Options prices signal stronger capital markets in 2023
Global Head of Asset Allocation Ashwin Alankar interprets forward-looking options market signals as favorable for both global equities and bonds as easing inflation enables monetary tightening to moderate.
6 minute watch
- Signals imbedded in forward-looking options markets indicate that inflation may have peaked, thus ushering in a more favorable backdrop for both global equities and bonds.
- Options for commodities and the U.S. dollar point to easing inflation, which would enable monetary tightening to ease, potentially diminishing a headwind for equity valuations and setting the table for a rally in shorter-dated Treasuries.
- While uncertainty remains high – especially with the “stickier” components of inflation still elevated – options markets indicate the main risk to investors is not fully participating in a broad financial market recovery in 2023.
Ashwin Alankar: A key piece of information that we use to gain some understanding into where the capital markets may be headed in the near to medium term are option prices. Options set expectations for both future expected upside volatility and expected future downside volatility across many asset classes through their pricing of both call and put options. This differential risk information is quite useful when assessing the health of the global capital markets, which right now the option market sees to be very strong. The options market is painting a very rosy picture in the near term.
So let me give you my three-minute rundown of the global capital market outlook through the lens of the option market.
First, global equities look very attractive, showcasing very high levels of expected upside volatility, or a good risk, per unit of expected downside volatility, or bad risk, with the U.S. equities and European equities leading the pack. The options market also is not worried about the fixed income markets. The attractiveness of global Treasuries has steadily risen from very poor levels to attractive levels. And interestingly, the options market also sees curve steepening carrying forward – very different from this massive curve flattening we’ve seen year to date in 2022. So don’t be surprised if shorter-duration bonds outperform longer-duration or longer-maturity bonds.
Switching to commodities and currencies, we see limited upside to commodities going forward, and the strength of the U.S. dollar we expect to be weaker as well. Commodities and currencies are important to look at, particularly in today’s environment, because inflation risk is the key source of risk out there. Commodity pressures are inflationary, so if you do see the upside to commodities being muted, that will help contribute to a moderation of inflation. The U.S. dollar strength is also especially important to look at today because it will give you insights into the future trajectory of short-term interest rates globally. If inflationary pressures continue to remain very high here in the U.S., your front-end interest rates will start rising faster and faster as the market starts to price a more aggressive tightening by the U.S. central bank. And as those front-end rates increase, the U.S. dollar looks more attractive.
So what’s the silver lining? If you connect the dots behind each of these so-called discrete pieces of information, a very clear story emerges. That story is one in which inflation pressures mitigate quicker than expected, and the Fed pivots to a more dovish stance faster than expected. Should this scenario unfold, you will see the interest rate curve steepen as shorter-duration bonds, their yields, fall more than longer-maturity bonds, such as 10-year Treasuries. You should see fixed income markets rally. You should see equity markets enjoying a bull run. You will see the U.S. dollar also weakening as the interest rate differential between U.S. rates and non-U.S. rates compress. So all of these outcomes, from a faster pivot by the Fed toward dovishness, a faster moderation in inflationary pressures, are all consistent with the observations we see today across how the option market is pricing risk.
Now, does this mean that this rosy picture comes without risk? Absolutely not. Uncertainty is high. While the option market does believe it seems that inflation pressures are going to moderate sooner than expected going forward, history tells you, “No way.” A historical fact is that inflation is much more sticky than anyone expects, and inflation stays around much longer than anyone likes. We have seen recently CPI [Consumer Price Index] showing some respite. But if you look at the sticky components of CPI, their prices have moved steadily upwards at a very fast clip. Unfortunately, reward doesn’t come without any risk. The risk, however, that we see in the near term is more of a melt-up risk than a meltdown risk.
There’s two forms of tail risk that every investor is exposed to. Bad tail risk, which is meltdown risk, and good tail risk, which you want to bear, which is melt-up risk. We see going forward the risk more tilted towards melt-up risk, where all asset classes enjoy a bull market in the near term.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Commodities (such as oil, metals and agricultural products) and commodity-linked securities are subject to greater volatility and risk and may not be appropriate for all investors. Commodities are speculative and may be affected by factors including market movements, economic and political developments, supply and demand disruptions, weather, disease and embargoes.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.