Unfolding Shift Underway: From Inflation to Real Rates
While inflation continues to be the talk of the town, our proprietary options-based tail risk model draws attention to real interest rates: inflation doesn’t appear to have much room to rise, and the risk to bonds has shifted to real rates. We see real rates moving up slowly, mitigating the downside risk to bonds, but nevertheless presenting a headwind to the upside.
As discussed in the March Tell Tail Signs, the rise in real rates is the final leg to bring bond markets back to “normal.” Our proprietary options-based tail risk model signals that the violent inflation winds that led to a sharp sell-off in rates have been replaced by much calmer real-rate winds. Calm, because our signals do not portend central banks turning hawkish and aggressively raising real rates.
Janus’ Adaptive Multi-Asset Solutions team arrives at its monthly outlook using option 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 a signal about the risk-adjusted attractiveness of the asset class. We think of that ratio as a “tail-based Sharpe ratio.” The tables below summarize the tail-based Sharpe ratio of three broad asset class categories.
So how does this play into growth and prices? First, we do not see inflation expectations rising sharply, but we also don’t see them collapsing. To the Federal Reserve’s (Fed) and other central banks’ credit, our signals suggest that they are in fact acting proactively and are not falling too far behind the curve. By acting gradually, inflation isn’t likely to run out of control, but acting gradually also won’t extinguish inflation.
Recent Monthly Tail-Based Sharpe Ratio
(Expected Tail Gain* / Expected Tail Loss*)
Capital Preservation Assets
Current Tail-Based Sharpe Ratios
n Current n Historical
Growth Assets ETG/ETL Ratios
Capital Preservation ETG/ETL Ratios
Inflation ETG/ETL Ratios
Beginning in August 2016, 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.
The result is that bonds don’t look as dire now as we have painted them for the past several quarters; there isn’t much upside to bonds, but the downside is also contained. Equities, on the other hand, continue to be attractive. Today’s normalized inflation keeps consumers motivated to spend and invest. Today’s low real rates, with little risk of a steep and quick rise, allow consumers to cheaply finance this spending and investing... This makes an attractive growth story, and the likely benefactor is equities.
In addition to our outlook on broad asset classes, Janus’ Adaptive Multi-Asset Solutions team uses option market signals to provide insights into specific markets. The following caught our attention:
- Growth Assets: France and Italy show the greatest expected upside to downside risk in Europe, even surpassing that of U.S. equities. In emerging markets, Mexico and South Korea stand out along with Russia.
- Capital Preservation: U.S. rates are a better place to gain duration exposure, as we see convergence between high U.S. rates and much lower rates in other developed countries.
- Inflation: We see agriculture commodities presenting the most attractive opportunities in the commodity space.
Tail-Based Sharpe Ratio
(Expected Tail Gain / Expected Tail Loss)
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