October 2019

Tell Tail Signs: What Are Markets Signaling?

 

View Transcript Ian: My name is Ian and I will be your conference operator today. At this time, I
would like to welcome everyone to the Tell Tail Signs: What Are Markets
Signaling conference call. All lines have been placed on mute to prevent any background noise. You may
ask questions at any time during the webinar using the Q&A box on the bottom of
the screen. Thank you. Mr. Dave Shrock, you may begin your conference. Dave Shrock: Well, hello. Thank you all for making the time to join us today. My
name is Dave Shrock. I’m joined by Dr. Ash Alankar, Head of Global Asset
Allocation at Janus Henderson Investors. Also, a lead portfolio manager on the
Adaptive Multi-Assets Solutions Team. In today’s webinar, we want to share our
perspective on the current risks and opportunities in the market as informed by
our proprietary tail risk signals, which are derived from the options markets. For those who may not be as familiar, our Adaptive Multi-Asset Solutions Team
arrives at its outlook using option market prices to incur expected tail gains and
expected tail losses for major asset classes. Quite often, we found that option
market prices are signaling something altogether different than more traditional
backward-looking valuation metrics. Similar to our call last quarter, we’re going to
focus on three high-level topics that are weighing heavily on the minds of many
of our clients, global growth, inflation, and trade. As we cover each topic, please feel free to submit questions. There’s a Q&A box
on the right-hand side of your screen. We’ll certainly do our best to address as
many of them as possible toward the end of our call. Ash, before we dive in, can
you just give us a quick overview of the signals that you use and why they offer a
different perspective. Ash Alankar: Sure. Absolutely, Dave. What you’re going to hear from us today is
a macroeconomic outlook based on what we like to call a different lens. It’s
different in two very important fundamental ways. First, you’re not going to hear
us comment on what we believe the average return or average risk of various
asset classes are going forward, but rather, we’re going to comment on the
extreme move. We’re going to talk about the macroeconomic landscape and paint a picture of
this landscape using a brush, a tail risk. Why tail risk? Because tail risk turns out
to be the most important driver of how well a portfolio performs, how well a
portfolio grows over time, how consistent a compound return that portfolio
delivers. You’ll hear us talking about two forms of tail risks. One is right tail risk,
which is the risk to the upside. The second is left tail risk, which is that painful
form of risk, which is risk to the downside. The second important way we’re going to differ from the standard typical
macroeconomic analysis is we’re going to provide a forward-looking assessment of the world by using market prices themselves. A great place to get information
about future risk is to look at what the option markets are telling you about risk
going forward. Why? Because option prices are nothing more than insurance
premiums. The good news is the option market is much richer than the real insurance
market. What we know from real insurance, what we know from black scholes is
insurance prices tell you everything about risk. If the price of the insurance
increases, it automatically tells you mathematically that risk is increased going
forward. The option market provides contracts not just to protect you against
losses, i.e. those put options, which give you estimates about future loss. The option market also provide you contracts and gives you participation to
upside via call options. Hence those call contracts and those prices of call
contracts tell you about future upside. Hence through looking at the prices of put
options and the prices of call options, we can exactly get an idea of what the
markets are telling us about future upside, i.e. right tail risk, and future downside,
i.e. left tail risk. That’s what this outlook is going to focus on. Dave: Great. Well, thanks, Ash. Let’s first address the topic of global growth and
this continues to be top of mind for our clients. Certainly, US stock markets
plunged the first couple of days this month. The ISM, as you know, signaled that
September was the worst month for US manufacturing in more than a decade.
The sell-off seems to echo last year’s fourth quarter’s fell off and even more
broadly than that, however, though global growth remains a concern. Many
would argue that valuations are stretched. Is there anything in the options
market that you see that causes significant concern related to global growth?
Any markets that may appear attractive? Ash: It does seem like Deja vu all over again. A year has already passed. We’re
back at the fourth quarter. We are seeing some concerning signs via option
prices regarding growth going forward. Slide 2 of the deck, what you see here is
we plotted out the attractiveness of four regional equity indices. Emerging
markets: Japan, US, and Europe. What we’re plotting out here and how we’re
defining attractiveness is the level of upside implied by call options on these
asset classes divided by the level of downside implied by put prices on these
various asset classes. Think of this ratio of upside, i.e. right tail risk, divided by
downside, i.e. left tail risk as the tail based sharp measure. The higher the tail-based Sharpe ratio, the more attractive that risk premium is
expected to be. What you see here, the bright red dots represent today’s level of
expected tail Sharpe ratio going forward. You don’t see a picture that’s very
bright at all. You see equity risk to be quite unattractive. Very unattractive in
Europe. Quite unattractive in the US. Equity risk in the emerging markets not so
attractive. One stand out is Japan. The equity risk premium in Japan does look decently higher or modestly higher than average levels. Globally, these aren’t
painting the most optimistic picture. We currently believe we’re in an environment where global growth is going to
slow. Is it going to slow to that point where we tip the economy into recession?
We don’t think so. The reason we don’t think so is sure, you’re tail Sharpe ratio
don’t look very attractive, but the absolute level of downside implied by put prices
are not at recessionary levels. What we’re plotting out here, it’s no longer the tail
Sharpe ratio, but rather, it’s the expected tail loss defined as the expected worst
two-month move with 10% probability going forward. Recessionary level of downside risk historically has implied a left tail risk closer
to minus 25%. There’s a 10% probability equities could fall 25% over the next
two to three months. We’re not seeing that. We’re currently seeing the downside
level of risk implied by options prices on global equities to be in the high teens.
The high teens are very different from the high 20s. We’re not seeing a lot of
flashing of an imminent recession, but we are seeing some very significant signs
of a slowdown. This brings up to a different question as Dave articulated in his intro. Fears of
recession have become front and center ever since this weeks ISM numbers
here in the US where the September numbers were the second number in a row
where the manufacturing level fell into contractionary territory. How scary really is
this? Well, ISM numbers historically, I would not say they’re the best predictor of
future recessions. Sure, when the ISM falls below 50, the manufacturing is
contracting. Historically, there’s a 40% probability that recession hits within one year. There’s
a 60% probability that it’s wrong. It’s a false positive. To rely and then have too
much faith on this ISM is probably not the best course of action to take right now.
Don’t get overly concerned, but at the same time, don’t ignore it. 40% profitability
is still a very high number. Pay attention to what the manufacturing numbers are
telling you. Don’t get overly cautious just because these ism numbers have fallen
in this contractionary region. More importantly than your ISM numbers when it comes to recession is to really
look at financial conditions. Really look at how stimulative monetary conditions
are today. The best way to get an idea on how accommodative the monetary
front is is to look at the price of money. How can one look at the price of money?
Well, it’s quite easy by thinking about what your natural overnight rate should be.
Theoretically, your natural overnight rate should be that rate where the real rate
is zero. Hence, your overnight rate should be pegged close to your inflation rate.
When that’s the case, your overnight real rate is zero. If you’re not taking any
risks, you should earn no real return. The price of money is fair. If your overnight real rate is much greater than zero, the price of money’s
expensive. When your overnight real rate is negative, so it’s below the inflation.
Your price of money is cheap. What’s happened in every single recession post
the World Wars, the price of money has been expensive. Your overnight real rate
has been significantly greater than zero. When the price of money is expensive,
the velocity of money fall. When the velocity of money falls, you have no growth. What does the price of money look like today? Well, in this figure, what you see
is the cost of money just very easily proxied by your three-month nominal
treasury yield minus CPI is sitting at minus 60 basis points. Your overnight
nominal yield is 60 basis points below CPI, so price of money is pretty cheap. I
wouldn’t say it’s significantly cheap, but not at that minus 200 basis points level
we saw post-2008, but it’s cheap. When the price of money is cheap, it’s hard for a recession to hit. Not only is the
price of money cheap at the short end, the price of money is cheap also at the
back end. At the back end, say your 10-year real rate, your 10-year real rates
shouldn’t be pegged at zero, but your natural bear equilibrium level of your ten
year real rate should hover right around the expected 10-year real GDP of the
US. Most expect the 10-year real GDP going forward to average somewhere
between 150 and 200 basis points, but your 10-year real yield today is under 10
basis points. The price of money is also cheap over longer horizon. When
financial conditions are disaccommodated, if history has any precedent, you’re
not going to see a recession. Dave: Great. Thanks, Ash. Let’s move on to inflation. Ash, I know that you’ve
continued to warn clients that we should not be too quick to write off the inflation
risk and that you’ve seen a greater risk of inflation moving higher as opposed to
the lower. Maybe if you could just comment on what you’re seeing on that front
and perhaps any considerations that allocators should keep in mind. Ash: Yes, sure. Inflation. Dead or alive, our signals are telling us inflation is still
alive, we should be so quick to write it off. If you look at the commodities
markets, where the commodities markets are obviously quite sensitive to
inflation, this measure of attractiveness, once again, based on the tail base
Sharpe ratio, so our ratio upside to downside is showing gold, silver, and oil have
much more upside than potential downside going forward. All signs that hey, inflation, we may not have seen, and we haven’t seen that that
robust inflation number that we’re all looking for. Dormant doesn’t mean dead.
We believe inflation is a risk that warrants our attention. I’ll talk about in a second
why I believe it’s the most significant risk that we really need to focus on. First,
why are we not seeing inflation? I just talked about how monetary conditions are
quite accommodative, quite simulative. Why isn’t this fueling inflation? Why isn’t
inflation unfolding? One reason, we believe a very powerful reason is excess reserves are still quite
high. Even though the supply of money is very, very large, a lot of this money is
still sitting at the Fed. Excess reserves today sit at over a trillion dollars. They
fallen significantly from the peaks in 2015 where they are an excess of $2 trillion.
You see a nice relationship here. As excess reserves fall, inflation rises. If this
trend in excess reserves continue, and banks continue to pull money out of the
Fed, we could see inflation surprising up to the upside. We should be aware of it. Why we should be worried about this has to do to a very important fact that all of
us have become much too complacent, that bonds will diversify equity risk.
We’ve all drawn conclusions that hey, during the 2008 crisis, equities collapsed,
bonds enjoyed a significant rally. This negative correlation between bonds and
equities has now become dogma. That’s not true. If you look over historically
longer periods of time. The correlation between bonds and equities is, in fact,
positive. If you look at the 40-year period from 1960 to 2000, 60% of the time that equities
fell by more than 3% in a month, bonds also fell. They fell by a large number that
they fell on average 1.8%. Sure, post-2000, we’ve had this incredible
diversification power between bonds and equities. That’s only post 2000. If you
look further back, then safeguard that we believe bonds will provide the equity
exposure, may not be so safe, it really depends on the type of stress events that
hit. If that stresses that is one that’s driven by inflation if that stress event is one
driven by the Fed tightening too quickly. You could see diversification failure
between bonds and equities and our safety net, which a lot of people are defining
today to be duration, may not protect you at all when that crisis unfolds. Dave: Great. Well, let’s move on now to our final topic, trade. Of course, the
trade tensions with China continue. We recently learned that the US plans to
impose tariffs on certain European Union goods. We heard that and that should
be coming out shortly. What’s your view on where we’re headed? Are there any
insights to be gleaned from the options market in terms of ultimate winners and
losers? Ash: Yes. There was a great academic paper written, I would say a few years
ago, which looked at political risk and risk premium stemming from political
uncertainty. What that papers showed is historically, when political risk is
heightened, political uncertainty is heightened, risk premium turned out to be
quite attractive. That’s the time where you should be buying risky assets because
you get an extra premium based on this political uncertainty. Today is political risk translating into attractive risk premium, I would say not yet.
If you look at Hong Kong and the UK, two areas where political uncertainty is
quite high. Once again, the tail Sharpe ratio, there’s measure of risk premium
attractiveness or cheapness across asset classes, Hong Kong doesn’t look
cheap, the UK doesn’t look cheap. China and Australia. Australia provides high data exposure to China. China and
Australia, I would say, attractiveness and cheapness is about fair. That they’re
looking about fairly price, their tail Sharpe ratios are not as low as you see in
Hong Kong and UK. Once again, I would say that the risk premium levels, the tail
Sharpe ratio levels are not compelling by. They’re not significantly high. Right
now, I would be patient. I do believe political uncertainty provides a good
opportunity to earn risk premium above and beyond the expected level of risk
premium one would expect. Today, that political risk premium is not being priced
at attractive levels across the global landscape.

Dave: Do you have any concluding comments before we turn to a question?

Ash: Yes, just really quickly. I think one of the key points here is don’t be too
alarmed yet about recessionary fears. We are seeing a slowdown so that’s
worrisome, but a slowdown is very different from a recession. There’s various
reasons why we believe a recession is somewhat difficult to unfold right now. We
are telling a lot of our clients that, hey, think about inflation risk. Inflation risk is
one of those risks where this diversification between bonds and equities could
break down. Don’t hold on to avoid the false safety net of thinking that bonds will always
diversify equities. That’s only been the case over the recent history. Over longer
periods, that has not been the case so be aware of that. Don’t just assume that
your duration exposure will provide a nice hedge to offset losses, should equity
risk tip over. Those are the key takeaway message based on what we’re seeing
through the lens of the options market. Dave: Great. Ash and everyone on the call, as a reminder, if you do have a
question for Ash, you can submit it via the Q&A box on the right-hand side of
your screen. We do have several that have come, Ash. This first one aligns with
your last comments there. If bonds aren’t essentially a safety net, or won’t be a
safety net, or a hedge equity, are there other places that clients might turn, other
things they might consider? Ash: Cash is always a good place to go. Cash will protect your portfolios with a
100% probability. One thing which always performs very well when geopolitical
risk starts to flare up, and most of us would argue, hey, we’re not calm on the
geopolitical side is that there are a lot of tensions brewing around the world.
Commodities, particularly oil, always do very well. Geopolitical risk disrupts
supply chain. When supply chains are disrupted, disrupted oil always rallied. Oil
could be a nice hedge. Right now, even though I emphasize that bonds– Don’t be so certain that bonds
will diversify your equity risk, our signals looking at how option prices are
forecasting the future upside to downside, for treasuries look attractive. Right
now, I do think a nice play and a nice diversifying strategy continues to be, hold a balanced portfolio between bonds and equities, but be dynamic about that. If
you’re noticing inflation trends percolating, don’t be so confident that you’re not
going to suffer a drawdown that hits bonds and equities exactly at the same time
like we’ve noticed in these mini crises over the last couple of years. Dave: Here’s another one. What’s the potential market impact of ongoing
impeachment inquiries? Any thoughts on that? Ash: Good old impeachment. Well historically, this is a nice anecdote,
impeachment proceedings, if you look at during the Clinton times, they started in
October 1998. From October 1998 to January 1st, 1999, S&P 500 rallied 27%.
Impeachment per se I don’t believe has as big of an impact on pricing of risk
premium. Historically, it hasn’t happened very often, but if you think about it
intuitively, I don’t believe impeachment risk represents the form of tail risk that
we’re worried about. In this particular case, I do believe the impact will probably
be more meaningful than during the Clinton era for the very simple explanation
that impeachment may distract the Trump Administration away from resolving or
making progress on the trade front but to dealing with the impeachment inquiry.
All else equal and that’s a negative. Dave: Okay. Thank you. Here’s another one. What’s the effectiveness of
monetary policy during a time when yields, really around the world, are negative? Ash: You see negative yield getting a lot of bad price over the past many years.
Theoretically, negative yields should help drive growth, they should help catalyze
spending because saving now is costly, you’re getting penalized to save. A lot of
people look at the example of Japan. Well, in Japan, they have low yield since
the late 1980s, but that didn’t help ignite inflation, that didn’t help ignite growth. Maybe monetary policy is ineffective when yields are so negative. I would say
don’t jump so quickly to that conclusion because the problem with Japan wasn’t
the fact that yields were low. The problem with Japan was the real yield was
very, very high. Even though yields were low, inflation was falling faster the
nominal yield, hence, your real yield was very, very high. Japan real yield has
been some of the highest real yield in the entire world over the past four
decades. The good news today is real yields are negative. Today’s environment, while a lot
of people think is similar to the Japanese experience given rates are low, it’s very
different because what’s low today is not just your nominal yield, but what’s low
today also is your real yield. I think monetary policy still can work as long as it
can drive real yield down. If monetary policy only drives nominal yields down,
then you have a problem. Dave: Interesting. Well, thank you for that. We are up against the half past the
hour, so we want to be mindful of people’s time. Thank you again for joining us. Thank you, Ash, for your comments and your perspective. Any questions that
Ash wasn’t able to cover, we’ll reach out to you to make sure that we address
those. If you want to receive Ash’s monthly update, you can subscribe by
providing your email address in the poll question on the right-hand side of your
screen. You’ll also find the slides from today in the September Tail Risk Report.
Thanks again. I look forward to speaking to you next quarter.

Ash: All right. Thank you.

Dave: Thank you.

 

 

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