Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D, a Freedom Advisors company

“Remember the Golden Rule: He who has the gold, makes the rules.”
– Johnny Hart, writer of comic strip Wizard of Id

The events that led to this past week’s market sell-off, especially in U.S. bank stocks (Figure 1), reminded investors of the lagged effects from restrictive monetary policy (i.e. central bank rate hikes and the reduction of bank reserves through quantitative tightening). The market’s fixation on Fedspeak, such as Chair Jerome Powell’s testimony in front of Congress warning of higher-than-expected interest rate hikes, and on key economic releases, such as the employment payrolls report on Friday, was abruptly jerked toward the troubles that surfaced, seemingly out of nowhere, across smaller regional banks, notably SVB Financial Group, the holding company of Silicon Valley Bank (SVB).

Figure 1 – U.S. Banks Lead This Month’s U.S. Stock Market Sell-Off Over Concerns of Diminished Profitability and Regulatory Capital Pressures Stemming from Asset Losses.

Source: Bloomberg

To read the full commentary, click here.

Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D, a Freedom Advisors company

February 2023 Highlights:

• After initially rallying on January’s strong start to the year, global equity markets pulled back reflecting increased uncertainty over the macroeconomic, geopolitical, and corporate profitability outlook, despite signs that the global economy was not facing imminent recession. Ongoing favorable winter and net energy demand reductions continue to help the European outlook as European equity markets have led global markets this year while emerging markets and pan-Asian markets pulled back as investor sentiment soured on China over renewed regulatory crackdowns and potential sanction risk if reports of China’s arms sales to Russia come to fruition. In February, the MSCI All-Country World Index (ACWI) dropped -2.9%.

Data Source: Bloomberg

• Across major regions, Europe and U.S. markets outperformed Pan-Asia. In February, MSCI Europe and the S&P 500 returned -0.6% and -2.4%, respectively, while MSCI Japan dropped 6.5% followed by MSCI Emerging Markets (-6.5%) and MSCI Pacific ex-Japan (-6.8%). The U.S. dollar recovered from January’s depreciation in response to higher inflation readings that would likely prompt a more hawkish policy response from the Federal Reserve.
• Within the U.S., U.S. smalls caps continued to benefit from a high beta rally outperforming large caps, while value stocks underperformed growth stocks, dragged down by late cyclicals such as Energy; however both Pure Style Indices underperformed the S&P 500. The S&P 600 Index returned -1.2% versus -2.4% for the S&P 500. S&P Pure Value underperformed Pure Growth, returning -5.9% versus -3.2%, respectively.
• Across sectors, large cap growth stocks that comprise the majority of sector weightings across Technology and Consumer Discretionary along with Industrials contributed to the sector outperformance while defensive sectors such as Healthcare, and Utilities along with Real Estate and Energy lagged; the Energy sector was hurt by lower commodity prices, particularly natural gas.
• February was another challenging month for Risk Factor performance as all major risk factors, except High Quality, underperformed the broader market. Among Risk Factors, High Quality outperformed Value, High Dividend, Minimum Volatility, and Momentum all clustered together.
• Fixed Income market returns also declined in February with the rise in interest rates, a reversal from the drop seen in January. The Bloomberg U.S. Aggregate Bond Index declined 2.6% for the month while the Global ex-U.S. Aggregate dropped 4.0%, pressured by a strengthening dollar against local currencies. The 10-Year U.S. Treasury yield ended the month at 3.9%, up from 3.5% at the beginning of the month.
• Non-U.S. bonds and emerging market local currency bonds underperformed U.S. bonds hurt by U.S. dollar strength. U.S. high yield outperformed investment grade corporates due to a combination of lower interest rate sensitivity (lower duration) and stable credit spreads versus widening investment grade spreads that hurt the former. The Bloomberg US High Yield Index dropped 1.3%, while Bloomberg/Barclays Emerging Market Debt LC dropped 4.0%.
• Within equity alternatives, Commodities outperformed Real Estate and Precious Metals although all three were down in February. The S&P GSCI Commodities Index returned -3.8% for the month while both the Dow Jones REIT Index and the S&P GSCI Precious Metals Index dropped 5.9%. Industrial metals dropped over diminishing industrial-driven demand coming out of China while oil prices remain range-bound between $70-$80/barrel. Commodity market weakness was broad-based across agriculture and industrials with only Cocoa, Coffee, and Live Cattle up for the month.

Hyped Up Over AI

“ChatGPT and other Generative AI platforms will have huge implications for business productivity…In a world where ChatGPT and other AI apps can do many things humans once needed to do themselves or needed to hire other humans to do, the question of ‘how will I add value?’ becomes more relevant than ever.”

– Hendrith Vanlon Smith Jr, CEO of Mayflower-Plymouth, Business Essentials

 “Part of the inhumanity of the computer is that, once it is competently programmed and working smoothly, it is completely honest.”

– Isaac Asimov, “Change! 71 Glimpses of the Future”

The launch of ChatGPT in November 2022 has kicked off a new gold rush in futuretech, namely the buildout of artificial intelligence capabilities to enhance industrial productivity and competitiveness (not to mention writing term papers). Growth-minded investors have shifted their focus from digital assets/crypotocurrencies to the metaverse and now to artificial intelligence as ChatGPT, which has helped bridge the practical to the theoretical based on “artificial general intelligence [built on deep learning and leveraging large amounts of data]…that can solve human-level problems (OpenAI).” Beyond ChatGPT, the potential for promising applications from AI-driven solutions and assistance seem endless. Some examples:

• Enhanced web searches and targeted advertising (i.e. more direct engagement),
• Medical treatments/diagnoses,
• Business productivity covering investment management and cybersecurity, and
• Enhanced customer service and social engagement.

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3D clients can log in to access our full February 2023 commentary. Not a client? Contact us at (860) 291-1998, option 2 or email sales@3dadvisor.com to get started.

In this episode, we discuss the market and economic landscape with Jeff Weniger, Head of Equity Strategy at WisdomTree. At the time of this recording, we find ourselves at an inflection point between peak inflation, peak economic activity, and peak central bank tightening – or are we? Jeff shares his views through a cross-sectional analysis of housing, labor, production, and valuations and where the risk/reward looks most favorable and unfavorable.

The information, statements, comments, views, and opinions expressed or provided in this podcast are not necessarily those of 3D/L Capital Management, LLC (3D), and may not be current. 3D does not make any representation or warranty as to the accuracy or completeness of any of the information, statements, comments, views, or opinions contained in this podcast. 3D does not endorse any products or securities mentioned.

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Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D

My how quickly a consensus-driven prevailing market narrative can shift over a couple of economic releases. Picture an incoming plane expected to make a bumpy landing but doesn’t land and instead pulls up the landing gear and accelerates upward. This essentially captures the switch from Soft Landing to No Landing scenario being priced into financial markets.

In the span of less than two months, the conventional consensus conviction for a Hard Landing in 2023 entailing 1) an economic recession, 2) collapsing inflation, and 3) pivoting central bank policies has yielded to the new narrative of No Landing or the Big Flip entailing 1) resilient economic growth (despite the sharp rise in nominal interest rates) and 2) elevated and persistent inflation that is not slowing down fast enough for central banks to ease up on tightening policies. Other aspects of the Big Flip include a persistently tight labor market where labor costs start to entrench themselves into higher overall costs of goods and services leaving central banks further behind the inflation curve.

There are differing opinions over who first coined the No Landing scenario, but we credit Neil Dutta from Renaissance Macro, who posts frequently on LinkedIn. Neil Dutta has been one of the few economists to not call for a U.S. recession despite the prevailing consensus among his peers. In a Wall Street Journal interview, Neil now believes that growth acceleration would require higher interest rates to tame inflationary pressures.

But outside of a handful of economists and market observers, Big Flip was hardly on anyone’s radar at the beginning of the year. At the end of 2022 through the FOMC meeting at the beginning of February, the institutional consensus of a hard landing had been expressed through an overweight of “defensive” assets to “risk-on” assets (Figure 1). Fund managers were expecting a slowdown that would benefit “duration” while seeing little need for inflation protection (via TIPS exposure).

Figure 1 – Fund Managers Overweight Bonds versus Equities Heading into 2023 Implying Hard Landing Outcome

Few fund managers expressed concerns that higher or elevated inflation would remain a prominent risk in 2023 (Figure 2).

Figure 2 – Few Fund Managers Expected Elevated Inflation as a Prominent Risk in 2023

This risk-off conviction was first challenged by a sharp YTD rally in high beta speculative growth stocks (see our January 2023 Market Commentary) that suffered in 2022 followed by Fed officials signaling increased confidence in a disinflationary slowdown that would see the eventual end of rate hikes (even though Fed officials kept pushing back the time table for rate cuts versus what was implied by Fed Funds futures prices). However, the Treasury curve continued to invert (long-term rates lower than short-term rates) which saw the 2-Year Treasury yield dropping to 4.1% and the 10-Year Treasury yield to 3.4% earlier this year (even though Fed officials were still projecting a 5% terminal Fed Funds rate) with the bond market convinced that central banks would need to cut rates later this year in reaction to an abrupt slowdown despite the rally in risk assets (high beta stocks and speculative-grade credit).

But then in less than the span of a month, dreams of a disinflationary soft landing characterized by slowing nominal growth and higher inflation-adjusted growth slammed into the Big Flip wall of reality captured by this month’s economic releases such as a robust January payrolls report, elevated CPI and PPI releases (inflation is slowing but perhaps not fast enough), and consumer spending (retail sales, credit card surveys). According to Atlanta Fed GDPNow (Figure 3), 1Q2023 annualized gross domestic product growth is now projected at 2.5%, higher than initial estimates of 0.7% at the beginning of the month, led by higher than expected personal consumption (PCE) and capital investments.

Figure 3 – So Far, U.S. Economic Growth Proving to Be Quite Resilient per Atlanta Fed GDPNow Estimates for 1Q2023 GDP

Source: Atlanta Fed GDPNow via @wabuffo

One way to track the Big Flip narrative is the change in inflation expectations priced into the breakeven spread between U.S. TIPS and nominal Treasuries. As the narrative has shifted to the Big Flip, 1-year term inflation expectations priced into breakeven rates between TIPS and nominal Treasuries have spiked from a low of 1.6% earlier in the year to nearly 3% today (Figure 4). Two- and 5-year breakeven rates have also risen although longer-term breakeven rates have not moved much from 2% (Figure 5).

Figure 4 – Implied Short-Term Inflation Expectations (Breakeven Rates Between U.S. TIPS vs Nominal Treasuries) Have Spiked Over the Past Month Reflecting the Narrative Shift from Hard Landing to Big Flip

Figure 5 – Even Though Long-Term Inflation Expectations (as Expressed Through 5Y/5Y Forward Breakeven Rate Between TIPS and Nominals) Remain Well-Anchored Around 2-ish%.

Higher short-term breakeven rates but well-anchored long-term breakeven rates suggest that the market expects higher inflation over the short term but for inflation to eventually settle down towards the Fed’s long-term average target of 2%. Comments from Fed officials (especially voting members who lean dovish such as Patrick Harker, Philadelphia Reserve Governor), seem to indicate a preference for the Fed to move incrementally while remaining confident in the disinflationary (slowing inflation) trends – or a willingness to tolerate elevated inflation in the near term so as not to risk overtightening that would send the economy into recession.

The risk is that the Fed overestimates disinflationary trends forcing them to backpedal their dovish comments and get more aggressive on tightening (former voting member Steve Bullard remarked that he pushed for a 0.50% rate hike at the 2/1 FOMC meeting instead of 0.25% and hasn’t ruled out a 0.50% hike at the upcoming March meeting). Invariably, the Arthur Burns versus Paul Volker inflation debate of the 1970s comparison could resurface as Fed Chair Jerome Powell faces prospects of renewed tightening in the face of the Big Flip. Even strategists who now subscribe to the Big Flip, such as Michael Harnett from Bank of America, believe that recession is just delayed until 2024 and risks being even more severe due to an anticipated overtightening response by the Fed.

What does the Big Flip mean for equities? While corporate profitability can hold up in a No Landing scenario (as it did in the 1990s), so far S&P 500 company earnings are being revised lower during the 4^th quarter reporting season. According to Factset Earnings Insight 2/10/2023, analysts are projecting just 2.5% earnings growth for CY2023 on 2.4% revenue growth, with the first half expected to see contraction followed by a 2^nd half recovery (10% growth in the 4^th quarter). Profit margins will likely come under pressure from rising costs, but this is being offset through higher price pass-throughs even if unit volumes shrink (hence slowing revenue).

The Big Flip doomsters largely believe that a reflationary No Landing scenario poses risk for all financial (stocks, bonds) and hard assets (gold, commodities), but year-over-year inflation trends are still expected to trend down due to a combination of base effects (i.e. comparisons from last year), lower shelter costs (as indicated by real-time surveys of newly signed leases), and easing of supply chain bottlenecks (as expressed by lower shipping and freight costs). The key will be the degree of moderation in recent “hot” releases into something resembling a soft landing characterized by slower disinflationary growth and weaker labor markets but not so weak as to push the economy into recession.

Although we are less sanguine on equities due to higher valuations stemming from this year’s rally, 3D holds to a strategic asset allocation mindset that aligns time horizons with underlying investment risks. We continue to be defensively positioned in fixed income with respect to duration, inflation-protection, and credit risks although we will revisit some of this positioning in light of recent interest rate movements. In equities, we continue to emphasize diversification across risk-based themes (value, high quality, dividend-focused) and across regions. We are not flipping out over the Big Flip but remain mindful of the quickening shifts in narratives based on the latest economic releases.

Disclosure:

The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes, and opinions of others are assumed to be true and accurate however 3D Capital Management does not warrant the accuracy of any of these. There is also no assurance that any of the above are all inclusive or complete. This article does not constitute an offer to sell or a solicitation of an offer to purchase interests in any investment vehicles or securities. This article is not a prospectus, an advertisement, or an offering of any interests in either the Strategy or other portfolios. This article and the information contained herein is intended for informational purposes only. It does not constitute investment advice or a recommendation with respect to investment. Investing in any strategy should only occur after consulting with a financial advisor.

3D does not approve or otherwise endorse the information contained in links to third-party sources. 3D is not affiliated with the providers of third-party information and is not responsible for the accuracy of the information contained therein.

Past performance is no guarantee of future results. None of the services offered by 3D Capital Management are insured by the FDIC and the reader is reminded that all investments contain risk. The opinions offered above are as of February 17, 2023 and are subject to change as influencing factors change.

More detail regarding 3D Capital Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing sales@3dlfinancial.com or visiting 3D’s website at 3d.freedomadvisors.com.

Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D

Data Source: Bloomberg

To read full market commentary, click here.

January 2023 Highlights:

• January saw a surge in risk appetite as global equities rallied from the year-end sell-off over signs of disinflationary slowdown that could prompt the end of central bank tightening. Favorable winter and net energy demand reductions also helped European stocks despite an economic slowdown/recession. 4th quarter earnings from beaten-up growth stocks helped drive this month’s high beta rally within the U.S. market as did the classic January effect that tends to see stocks subject to tax-loss harvesting the prior year rebound sharply in January. In January, the MSCI All-Country World Index (ACWI) returned 7.8%.
• Across major regions, International Developed and Emerging Markets outperformed the U.S. although Emerging Markets saw a month-end sell-off across China and India, giving up some of its earlier leadership. In January, MSCI Europe and MSCI Pacific ex-Japan led major regions, returning 8.7% and 8.6%, respectively, followed by MSCI Emerging Markets (+7.9%). MSCI Japan (+6.2%) and the S&P 500 (+6.3%) lagged major regional performance. The U.S. dollar weakened further from last quarter’s depreciation over prospects of an end to Fed tightening while the rest of the world is viewed as catching up to the U.S. with respect to policy tightening.
• Within the U.S., small caps benefited from the high beta rally outperforming large caps, while value stocks surprisingly outperformed growth stocks despite the strong performance of speculative growth stocks. The S&P 600 Index returned 9.5% versus 6.3% for the S&P 500. S&P Pure Value outperformed Pure Growth, returning 11.6% versus 3.7%, respectively.
• Across sectors, beaten-up large cap growth stocks that comprise the majority of sector weightings contributed to the outperformance of Communications and Consumer Discretionary sectors as well as Technology and Real Estate (both 2022 year-end laggards) while defensive sectors such as Consumer Staples, Healthcare and Utilities lagged as did traditional cyclicals such as Industrials and Energy.
• January was a challenging month for Risk Factor performance as all major risk factors underperformed the broader market. Among Risk Factors, High Quality and Value outperformed High Dividend, Minimum Volatility and Momentum, as the latter three lagged due to the lower risk profile of the underlying holdings. Long/short low volatility and momentum were negative for the month while long/short multi-factor also struggled even though long/short value and quality were positive.
• The Bloomberg U.S. Aggregate Bond Index rose 3.1% for the month while the Global ex-U.S Aggregate returned 3.5%. The 10-Year U.S. Treasury yield ended the month at 3.5%, down from 3.8% at the beginning of the year, while the 2-10 Year Term structure remains deeply inverted even though inflation expectations implied by breakeven rates between TIPS vs Nominal Treasury yields remain elevated.
• Non-U.S. bonds and emerging market local currency bonds outperformed, helped by U.S. dollar depreciation over prospects that the U.S. Fed is close to the end on rate hikes while the rest of the world remains behind the U.S. on the inflation front. U.S. high yield benefited from the U.S. equity rally and a drop in interest rates as credit spreads narrowed. The Bloomberg US High Yield Index returned 3.8%, while Bloomberg/Barclays Emerging Market Debt LC returned 4.4%.
• Within equity alternatives, Real Estate rose sharply recovering from the prior quarter’s sell-off. Precious Metals also rallied over prospects that the Fed was close to ending interest rate hikes. It was a mixed month for commodities as industrial metals rose in conjunction with China reopening from COVID lockdowns, while oil prices were unchanged (even though natural gas saw a sharp sell-off). The S&P GSCI Commodities Index returned -0.1% for the month while the Dow Jones REIT Index rose 10.1%. The S&P GSCI Precious Metals Index rose 5.4% for the month.

To read full market commentary, click here.

We are pleased to kick off our 2023 season of the Advisor Success Series Podcast with Dave Nadig and Todd Rosenbluth from VettaFi. Both Dave and Todd are veterans of the fund industry and share their perspectives on prevailing industry trends such as ETF adoption, active versus passive management, and how advisors are shifting their practices to an ever-changing landscape.

The information, statements, comments, views, and opinions expressed or provided in this podcast are not necessarily those of 3D/L Capital Management, LLC (3D), and may not be current. 3D does not make any representation or warranty as to the accuracy or completeness of any of the information, statements, comments, views, or opinions contained in this podcast. 3D does not endorse any products or securities mentioned.

See All Podcasts »

Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D

Data Source: Bloomberg

To read full market commentary, click here.

December 2022 Highlights:

• The 4th quarter recovery in global equities stumbled somewhat in December, particularly U.S. equities, partially hurt by a more hawkish-than-expected Fed meeting (FOMC) in mid-December that pushed the benchmark overnight lending rate to 4.50%. An uneven economic lift-off from the end of Chinese COVID lockdown restrictions also contributed to market weakness, especially across Asia. In December, the MSCI All-Country World Index (ACWI) returned -3.9%.
• Across major regions, International Developed and Emerging Markets (equities and currencies) outperformed the U.S. as investors bet that the worst has passed for Europe and broader Asia. In December, MSCI Japan (+0.3%) and MSCI Europe (0.0%) led major regions followed by MSCI Pacific ex-Japan (-0.5%) and MSCI Emerging Markets (-1.4%) while the S&P 500 ended down 5.8%.
• Within the U.S., small caps underperformed large caps amidst the broader sell-off in U.S. equities, while value stocks outperformed growth stocks, the former benefiting from energy and industrial cyclicals. The S&P 600 Index returned -6.7% versus -5.8% for the S&P 500. S&P Pure Value returned -5.5% versus -7.3% for S&P Pure Growth.
• Across sectors, defensive sectors (Utilities, Health Care, Staples) and traditional cyclical sectors (Energy, Industrials) outperformed while Growth Sectors (Communication Services, Technology, Consumer Discretionary) lagged.
• Major Risk Factors outperformed the S&P 500 although High Quality lagged the other factors as High Dividend and Minimum Volatility benefited from the exposure to defensive segments of the equity markets.
• Investment grade fixed income had benefited from a continued drop in long-term interest rates; however, a sharp rebound in interest rates following the December FOMC meeting weighed on overall U.S. fixed income. Investment grade sectors (mortgages, credit) continued to benefit from narrower credit spreads. The 10-Year U.S. Treasury yield ended the month at 3.88% off intra-quarter lows of 3.45% prior to the December FOMC meeting.
• The Bloomberg U.S. Aggregate Bond Index dropped 0.5% for the month while the Global ex-U.S Aggregate returned +1.3%, helped by a weaker U.S. dollar. The Bloomberg US High Yield Index returned -0.6% hurt by higher interest rates, while Bloomberg/Barclays Emerging Market Debt LC returned 2.1% as local currencies appreciated against the US Dollar.
• Within Equity Alternatives, S&P GSCI Commodities Index returned -1.4% as commodities recovered late in the quarter over prospects of China reopening but ended marginally down despite oil prices rallying late in the month. Precious metals continued to benefit from increased uncertainty over monetary policy and the economic outlook. S&P GSCI Precious Metals returned 4.8% for the month. S. REITs suffered from U.S. equity market weakness and higher interest rates with the Dow Jones REIT Index down 5% for the month.
• If the economic outlook continues to ‘flatten’ following the surge in post-pandemic demand, then investor and policymaker focus will likely shift towards the strength and resiliency of labor market conditions and whether rising wages represent an imbalanced labor market.
• 3D believes that investors should remain fully invested for the most part as part of a strategic asset allocation built on risk-based investment programs. Unlike the beginning of 2022 where we were more cautious due to rich valuations on both equities and fixed income, the current environment speaks to more attractive valuations across risk-based assets, reflecting the higher uncertainty of the macro environment heading into 2023.

To read full market commentary, click here.

In this episode, we welcome Andrew back to our podcast series as we discuss the economic and investment landscape for 2023. We discuss why the U.S. economy will just skate by on real (inflation-adjusted) economic growth, why inflation will come down but not as fast as implicitly priced in by financial markets, and their preferences for how asset allocators should be positioned in a less certain environment for economic and earnings growth.

The information, statements, comments, views, and opinions expressed or provided in this podcast are not necessarily those of 3D/L Capital Management, LLC (3D), and may not be current. 3D does not make any representation or warranty as to the accuracy or completeness of any of the information, statements, comments, views, or opinions contained in this podcast. 3D does not endorse any products or securities mentioned.

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Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D

Data Source: Bloomberg

To read full market commentary, click here.

November 2022 Highlights:

• November saw a continued recovery in global risk assets helped by a dovish speech from Fed Chair Jerome Powell on the final day of the month as well as stronger than expected consumer spending data and hopeful signs of China easing COVID lockdown restrictions. In November, the MSCI All-Country World Index (ACWI) returned 7.8%. MSCI China rose 29.7% recovering from the steep sell-off in October.
• Once again, the U.S. Federal Reserve took center stage and drove market volatility (both on the downside and the upside) throughout November despite other market-moving headlines, such as the collapse in digital assets/crypto exchanges, China Zero-COVID lockdowns, and November mid-term elections.
• Fed Chair Jerome Powell acknowledged that the Fed is monitoring more real-time data, having faced repeated criticism that it’s too reliant on backward-looking data. The Fed remains confident that its policy setting can strike the right balance to engineer a soft landing or at least a landing that is not hard enough to break the financial system and broader economy.
• Across major regions, International Developed and Emerging Markets outperformed the U.S. helped by improving inflation data across Europe and prospects of renewed global demand as China emerges from COVID lockdowns. In November, MSCI Pacific ex-Japan and MSCI Emerging Markets led major regions, returning +17.6% and +14.8%, respectively followed by MSCI Europe (+11.4%), MSCI Japan (+9.7%) and the S&P 500 (+5.6%). The U.S. dollar weakened considerably during the month over prospects of an end to Fed tightening.
• Within the U.S., U.S. smalls caps underperformed large caps, while value stocks performed in line with growth stocks, the latter benefiting from ‘high beta’ surges following the mid-month CPI release and the 11/30 Powell speech. The S&P 600 Index returned 4.2% versus 5.6% for the S&P 500. S&P Pure Value performed similarly to Pure Growth, returning 5.3% versus 5.4%, respectively.
• Across sectors, traditional cyclical sectors (Materials, Industrials) and Financials along with Interest Rate Sensitive sectors (Utilities, Real Estate) outperformed while Energy and Consumer Discretionary lagged, with the former hurt by lower oil prices and the latter by underperformance of large cap constituents.
• Among Risk Factors, High Quality, High Dividend and Value outperformed helped by exposure to cyclicals and financials, while Momentum underperformed partly due to the underperformance of the Energy sector which has handily outperformed over the past year and remains a large component within momentum baskets.
• Investment grade fixed income rallied on a sharp drop in long-term interest rates as well as narrower credit spreads across investment-grade sectors (mortgages, corporate credit. The 10-Year U.S. Treasury Yield dropped almost half a percent from the prior month, ending the month at 3.61%.
• The Bloomberg U.S. Aggregate Bond Index rose 3.7% for the month while the Global ex-U.S Aggregate returned 5.6%. Non-U.S. bonds and emerging market local currency bonds outperformed helped by U.S. dollar depreciation over prospects that the U.S. Fed would not be tightening as aggressively relative to other world central banks.
• S. high yield benefited from the U.S. equity rally and a drop in interest rates. The Bloomberg US High Yield Index returned 2.2%, while Bloomberg/Barclays Emerging Market Debt LC returned 7.1%.
• Within equity alternatives, Real Estate rose sharply following the Powell speech as lower interest rates can buttress valuations. Precious Metals rose following the mid-month CPI release that came in lower than expected while Commodities suffered from a sell-off in oil prices (Figure 31) and renewed China COVID lockdowns before recovering at month-end following the Powell speech. The S&P GSCI Commodities Index returned -1.7% for the month while Dow Jones REIT Index rose 6.0%. The S&P GSCI Precious Metals Index rose 7.4% for the month.
• Bottom line as we head into 2023: after peak Fed tightening expected in early 2023, a flattish outlook for the U.S. economy and earnings outlook punctuated by ex-U.S. global developments where China reopening remains the ‘delta’ on marginal supply and demand.

To read full market commentary, click here.

Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D

A long, long time ago (well not that long – 2018) during a market regime far, far away (pre-pandemic seems so distant now), we wrote about the return of active management, or investment strategies built on traditional fundamental analysis (a.k.a. professional stock-picking) or quantitative factor tilting. At the time, we postulated that, after years of perennial disappointment having lagged cap-weighted passive indices, actively managed strategies would finally see a renaissance of sorts. At the risk of ‘cursing’ active management, we are publishing an updated thought piece suggesting the return of active management.

Over the intervening period (pre-and post-pandemic recovery) since our last update, the wait continues as passive continues to dominate with respect to relative performance and fund flows, as 85% of US-focused mutual funds have underperformed the S&P 500 Index over the trailing 3-year period ending 6/30/2022 according to the June 2022 SPIVA Study. Indeed, it’s been a struggle for actively managed funds worldwide (Figure 1), not just in the U.S.

Figure 1 – SPIVA Study Illustrates the Challenge of Actively-Managed Funds versus Passive Peer Benchmarks Over the Trailing 1-, 3-, and 5-Year Periods (Ending 6/30/2022) (High % = Top Performance)

Source: S&P Dow Jones Indices SPIVA Study Ending 6/30/2022

Looking specifically at the US Large Blend category in Morningstar, we also see the S&P 500 Index (using Vanguard S&P 500 Index Fund as a proxy) sitting at the top of the fund category for the trailing periods ending 10/31/2022 (Figure 2). Note, we refine the category list to only include 1) traditional long-only active funds as designated by Morningstar, and the oldest share class.

Figure 2 – Similar Findings Comparing the Vanguard 500 Index Fund (Inv Class) versus Active Large Blend Category Based on Morningstar Classification (Performance Ending 10/31/2022) (Low Rank % = Top Performance)

Source: Morningstar Office

But notice that the % ranking for the passive indices are in decline even if they still outperform the majority of active funds. Could we be entering that much long-sought period of active outperforming passive?

With cap-weighted indices like the S&P 500 at top-heavy record levels relative to history (Figure 3), passive indices have enjoyed a major tailwind as a handful of large cap technology stocks dominate overall market return and variance (a.k.a. Top N effects where a small number of large stocks equal the systematic risk of the broader market). This has led cap-weighted indices to dominate alternative index constructions, such as equal-weighted indices and generally posing a headwind for active strategies that tend to weight individual holdings based on ‘conviction’ or equal-weighting of best ideas.

Figure 3 – The ‘Top-Heaviness’ of the US Equity Market Exceeded That of the Prior Peak During the Late 1990s Dot-Com Bubble

However, there might be a ray hope of emerging in 2022 for actively managed strategies. The equal-weighted S&P 500 is starting to outperform the cap-weighted S&P 500 for the first time in quite a while (Figure 4), as the top-heavy technology names that dominate the latter begin to lag the broader market. Generally, most actively managed funds will underweight or not own the biggest names in a cap-weighted index, mainly to differentiate their portfolio from that of a passive index or feared being labeled with low ‘Active Share.’

Figure 4 – Equal-Weighted S&P 500 Index Outperforming S&P 500 Index As We Move Past the Worst of the Pandemic

Source: Bloomberg (Monthly Through 10/31/2022)

In addition, the valuation gap between the S&P 600 Value Index (Small Cap Value) versus the S&P 500 Index has narrowed from the post-pandemic extreme levels when investors were extrapolating technology growth success well into the future versus the broader market.

Figure 5 – The Price/Book Valuation Gap Between the S&P 600 Small Cap Value Index versus the S&P 500 Index Has Narrowed from the Extreme Levels Reached During the Pandemic

Source: Bloomberg

Greater market breadth and a narrowing of valuation gaps may prove to be the necessary tailwinds for active management to finally make its comeback. Regardless of whether a comeback manifests itself, investors should be mindful of how systematic forces can influence (market breadth, small vs large, valuation gaps) the relative fortunes of active management. Even the most skilled stockpickers can be held hostage to these systematic forces that have proven to be major headwinds during the extreme periods of market concentration and tech growth dominance.

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