Research in Action: What options prices are signaling about economic growth

Carolyn Bigda: From Janus Henderson Investors, this is Research in Action. A podcast series that gives investors a behind-the-scenes look at the research and analysis used to shape our understanding of markets and inform investment decisions.

For investors trying to determine what’s next for markets, they often consult some common sources of data: economic growth, inflation, jobs reports, and consumer spending. But Ash Alankar, Head of Global Asset Allocation at Janus Henderson, says there’s another valuable source that often gets overlooked: the options market. And what’s important is that this data is not based on what’s happened already in the economy but what’s likely to happen, and he says that for the second half of 2023, some of the signals from the options market may be surprising.

Ash Alankar: Across options on global bonds and global equities, the wisdom of the market is not flashing any red lights. Now, it’s not unanimously flashing green lights either, but the most important message to take away is the fears of a recession might be overdone.

Bigda: I’m Carolyn Bigda.

Matt Peron: I’m Matt Peron.

Bigda: This is Research in Action.

Ash, welcome to the podcast.

Alankar: Great. Great to be on. Very excited to share with you our insights on the markets. We, as a group, are huge fans of big data and particularly using the intelligence of the markets, the collective wisdom of the markets, to give us a look into the future. The market can be a crystal ball in our thinking, so given this, why ignore what the market is telling us?

This lens is a very different lens from a traditional economist. So, while I really have no idea if my outlook will turn out to be right or turn out to be wrong, I am pretty sure what you will hear today is something different. You might like it, you may not like it, but as long as it’s different, we hopefully will get listeners to question and debate what they hear from us and what they hear from others. And if we spark your curiosity to debate, if we spark your curiosity to question, I think we’ve done our job.

Bigda: Well, Ash, you basically anticipated what my first question was going to be, so that’s great. Just to give a little bit more context, so here, you work on what are known as adaptive allocation strategies, which basically, you’re making asset allocation decisions based on forward-looking views of big market moves. And those forward-looking views, if I’m correct, are tied to the options market. So, maybe, can you just describe that in a little bit more detail and how this investing approach came about?

Alankar: Yes, absolutely. Just like you mentioned, we run a suite of investment solutions here where the anchor or the backbone of what dictates of how the portfolios look like is risk management. It’s using the idea of managing risk correctly to enhance and accelerate what’s most important to all of us when it comes to the capital markets and our savings and our investments in the capital markets, which is the rate of compound return.

All of us know that compound return is everything. Einstein even is credited with saying that the most powerful force in the universe is the compound return; is compounding. So, we have to think a lot about what drives compounding, and what drives compounding is risk. Risk is the number one factor that determines how quickly or how poorly and slowly your investment will compound wealth over time.

And where we get information about risk is looking at, I wouldn’t call it a unique source of data, but I would call it a source of data that many seem to ignore and do not utilize, which is the options markets. The options markets tell us exactly – and we’ll talk about this a bit later on – tell us exactly about the markets’ forecast of future risk. And using that information of risk, you can actually do a lot of things to improve portfolio management and portfolio construction.

Bigda: Okay, so, with that in mind, let’s get into what the options market is basically saying about the broader market now. We’re halfway through the year and so far, the much-anticipated recession hasn’t yet materialized. What is contributing to the economy’s resilience, in your view, and what is the options market saying about it?

Alankar: So, very simply, the resilience of the economy is really due to the resilience of the U.S. consumer. Recessions almost by definition are caused by a weak consumer. I can’t think of one recession historically that unfolded while the consumer was strong, while the consumer was healthy. And the health of the U.S. consumer is far from dismal. Labor markets are on fire. People have jobs. There are more jobs than people looking for jobs. Banks continue to say that checking and savings balances of the retail consumer are much higher than pre-pandemic levels. I personally would take this with a grain of salt because there’s a lot of conflicting data as to whether or not this is true, but nevertheless the finances of the retail consumer, the finances of the U.S. consumer seem to be on solid ground.

And if you dig into more micro data, such as credit card and regional bank loan data – which both credit card companies and regional banks predominantly lend to individuals and small businesses – you can get a very clear read on consumer health. Loan default and impairment levels are nowhere reflective, nowhere near the levels you see during prior recessions. Even forecasts of future loan defaults by both credit card companies and regional banks, while they have ticked up a bit, they’re once again well outside of the levels you see during prior recessions. Analysts are even forecasting increasing earnings for marquee consumer companies. All of this has to be a good barometer of the expected strength of the consumer, and it’s all pointing to a fine, a resilient, a healthy U.S. consumer.

So, a necessary condition for a recession is a weak consumer, and we’re just not seeing it. And I honestly don’t know how a consumer becomes weak with so much hiring going on.

Bigda: And so, is the options market, is that also reflecting the strength of that consumer? Is it concurring with the economic data out there about the consumer?

Alankar: Yes, great question. We’re seeing consistency also in what the option markets are saying. And why looking at the option market is important, all of this macro and micro data I talked about, most of it is backwards looking. The great thing about extracting information from market prices is that information is forward looking. And if you had market prices on the cost of insurance, these insurance prices would tell you everything about future risk because we know that the price of insurance is a function of forward risk assessments.

As an example, a smoker who is perfectly healthy today will still pay more for health insurance than a non-smoker because the future health of the smoker is much more risky. And the great news today is that the price of insurance to protect us against market moves is right in front of us. It’s in front of all of us. These are option prices.

The option market is really nothing more than an insurance market. If you look past all the fancy math, all the fancy calculations, it’s nothing more than an insurance market and those option contracts, like I mentioned – put contracts, which protect you against losses; call contracts, which protect you against missing out on gains – they will tell you exactly about the market’s expectation of future upside risk and future downside risk.

And across options on global bonds and global equities, the wisdom of the market is not flashing any red lights, very similar to the fundamental macro and micro data we just talked about. Now, it’s not unanimously flashing green lights either, but the most important message to take away is the fears of a recession might be overdone.

Many are extrapolating from the ‘70s and ‘80s that inflation can only be brought down by choking the economy, and this is a demand-side argument. But maybe this time around, what we need, is for supply to return. What we need is a boost in productivity, not a recession for inflation to come down. And at the end of the day, we all know productivity is the best panacea for inflation, and companies are realizing this. They’re cutting costs, they’re cutting excess labor, they’re being smarter about spending and acquisition activity, and hopefully embracing new technologies, particularly on the production side of things to improve efficiencies and how they make products.

So, is this to say…? And this is also really important: I’m not saying that the Fed [Federal Reserve] has done what no other Fed chair has done historically, which is to successfully navigate the trade-off and tiptoe that delicate balance between fighting inflation and choking economic growth. Because there’s a lot more work to be done and until we are at the finish line, popping champagne that we beat inflation, tapping ourselves on the shoulders, making a policy error is a real risk. But so far, kudos to [Fed Chairman Jerome] Powell and the team.

Peron: So, Ash, your toolkit can be used in so many different applications, such as asset allocation, as you were talking about. How do you think a fundamental investor can use some of your work?

Alankar: Today, we all know that the most important commodity is data, that the most important commodity is information. We are sourcing information from areas that many don’t source information from. So, as a fundamental investor, their information set, the work that they do to understand the intricate operations and business-as-usual activities of a company can be augmented by looking at information from the options markets as it relates to the risk of those companies going forward.

And what’s interesting here is it’s not to say option-implied information, option-derived estimates of risk are better or worse than conclusions drawn from fundamental data. But, once again, they’re different, and as long as they’re different, there’s value added. So, that’s where we see a fundamental investor can get additional insights besides those insights garnered from fundamental data by looking at a different source of data, such as option prices.

And then – this is true for any alternative data sets – that there might be interesting signals that can be extracted from sentiment data, from soft survey data. The whole idea is the more data, the more information one is using to make an investment decision, the better that investment decision likely will be.

Peron: Basically you see it not only as an asset allocation toolkit it can be used to inform fundamental investing, which I think makes it really an interesting set of tools, complementing all the survey work and all the on-the-ground work as a normal course. I think that’s great.

Alankar: Yes, it’s really a function and it’s a fact that the option market is giving us a gift here. The option markets are very broad. They’re very deep. Options trade on individual stocks. Options trade on individual bonds. Options trade on asset classes, such as U.S. equities, such as European equities or Japan equities. So, there’s a huge breadth of information that option markets provide and that information can be used for asset allocation decisions, that information can be used for more micro decisions, such as security selection.

And we like to tell ourselves that we’re actually stealing information from the smart money. Smart money comes up with a fundamental view. They’ve done their homework and they may express this view. They may express their views by purchasing options, and once they start purchasing those options, the price of options will adjust, reflecting the insights of that smart money. And now we have a lens into what smart money is thinking, and that information is valuable.

Peron: So, Ash, your toolkit is a broad set of tools that you use with some of the largest institutions globally to help them build really interesting and unique investment strategies to inform them of everything from asset allocation to capital preservation. Can you tell us a little bit more about what you do and what you offer to these large institutions?

Alankar: Yes, great question. So, institutions globally, what concerns them most when you talk to their CIOs or you talk to their heads of risk, has to do with meeting objectives. It’s less about outperforming benchmarks, it’s less about generating great alpha, it’s more about building a portfolio that will more consistently deliver the outcome that they’re looking to deliver.

And what’s crucial in making sure you’re going to deliver the desired outcomes is managing the risk correctly and making sure first and foremost that you have reduced the probability of suffering an unexpected large loss and have reduced the probability of missing out on an unexpectedly large gain.

So, what we have been working with institutions over the last many years is really improving and helping them gain more insights into, A, how they measure risk and, B, how they respond to changes in risk in their portfolios. Solutions we’ve built for them, which are focused and designed to do exactly this, include capital preservation solutions where big institutions need to maintain a certain amount of liquidity in their portfolios. They can maintain that liquidity by holding cash. Holding cash is costly because you give up upside and, remember upside risk is a risk you also have to manage. So, building ways of enhancing their cash returns by being very smart yet very careful in allocating cash into the markets to earn risk premium, but being very delicate and making sure you’re not subjecting that cash to large losses. That’s a strategy, that’s a solution that has garnered a lot of interest from a variety of institutional clients globally, from sovereign wealth funds to insurance companies to endowments.

Tail-risk hedging solutions are also front and center for many institutions. Liability-matching solutions, so thinking about how to manage assets to meet future liabilities. That’s at the end of the day what all of us do. Why we invest our savings in the capital markets is to help ensure we have enough money as individuals to meet our liability streams when we get older, which are consumption streams, so we can meet healthcare expenses, we can meet housing expenses, we can meet entertainment expenses. An institution has the same type of problem.

So, thinking about that risk mismatch between your assets and your future liabilities is the most important topic and most important activity and question that global institutions need to solve, and we step in with our toolkit, we step in with our technology to help answer and address that question for global institutions.

So, a lot of the work we do with institutions globally is really thinking about how they best can position their portfolio from a risk perspective to meet their future liabilities, whether those liabilities are 10 years down the road, two years down the road, or 30 years down the road.

And that’s why they find what we’ve built to be particularly useful for them, both as an investment service, an investment solution but also from the knowledge transfer perspective, to get them to think about risk in different ways to get them to think about the various forms of risk that can hit their portfolios, from tail risk to normal volatility moves; to get them to think about how they can both hedge the risk of suffering a large loss, which is a risk you don’t want to bear, as well as hedging that risk of missing out on a large upside, which is risk you do want to bear.

So, we bring our holistic framework to them, which allows them to act upon changes in risk profiles, changes in outcomes they want to deliver in a very quick and efficient way.

Bigda: So, if we’re looking at the second half of 2023, where are you seeing these discrepancies arise or where are you seeing confirmation in the option market in terms of the asset allocation, in terms of valuations? How is it all coming together for the second half of the year?

Alankar: We’re not seeing any great signs of stress anywhere across the vast sets of data that we’re looking at, including forecasts from option prices, and this may ironically – and then this will be surprising – but I really think it might be due to the U.S. regional banking crisis.

One of the most important pieces of information revealed during this crisis was that governments and central banks around the world will not hesitate for a second to support economic stability, even if it means risking more inflation. The Fed undid nearly four to five months of tightening in just a few days by expanding their balance sheet and providing unlimited funding to banks.

While I believed, and many out there did believe – and then this was really a catalyst to the drawdowns we saw in 2022 – that inflation would handcuff, would prevent the Fed from flooding the markets with cash and stimulating growth, what the central banks showed, and what the Fed showed during the banking crisis, that this so-called central bank put is alive and well, and they will do anything in their power to insure [against] a breakdown in the markets. So, once again, I think that the lesson that we should have been paying attention to, and hopefully we all paid attention to over the last decade, is don’t fight the Fed.

But with that said, the picture isn’t all rosy. There’s risks out there that can’t be ignored and that number one risk, in my opinion, is still inflation. If inflation continues to be more persistent than hoped, the Fed will step up its game. There’s a lot of room to do so because borrowing rates, even though they’ve risen a lot over the last 18 months, they’re not restrictive at all. Overnight interest rates should be pegged to inflation levels, and this is exactly where they are currently. They are fair. The levels are not restrictive.

And we should also be thinking about a rotation in the drivers of growth globally. Over the last 10-plus years, the driver of growth, the source of growth here in the U.S., as well as outside of the U.S., was technology. But now, with very clear geopolitical divides between the U.S. and between China, the driver of economic growth may switch from the tech sector to manufacturing, to materials, to infrastructure sectors as we build more things here in the U.S. to control our supply chains. So, we should really be thinking about potentially adding exposures to these new sources of growth in our portfolios.

Bigda: All right, well, Ash, thanks so much for joining us today. You’ve given us a lot of great insights on the market. You’ve even brought in Einstein, talking about the power of compounding, which are all great points, so thank you so much for joining us.

Next month, we’ll be joined by Denny Fish and Shaon Baqui, two members of our Technology Sector Research team, to discuss AI and how much of the excitement around AI is hype and how much is a real investment opportunity. We hope you’ll tune in.

Until then, I’m Carolyn Bigda.

Peron: I’m Matt Peron.

Bigda: You’ve been listening to Research in Action.