants to achieve in the latest job openings report – the seasonally adjusted number of open positions fell by over one million (about a 10% decline). But with roughly 1.7 job openings remaining for every unemployed person, it’s safe to say that the labor market remains tight¹.
One additional sign that the Fed’s efforts are starting to pay off? According to the Mortgage Bankers Association, mortgage applications just fell to the slowest pace since 1997, as 30-year fixed rates reached 6.75%. Pain is going to be necessary to achieve price stability, exactly how much and for how long is unknown. But with J.P. Morgan reporting that five of the six primary variables that the National Bureau of Economic Research monitors to determine when / if a recession has begun have improved over the last six months, the pain may just be getting started.
To close on a positive note, with the midterm elections approaching, it’s worth pointing out that U.S. stocks have risen in the one-year period following midterms without fail for eight straight decades, according to the Wall Street Journal and Dow Jones Market Data. Interestingly, while the theory is that midterms relieve uncertainty about the direction of policy, if the market goes up every time, then it doesn’t seem to matter much what policies are coming down the pike, just that they are known. Hmm. As S&P calculates that 56% of trading days this year have been risk-off / down, eclipsing ‘08 and about matching ‘02, and Goldman Sachs reports that U.S. households have rarely been so exposed to equities, let’s hope that history repeats itself after what I’m sure will be an election season that will stand for generations as the archetype of civility, statesmanship, and intellectually driven debate.
What happened in the markets in the third quarter?
1. Equities: Caution, falling stocks
September lived up to its inhospitable reputation, solidifying a deep malaise in the minds of investors. The S&P 500® fell by 9.2% during the month and by 4.9% for the quarter, taking it to almost -24% on the year, and reaching a level that will require a 34% gain to get back to the high in January. According to S&P, only 27 issues in the index posted a gain for the month of September, indicating just how indiscriminate selling was. Value stocks fared slightly better during the month, but growth prevailed over the 3-month period, and consumer discretionary (+3.6%) and energy (+2.4%) were the only sectors in the black for the quarter. Small caps performed somewhat perversely, as the higher quality S&P 600 Index underperformed the Russell 2000 (which contains a substantial number of negative earners) by about 300 bps. And bringing up the rear within U.S. equity markets were REITs, which suffered greatly in the face of rising rates, shedding 12.2% for the month, and about 10% for the quarter.
2. Bonds: Interest rate rampage
With the yield on the 10-year increasing from 2.98% on June 30th to 3.83% as of the end of September, fixed income markets had their work cut out for them. Long-term Treasuries plummeted by 10.3%, TIPS and investment grade corporates each fell a bit more than 5%, and municipals lost about 3.5%. Somewhat surprisingly, in the face of tightening financial conditions and an increase in expected defaults, high yield bonds finished down by just 68 bps. And more understandably, their leveraged loan peers managed to gain 1.3%, even after accounting for an almost 3% decline in September, given their positive correlation with rising rates.
The yield curve is now deeply inverted when measured by 10’s minus 2’s, at -39 bps, while the 10-year minus 3-month measure climbed into quarter end, landing at 0.5%. Related, inflation breakeven rates continue to signal confidence in the Fed’s efforts, as the 5-year IBR (Incremental Borrowing Rate) has fallen from a peak of 3.6% in March to just 2.1% at month end, and interestingly, hovers slightly below the 5-year / 5-year forward IBR at 2.2%.
3. Commodities: U.S. dollar dampens demand
Broad-based commodity indices were off by a little over 4% for the quarter, with wide divergence below the surface. Natural gas soared by 25% on low inventories, bringing the year-to-date advance to about 87%, while WTI crude futures fell by 21% over the three months ending in September (WTI was still up by about 19% year-to-date). Generally, agricultural contracts fared well during the quarter, while precious metals (-7.6%), industrial metals (-7.3%) and energy products (save for natural gas) suffered from a combination of rising real rates, U.S. dollar strength, and the increasing likelihood of a global slowdown.
How are Frontier strategies positioned?
Allocation changes
As we begin the fourth quarter, our allocation shifts are quite modest and there were no universal changes across our strategies. The more conservative strategies experienced a shuffling of exposure between high quality bonds, cash and absolute return, and the more aggressive strategies shifted equity and high yield exposures ever slightly. In our Tax-Managed Strategies, we are taking advantage of the fleeting opportunity to harvest losses for clients with year-end fast approaching.
Relative to our long-term allocations, we are overweight long-term Treasuries, managed futures, emerging market equities, small caps both in the U.S. and overseas, and bank loans. We are underweight absolute return, commodities, high quality bonds, and US large caps. It’s worth noting that our long-term return expectations for emerging markets and international equities have never been higher in our 22+ year history. And thankfully, our expectations for all things fixed income have risen appreciably over the past year…it’s best to forget why.
Performance attribution
For the quarter, in general our overweight to emerging markets, international small caps, and long-term Treasuries were detrimental to absolute and relative performance. The currency impact on foreign assets this year cannot be overestimated. During the third quarter alone, the strength of the dollar subtracted almost 580 bps from international developed stocks, and that currency translation wiped out the performance advantage that international stocks had in local currency terms. In addition, our preference for higher quality U.S. small caps was also a headwind, which was disappointing as the broader small cap universe contains a large percentage of negative earners, companies that one would expect would suffer in a tough market.
On the positive side, our underweights to REITs and TIPS were both beneficial, as was our overweight to floating rate loans in our more conservative strategies, and managed futures funds across most of our strategies. The end result was on a gross-of-fee basis, the lower half of the risk spectrum in terms of Frontier’s offerings, from Capital Preservation to Balanced, all outperformed their benchmarks for the quarter. Conversely, all our more aggressive strategies, from Moderate Growth to Global Opportunities trailed.
[1] U.S. Bureau of Labor Statistics