The recent assault on inflation expectations left the well-watched five-year breakeven just above the Federal Reserve's (Fed) 2% target, leaving the Fed little choice but to closely monitor price pressures. With a watchful Fed, it becomes increasingly difficult for inflation to push sharply higher. Our signals support this case, as seen by January's declining attractiveness of assets that generally do well during inflationary episodes. However, it is important to note that the attractiveness of these assets is still above average, likely indicating that we are not going to see an aggressively hawkish Fed anytime soon.
(Expected Tail Gain* / Expected Tail Loss*)
This brings us to equities. With real rates still very low and inflation moderating at normal levels, the environment is fertile for growth, which our signals support by assigning the brightest outlook to equities.
In addition to our outlook on broad asset classes, Janus' Asset Allocation team uses option market signals to provide insights into specific markets. The following caught our attention:
U.S. equities are still most attractive. Emerging markets also look attractive, reinforcing the view that President Trump values the importance of free trade and globalization. Peripheral Europe, in particular Italy, offers opportunities, as the potential resurgence of the center-right in Europe (i.e., France), and its pro-growth policies cannot be ignored.
We see U.S. rates and non-U.S. developed rates, particularly Germany, following a path of convergence. With inflationary pressures mounting in Europe and yield differentials still very wide, we are near a tipping point where European yields need to catch up with U.S. yields.
Janus' Asset Allocation 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.