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Dave Schrock: Good afternoon, everyone. Thank you for making the time to join us today. My name is Dave Schrock, and I’m joined by Dr. Ashwin Alankar, Head of Global Asset Allocation at Janus Henderson and Lead Portfolio Manager of the Adaptive Multi-Asset Solutions Team. In today’s webinar, we really wanted to share our perspective on the current risks and opportunities in the market as informed by our proprietary tail risk signals from the options markets.

For those of you who may not be as familiar with our Adaptive Multi-Asset Solutions Team, they arrive at their outlook using option market prices to infer expected tail gains and expected tail losses for major asset classes. Quite often, we find that the option market prices are signaling something altogether different than the more traditional backward looking valuation metrics. We’re going to focus on three high level topics today that are weighing on the minds of most investors: inflation, trade and global growth.

Ash, before we dive in, perhaps if you could just give us a quick overview of the signals that you use and why they offer a different perspective.

Ashwin Alankar: Sure. Good afternoon, everybody. My name is Ash. What I’m going to do for you today is provide our views on where the economy might be headed by aiming to answer, as David mentioned, some of the most grappling questions that are on top of all of our minds. What will be unique about how we answer these questions is we will be coming at it from a very different perspective than a typical macroeconomic assessment.

You won’t hear from us about valuation ratios, you won’t hear about reversion to the mean, you won’t hear about the typical hard or soft macroeconomic numbers, rather our outlook is going to be built upon what the market is telling us specifically through the risk being priced by the options market.

Why the options market? Well, the option market and option contracts theoretically are insurance contracts. What we know from economics is the price of insurance give s you a one-to-one correspondence between price and risk. From the price of an insurance contract, you know exactly what the level of risk that insurance premium is implying.

What’s rich and powerful about the financial insurance market is the financial insurance market not only provide insurance contracts that protects you against large losses, i.e. those put options, but they also provide you contracts to protect you against missing out on large gains, i.e., call options. Hence, call options tell you exactly about the future upside, price by the market, and put options tell you exactly about the level of expected downside as implied by the market.

The types of risk we’re going to focus on in this outlook are those risks which matter most to the compound return of any portfolio, which are tail risk. We’ll be focusing on right tail risk, which is defined as the expected best two months forward return with 10% probability, and less tail risk, which is defined as the expected worst two months return with 10% probability.

As a result, because our outlooks are based on market prices, and they’re based on these market prices in a very systematic and quantitative way, our outlook is going to be forward looking, not backwards looking, it’s going to be free of subjective bias. Most importantly, our outlook, hopefully, will be different. We’ll be coming at it from a different lens. One can argue whether or not using market prices to help educate on what the future risk of the market might be is better or worse than a traditional approach. What I’m pretty sure and confident in saying is our approach is going to be different. Hopefully, we’ll complement what other standard and a non-standard research you do in-house. With that, let’s move on.

Schrock: Great. Thanks for that overview, Ash. Let’s dig into our first topic, inflation. I recently saw a headline that inflation is dead. I think many investors think that that could continue to be the case for many years to come. Yet at the same time, I know last month, to follow on to the point that you were just making, your team observed that the options market was starting to register above average inflationary signals. While you indicated that the signals were not necessarily indicating an inflationary breakout, you did caution investors that the risk of inflation should not be written off altogether. Perhaps if you could comment on what you’re seeing on that front and considerations that investors might keep in mind.

Alankar: We’re starting off with inflation, first and foremost, and trying to answer the question of whether inflation is dead or alive. Because in our opinion, the greatest risk to disrupt the calmness that has persisted in the markets over the past many, many years is an unexpected shock to inflation, because that unexpected shock to inflation will cause the Fed to rethink its dovish stance, and in all likelihood, could quickly cause the Fed to pivot it to something much less accommodative, if not much more tightening going forward.

What’s the evidence that we have to suggest that, “Hey, inflation is still alive, we shouldn’t write it off.” Well, for one, the bond market doesn’t seem to be concerned about inflation. Inflation expectations are still very, very low. However, what are the equity markets and commodities markets telling us about inflation? First, let me describe what I’m showing you here in these box plots. If you focus on the right most box plot under the title discretionary, what these boxes are plotting is the Tail-Based Sharpe Ratio of each security over the last three years.

What the Tail-Based Sharpe Ratio is, for the purposes of this call, it’s the ratio of the size of the right tail divided by the size of the left tail. If that ratio is large, it’s indicating an attractive security to own. The gray shade area of the box represent the interquartile range of the Tail-Based Sharpe Ratio over the last three years. The wings of the box represent the outliers. The red dot represents the current value of the Tail-Based Sharpe Ratio for each asset.

For example, historically in inflationary episodes, consumer staples have outperformed consumer discretionary for the very simple economic reason that consumer staples have pricing power, they can pass inflation or price changes to the end client. Discretionaries, on the other hand, don’t have that luxury. What are we seeing today? Well, the Tail-Based Sharpe Ratio for consumer staples is sitting much higher on the box than consumer discretionaries. Consumer discretionaries today look about average, with its Tail-Based Sharpe Ratio sitting right around the median historical level over the last three years, consumer staples look more attractive sitting closer to the 75th percentile. The option market is telling us we’re likely to enter an environment where staples will outperform discretionary.

One piece of evidence in favor of, “Hey, we might see inflation going forward.” Historically, in inflationary periods, gold stocks have acted as one of the most robust hedges. Gold stocks look attractive, gold commodity or gold spot looks attractive. While there are many reasons potentially why gold looks attractive, staples look more attractive than discretionaries, one potential reason is inflation.

What other supporting evidence do we have on the inflationary front? Well, currency plays a big role in inflation. What we’re seeing today is weaker dollar going forward. Yen looks strong. Canadian dollar looks strong. Pound looks strong. Euro looks about average. A weak dollar does play a very important role in price pressures to the upside. We must not forget Canada last week just printed its highest core inflation number over the last seven years, and last night Singapore printed an inflation number which was much higher than expected survey numbers by economists. We’re starting to see potential signs of global inflation picking up. Which begs the question why haven’t we seen inflation?

Let’s take a step back and look at the quantity theory of money supply, which is the governing equation of the macroeconomy. The very simple equation, one which we’ve all likely heard of, which is money supply times the velocity of money equals prices times output. What does this macroeconomic governing equation tell us about inflation? First, for prices to pick up, which is inflation, money supply has to be large. Today we have a very large money supply. That’s a tailwind for inflation.

Money supply by itself is not enough to cause inflation. The velocity of money also has to pick up. Currently, the velocity of money is quite low. One of the main reasons we believe the velocity of money is quite low is excess reserves sitting at the U.S. Fed are still very, very high. They peaked at over 2.5 trillion at around 2015. Today they’re sitting just below 1.5 trillion. Why excess reserves are important to price pressures are excess reserves represent that high-powered money. They represent the money that goes out, lending and extending credit to real borrowers.

If banks are not lending money out, this extra supply of money, which the Fed has created, is not real money. It’s simply money sitting at the Federal Reserve as an accounting relationship. As these excess reserves start leaving the Fed, start entering the real economy, we should see the velocity of money pick up. We should see transactions pick up, and that increase in the velocity of money theoretically should bare inflation.

Schrock: Let’s move on to our next topic: trade, particularly the trade tensions with China. What’s your view, Ash, on where we’re headed and are there any insights to be gleaned from the options market in terms of potentially the ultimate winners and losers?

Alankar: While we believe the greatest risks out there to the stability that we’ve enjoyed so far is inflation, trade war is another risk and a risk we shouldn’t ignore and a risk which is on the top of many people’s minds today. Very quickly, according to the options market, there are very little, if any, signs of today’s trade war escalating.

If you look at the attractiveness of those instruments or security that are most sensitive to a breakout in trade wars, they all look quite good. It’s quite a bright picture. Australia, which is very sensitive to the Chinese economy, looks attractive. China A shares and H shares both look quite attractive. India, which Trump has recently started attacking and imposing tariffs on, are the most attractive equity region globally. Taiwan looks attractive.

In an emerging market space, those names that are most likely impacted by an escalation on the trade front are showing brightness, that they’re not showing signs of severe fragility. In the U.S., for example, which is another piece of evidence, should a trade war breakout, small cap stocks which are more focused on the domestic U.S. economy and are not impacted as much by global trade versus large cap stocks are much less attractive than large caps.

That’s another sign which is saying that on the global trade front, we’re not seeing alarming red light flashing. In our opinion, these trade wars are clearly not going to get worse. It’s not to say that they’re going to get resolved anytime soon, but worst fears of a trade war becoming– or today’s trade battle actually transpiring into a war is very unlikely.

Schrock: Moving on then to global growth. Certainly, a concern for many investors, particularly if we’re considering potentially a long-term low return environment, many would argue, Ash, that valuations of threats and particularly with growth assets considering how long the whole market has run and therefore any potential upside to growth assets is probably limited. Is that consistent with your view in what you’re seeing priced into the options market and maybe more specifically what are you finding from a market perspective as being most attractive?

Alankar: We’re not seeing any signs of a slowdown in real economic activity; we’re not seeing any signs that we’re close to a tipping point to push economies into a recession. At the very high level, if you look at global equities, Japan looks attractive. U.S. equities look slightly above average attractive levels. Europe is sitting at attractive levels. There’s nothing that we see according to option prices that is alarming. Why is that?

I think we can thank the Fed for this. What I mean by that is the most important driver, an impactful driver as a historical recession is the price of money. When the price of money trades expensive, recession has hit, every single time post the world wars. Is the price of money today expensive, cheap or fair? One could argue the price of money over the short run, the overnight interest rate, is about fair. The reason being the overnight interest rate should more or less anchor to inflation. One shouldn’t get a real return or much of a real return lending money overnight.

What you find today is the overnight rate which is sitting between 200 and 225 basis points, is right around the realized and the Fed’s targeted inflation rate which is right around 2%. One could argue the price of money at the front end is fair.

On the other hand, what about the price of money in the long end? For one, we argue that financial conditions today are still very accommodative because the price of money over the long run is very cheap. Whereas we argued in the short run your interest rate should equal about your inflation rate, so there’s no real return to be earned by lending money overnight to a credible party.

When you’re lending money over longer horizons, say a 10-year horizon, macroeconomics would suggest your 10-year real rate should equal the real GDP of the local country you are lending in. If you believe the real GDP of the U.S. over the next 10 years is going to be somewhere between 1.5% under the new normal assumptions to 2% under the old normal assumptions, the price of money over longer horizons is very cheap because your 10-year real yield today sits at 32 basis points. It’s over 100 basis points lower than the expected real GDP of the U.S. under the new normal.

With the cheap price of money over the long end and a fair price of money over the short end, the conditions are almost impossible for a recession to hit it. We think, Dave, that the outlook looks okay. Recessionary concerns should not be a risk that any of us are worried about.

Which brings us to quickly the conclusion. We are to believe today we are in a goldilocks scenario, thanks to the re-emergence of the Fed put that Fed dovish stance has brought, once again, calm to the market because of this put. The left tail risk, however, we need to monitor very closely is inflation, because we could be seeing a policy mistake unfold and turning to a more dovish pivot just as inflation starts to awaken. The key takeaway message of our outlook is you need to monitor inflation trends today if inflation hits, it’s likely to be the worst form of tail risk because the diversification between bonds and equities will also disappear.

What does that mean for asset allocation today? Well, we believe in a recommending one should keep risk at above-average levels as the Fed put is alive and well. Trade war escalation risk is very minimal. From a technical perspective, the vast majority of market participants are still very underweight risk. If the vast majority are underweight risk, that’s a good time to be above weight risk. That succinctly summarizes our views according to the lens of the options market.

Schrock: Very interesting, Ash, thank you for that. Let’s turn over to questions from the audience, we do have several already in the queue. Ash, let’s start off with this one. The Treasury yield curve has been flat for quite some time. What’s driving that? Are there any particular parts of the curve that cause you any special concern?

Alankar: Yes, we’re honestly not too afraid about the inverted yield curve. You hear a lot about previous recessions being proceeded by an inverted yield curve, and we believe that that, once again, is a mistake of causality versus correlation. Sure, it’s 100% true that inverted yield curves have been a forewarning to future inflation, but what has also been true, as we talked about during the price of money discussion, the price of money has also been very, very expensive, i.e. your front end overnight rates have shot up well above 200 basis points above your expected inflation.

Today we’re not seeing that. We believe that the flatness of the yield curve, and any conclusions being drawn on the shape of the yield curve should be drawn with some degree of skepticism because it’s been distorted by this unprecedented central bank activity. The yield curve, you should pay more attention to where inversion would really mean something is the credit curve. If you start noticing the credit curve inverting, i.e. two-year CDS or five-year CDS trading at levels higher than 10-year CDS, time to get worried. That’s a very ominous sign.

Schrock: Moving onto another question here. Will the FAANGs continue to lead?

Alankar: Great question. Our signals– we obviously have signals on the upside and downside risk to the FAANGs, we are seeing the attractiveness of the FAANGs to be quite poor. We could be entering an environment where growth and equities aren’t led by these tech companies but are led by more traditional sectors. Be a bit worried or pay more attention to any overweights you have in these FAANGs group of stocks.

Schrock: Let’s see another question here, what are the potential economic and market impacts of escalating tensions between Iran and the U.S.?

Alankar: This is a very good question, which actually relates to our concern about inflation; that one thing which happens with almost 100% probability is when war breaks out, commodity prices skyrocket because supply chains are disrupted. A jump in commodity prices is inflationary, and that inflationary impact is something the Fed will have to consider and should the Fed get worried about that jump in commodity prices persisting more, persisting longer that they may feel is prudent, you could see that the Fed reversed its accommodative policy to a more tighter policy, which then could derail not only financial acids, but could potentially derail the real economy and tip us into a recession.

Schrock: Good. Do you have any final thoughts here, we’re approaching the top of the hour, Ash?

Alankar: The one final thought I had is right now enjoy the Goldilocks scenario that the Fed is delivering on a nice silver plate. If there’s one rift to watch out for, in our opinion that’s inflation. Pay a lot of attention and then closely monitor inflation trends. Think about inflation out of the box and be ready to really pivot to a risk off environment should those inflation trends start pointing to the upside. Also think carefully today, it’s not a bad idea to start thinking about putting some inflationary hedges on given the prices of inflation or the level of inflation being priced by the bond market is still very, very low. It might be a good time to put on some inflation hedges which you likely could put on at a quite cheap level also given monetary levels are quite low.

Schrock: Great. Thank you. We want to be mindful of your time, so we’re going to wrap up the call. Thank you all for making the time to join us and thank you, Ash, for your comments and perspectives.

Alankar: Great. Thank you all.

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