(Frontier Asset Management) The first release of second quarter U.S. Gross Domestic Product (GDP) growth came in at 6.5%, according to the Commerce Department. This pace is slightly higher than the 6.3% rate in the first quarter, but nowhere near the consensus of about 9% or the Atlanta Fed’s pre-release GDPNow forecast of 7.4%. Explanations for the miss centered around inventories that are expected to rebound in Q3, and economists were heartened by better-than-expected consumer spending (11.8% vs. 10.5% estimate).
The Bloomberg consensus GDP estimate at the end of June for 2023 had already fallen back to 2.3% before this miss. And as a reminder, real GDP[1] growth averaged just 2.3% from the end of the last recession in June of 2009 through calendar year end 2019, just before the pandemic hit. Despite recent continuous quantitative easing (QE) and trillions of dollars of stimulus, the Bloomberg consensus expectation is that we’re going right back to the slow growth environment that we had before. Oh, and seemingly nobody cares. The market is up.
A probable contributing factor to a resumption of “Operation Slow Growth” is the fact that the ratio of births per death in the U.S. inched its way closer to one last year, with 25 states recording more deaths than births, according to the CDC and reported by the Wall Street Journal. But to be fair, that’s a longer-term issue that likely has no material impact on the present. And what we know about the present is that:
- Manufacturing continues to be on a tear, based on the Markit US Manufacturing PMI.
- Services are continuing to improve but have cooled a bit presumably due to the Delta variant and lack of labor.
- Sell-side analysts expect earnings to rise another 10-11% in both 2022 and 2023 according to Refinitiv, seemingly ignoring both the slowing growth environment and the pressures that margins are likely to experience from their current highs, estimated to be 13.1% for the S&P@ 500 in Q2, according to S&P@.
As it is earnings season, hats off to Corporate America. With 69% of companies reporting through August 2nd, S&P reports that 88% beat on both sales and earnings. Earnings are only expected to advance by about 3.4% from the first quarter, but by fully 83% from the second quarter of last year. And that’s on an operating basis, that is, excluding all the non-recurring bad stuff that tends to reoccur about every quarter. On an as-reported basis, which plummeted last year because, well, you know, bad stuff, 2Q earnings are estimated to be up 163% from 2Q20. Exciting times to be sure.
What happened in the markets in July?
- Equities: Emerging Market Equities Taken Behind the Woodshed
With the yield on the 10-year ending the month at 1.24%, down 21 basis points (bps) from the prior month, REITs were the relative heroes with the Wilshire U.S. REIT Index advancing by 5.1%. Growth stocks in the U.S. and abroad may have also benefitted from the decline in rates, with the Russell 1000 Growth returning 3.3% (the correlation between FAANGM (Facebook, Amazon, Apple, Netflix, Google (Alphabet), and Microsoft) and long-term Treasuries has been increasing). In addition, MSCI EAFE Small Growth was up 2.2%, and MSCI EAFE Growth gained 1.7%. We believe value did okay, at least in the mid to large cap space, and the Russell 3000 Value added 0.5%. But size, or the lack thereof, was a deterrent for the month, with micro caps (Russell Microcap Index) down 5.5%, the Russell 2000 off by 3.6%, and the S&P 600® losing 2.4%. All of which paled in comparison to the beating that Emerging Markets took, which we suspect is due primarily to the expansion of China’s regulatory crackdown from big tech initially, to media, food delivery and education related companies. The MSCI Emerging Market Index fell by 6.7% in U.S. dollar terms (the bloodletting was worse in local currency terms).
- Bonds: Treasuries, the Kale of a Balanced Investment Diet
You may not like them, but Treasuries can sure pack a financially nutritious punch that can add to a balanced portfolio. Long-term Treasuries gained 3.8% for the month (Bloomberg Barclays US Treasury 20+), outpacing every major and minor asset class that we monitor, with the exception of REITs. And there were other bond market winners besides long duration: investment grade credit (Bloomberg Barclays US Corp Bond) and municipals (Bloomberg Barclays Municipal Bond Index) had good months, being up 1.4% and 0.8% respectively. In addition, high yield (Bloomberg Barclays U.S. Corp High Yield) and emerging market debt (Bloomberg Barclays Emerging Markets USD) were also in positive territory.
- Commodities: Gold Gets its Mojo Back
Spot gold climbed by 2.6%, rebounding from a rough June when it lost over 7%. Other precious metals weren’t as lucky, as silver futures slipped 2.5% and platinum futures fell by 2.3%. More broadly, commodities were up, with the Bloomberg Commodity Index advancing by 1.8%, helped by coffee (+12.4%), tin (+11.6%) and natural gas (+8.0%). If you find it odd that inflation-hating Treasuries and inflation-loving gold (or so the shaky story goes), were both up sharply, you’re not alone.
How are Frontier strategies positioned?
Allocation Changes
July was a sleepy month in terms of allocation changes. Our models suggested slight adjustments to U.S. equities – adding to large caps and reducing small caps – marginally reducing commodities, and adding slightly to emerging markets in the more aggressive and/or unconstrained strategies. In practice, most of the allocation changes were not sufficiently additive to justify implementation, and within the Globally Diversified set of strategies, we only traded Long Term Growth on the qualified side and Global Opportunities on the taxable side.
Performance Attribution
For the month, our strategies exhibited mixed performance, which makes it difficult to generalize about the outcomes and reasons thereof. With that said, large allocations to small caps in the more aggressive strategies, coupled with meaningful exposure to emerging markets, while being a bit underweight to U.S. large caps and REITs, all contributed to lower returns. Exposure to long-term Treasuries was beneficial. And on the more conservative side of our strategy lineup, overweight exposure to Treasuries and high-quality bonds was additive and offset some of the same relative equity positioning issues described above.
