When positing what risk investors may be overlooking heading into 2020, inflation nears the top of the list. Since last month, signals of potential tail-risk events derived from our proprietary options-based model indicate a significant increase in the possibility of upward price pressure. Assets that tend to hedge against inflation, such as precious metals and inflation-linked government bonds, have seen their attractiveness increase over the past several weeks. Consistent with a possible pickup in inflation, bonds do not appear attractive, as inflation break-even rates are predicted to rise. This is analogous to a decline in a bond’s price.

As long as real rates continue to stay low and the Federal Reserve (Fed) remains accommodative, which they have voiced is their intention, we believe the economic environment heading into 2020 is conducive to a level of growth sufficient to stave off recessionary risk; hence, the options market’s expectation for an uptick in inflationary pressure.

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.

Model_Portfolio_Institutional
Current_Tail-Based_Sharpe_Ratios_2

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.

Wage growth for full-year 2019 is expected to come in at a healthy 3.5%, according to the Atlanta Fed, while Goldman Sachs projects the wages of lower-income earners growing at a 19-year high of 4.3%. Together with strong nonfarm payrolls and banks reducing their excess reserve holdings (which we presume they will lend out and thereby create credit), this should lead to a pickup in the velocity of money and spending. Should these trends continue, inflation may come out of its long hibernation. And depending on how quickly it roars out, we could see the purported diversification benefits between bonds and equities that investors have grown so accustomed to disappear.

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 equities appear attractive, with emerging markets (EM) being more appealing than developed markets. Analysts are expecting an acceleration in corporate earnings in emerging countries, the lack of which being a key reason why EM equities have considerably lagged those of more advanced peers over recent years. Contributing to this development is the expectation for stabilizing global growth.
  • Currency and Rates: Duration attractiveness has sharply fallen below average levels, with greater downside than upside to bonds. Options markets also see a weaker U.S. dollar.
  • Commodities: Precious metals are reflecting meaningful attractiveness, while oil is not.

Historical Monthly Tail-Based Sharpe Ratios

(ETG/ETL)*
3_Historical_Monthly_Tail-BasedSarpeRatios

Source: Janus Henderson Investors, as of 11/30/19
Data was not calculated for all months.