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Our signals of forward-looking inflation continue to point to the upside. The robustness of this view is reflected in its consistency over the past several months. As we start the new year, we believe that inflation is the greatest risk faced by markets, particularly because most have written it off, citing structural headwinds. Often, an ignored risk turns out to be the most painful kind.
The central bank-manufactured “cheap” money environment that financial assets have ridden to new highs could quickly disappear in the face of unexpected inflation and a likely shift toward a tightening regime. We have seen time and time again how the market responds when fears of tightening unfold, and it is not pretty.
And one must not forget that despite these structural headwinds, the year-over-over U.S. core inflation, as measured by the consumer price index, sits at 2.3%, far from any notion of disinflation.
Using proprietary technology, Janus Henderson’s Adaptive Multi-Asset Solutions Team derives tail risk signals from options market prices on three broad asset classes. Given our current estimates of tail risks, we illustrate how those signals would impact a 60/30/10 allocation.
Our Adaptive Multi-Asset Solutions Team arrives at its monthly outlook using options 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 signals about the risk-adjusted attractiveness of each asset class. We view this ratio as a “Tail-Based Sharpe Ratio.” These tables summarize the current Tail-Based Sharpe Ratio of three broad asset classes.
Consistent with a possible pick-up in inflation, we see nominal bonds as challenged, according to our signals.
In response to potential structural headwinds and inflation data showing restraint, the Federal Reserve (Fed) and other global central banks have made it very clear that not only will accommodation last but they are comfortable with inflation climbing above their targets. This is potentially a dangerous game to play because inflation is rarely tame. During hibernation, a bear appears tame, but when it wakes up it is anything but docile. History suggests that same holds true for inflation. The good news is our signals are not currently pointing to “stagflation.” Rather, we see attractiveness in equities, suggesting economic growth going forward. But beware that inflation could compromise today’s stimulative financial conditions as well as economic growth, as the Fed would inevitably respond by increasing interest rates, leading to higher real rates and costs of capital.
In addition to our outlook on broad asset classes, Janus Henderson’s Adaptive Multi-Asset Solutions Team relies on the options market to provide insights into specific equity, fixed income, currency and commodity markets. The following developments have recently caught our attention: