During the second quarter of 2022, RLY finished down in absolute returns, but outperformed its custom strategic benchmark. The fund finished the quarter with overweights to natural resource equities, commodities, and global Infrastructure.
Driving outperformance were overweights to commodities, global infrastructure equities and cash. Funding these allocations from inflation-linked bonds was also beneficial. We held a persistent overweight to commodities throughout the second quarter. Despite plunging in June on demand concerns from growing recession fears and China’s COVID lockdowns, strong outperformance in April and May supported commodities finishing ahead of other risk assets and interterminal inflation linkers. Tight supply and demand fundamentals within Energy helped propel the sector higher and offset weakness in metals. With our proprietary risk sentiment indicator suggesting a fragile risk appetite, we held an allocation to cash throughout the quarter which proved beneficial as both most assets sold off. A targeted overweight to global natural resource equities dented returns as increased recession fears and fresh COVID lockdowns in China weighed on sentiment. Global natural resource equities were quite volatile, dropping by 15%. All three segments experienced negative returns, with energy holding up best.1
Portfolio Positioning and Outlook
The outlook for real assets has become more balanced, but remains constructive. With headwinds to global growth intensifying and sources of resilience softening, we have downgraded our growth forecast. While global shocks have continued to compound and weigh on our outlook, the downgrade reflects a much faster monetary tightening pace that shifts the economy from the prior path of a gradual deceleration to a more abrupt downshift. With inflation accelerating, the US Federal Reserve (Fed) and other central banks have confirmed their dedication to curbing inflation at all costs. Inflation is broad based and proving more sticky than anticipated, and the potential for upside surprises remains. Elsewhere, geopolitical risks from the war in Ukraine have seemingly increased and we are becoming less convinced the Fed can administer a “soft landing” with the current trajectory of both interest rates and growth. Risks remain skewed to the downside and we will monitor developments closely.
With that said, we still see a favorable risk/return trade-off in commodity markets. The short-term balances between the bullish supply pressures and the bearish demand drag from fears of economic slowdown as central banks adjust their policies to higher inflation continue to fuel short-term volatility. While a fundamental backdrop of tight supply, low inventory and limited excess capacity in energy sectors remains supportive for prices, rising recession risk, and demand destruction from higher commodities prices tempers this outlook to some degree compared with our outlook from earlier in the year. But contango across commodity curves remains scarce and the June selloff has not shaken our regime-aware momentum signals. Although risks do appear more balanced at this point, our outlook for commodities remains firm, relative to other asset classes.
Both global natural resource equities and infrastructure equities stand to benefit from infrastructure spending along with longer-term decarbonization trends and other green energy thematics. Additionally, we anticipate that raw material prices will remain elevated throughout 2022, as the structural bull market in commodities is supported by limited spare capacity and supply-demand imbalances that are proving difficult to alleviate. This momentum has carried over to the global natural resource equities that focus on these three commodity sectors. Though many natural resource companies faced substantial pre-pandemic challenges, the recent surge in commodities prices, along with low relative valuations, continue to make them attractive to investors.
Even with the potential for lower demand, supply constraints and geopolitical risks remain. Should this cause inflation to be sticker or longer-term expectations to adjust higher, real assets can continue to do well relative to traditional equities and bonds.
Market Regime Forecasts
The Market Regime Indicator (MRI) employs a quantitative framework and forward-looking market indicators, including equity- and currency-implied volatility, as well as credit spreads, to identify the current market risk environment. Tracking risk appetite shifts in the market cycle helps frame tactical asset allocation and volatility targets.
A Look at the MRI
1 FactSet, as of 06/30/2022.
Treasury Inflation-Protected Securities (TIPS) Treasury securities that are indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are backed by the US government and are thus considered an extremely low-risk investment. The par value of TIPS rises with inflation, as measured by the Consumer Price Index, while the interest rate remains fixed.
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