Since last month, signals of potential tail-risk events derived from our proprietary options-based model have shown a sharp increase in the attractiveness to equities.
On the back of a brighter trade outlook, China – along with Japan and U.S. tech companies – has become one of the more attractive pockets of global stocks. Also likely raising the prospects of equities are U.S. consumers and the labor market continuing to show strength, geopolitical risks thawing with a phase one of a U.S.-China trade deal progressing, and most importantly, money remaining cheap with a commitment by the Federal Reserve (Fed) to keep rates low. Under these conditions, if history is any precedent, a recession is highly unlikely to materialize.
Impact of Tail Risk Signals on Hypothetical Asset Allocation
Using proprietary technology, Janus Henderson’s Adaptive Multi-Asset Solutions Team derives tail risk signals from options market prices on three broad asset classes. Given our current estimates of tail risks, we illustrate how those signals would impact a 60/30/10 allocation.
The “Tail-Based Sharpe Ratios” have been normalized to 1.00 to allow for easier comparison across the three macroeconomic asset categories.
*We define ETG and ETL as the 1-in-10 expected best and worst two-month return for an asset class.
Our Adaptive Multi-Asset Solutions Team arrives at its monthly outlook using options market prices to infer expected tail gains (ETG) and expected tail losses (ETL) for each asset class. The ratio of these two (ETG/ETL) provides signals about the risk-adjusted attractiveness of each asset class. We view this ratio as a “Tail-Based Sharpe Ratio.” These tables summarize the current Tail-Based Sharpe Ratio of three broad asset classes.
Additionally, our signals have taken a bearish view on duration with a greater risk that interest rates will rise than fall. Reinforcing this notion is our model continuing to buck the prevailing disinflation narrative, as inflation signals are near average levels. This suggests the rise in rates could be led by normalizing inflation expectations rather than higher real rates.
With the Fed remarking that rates will be kept low and money cheap until such a point that significant inflation is seen, and with excess reserves held at the Fed continuing to fall, labor markets resilient and annual wage growth in excess of 3.5%, according the Atlanta Fed, the ingredients for inflation are here. A surprise in inflation would not only be unwelcome by bond investors, but also potentially by equity investors as the Fed would most likely pivot back toward tightening. Hence, the diversification that – perhaps at our own peril – we have dangerously become accustomed to between bonds and equities may quickly disappear.
While our signals are bearish on fixed income, they have improved quite sharply for equities compared to last month, debunking any fears of a recession.
In addition to our outlook on broad asset classes, Janus Henderson’s Adaptive Multi-Asset Solutions Team relies on the options market to provide insights into specific equity, fixed income, currency and commodity markets. The following developments have recently caught our attention:
- Growth: Global equity attractiveness has risen sharply. Japan is still the most attractive developed market and UK equities the least attractive, as Brexit uncertainty continues to plague options investors’ confidence in the country. Technology and higher-growth companies are some of the most attractive segments in the U.S. equity market, consistent with the notion that global technology names are likely to benefit most from an improving global trade picture.
- Currency and Rates: Duration attractiveness has sharply fallen below average levels with a greater downside than upside for bonds. We also see a weaker U.S. dollar.
- Commodities: Natural gas is a large positive standout in the commodity space, while oil is hovering slightly below average levels.
Historical Monthly Tail-Based Sharpe Ratios
Source: Janus Henderson Investors, as of 10/31/19
Data was not calculated for all months