Lessons from February: A Multi-Asset Perspective

Lessons from February: A Multi-Asset Perspective

Last month showed vividly that sentiment can shift rapidly even when fundamentals stay solid; the heightened focus on the Fed and inflation is likely to persist, although we expect the impact of upcoming increases to be primarily on short-term rates.

February was proof that market sentiment can shift abruptly, even despite seemingly solid fundamentals.  During just the first few trading days of the month, the S&P 500 fell by almost -9%, and the VIX implied volatility index surged to multi-year highs after an extended stretch of low levels.  Treasury yields also increased across the curve, and spreads in both investment grade and high yield credit widened.  While exacerbated by several other factors, concerns over inflation and rising interest rates were the main triggers behind the turmoil.

February: rough month for equities:  VIX Index (%; lhs) vs S&P 500 Index (%; rhs)

VIX Index vs. S&P 500 Index

Source: Bloomberg and QS Investors

Since mid-February, the dust has settled and markets have rebounded to an extent.  However, equities are still down -6% from their highs at the end of January and are slightly positive YTD.  US Treasury yields and credit spreads also remain elevated.  Generally, it feels like investors are remaining cautious and lack major conviction, at least for the time being.

At QS Investors, we take a systematic, quantitative approach to formulate performance forecasts for a broad range of asset classes used in our allocation models and multi-asset portfolio management platform.  The market developments discussed above have had a moderate impact on the forecasts generated by our models.  Consequently, our tactical (near-term) outlook for both equities and fixed income has shifted.  However, because most fundamentals have not changed and our models are based on longer time periods, shifts in our views are not as dramatic as what we have recently observed in the market.

Equities Outlook

US Equities are neutral versus US bonds, but still attractive versus cash.  After being bullish for most of 2017, our outlook for equity performance has tempered to neutral.  Compared to bonds, our proprietary models indicate just above a 50/50 probability of equity outperformance over the next month, which is its lowest level since late 2016.  Unsurprisingly, this is due largely to rising interest rates, which are factored into our model and negatively influence our view on stocks, as they indicate tighter credit conditions and lower relative valuations to bonds.  That said we still think that it makes sense to stay invested in some form or another versus going into low-yielding cash, whether it is in equities or fixed income.  Currently, we assign a 74% probability of stocks outperforming cash over the next month.

The QS view: near-neutral on stocks vs bonds Estimated probability of equity outperformance over the next month (%; 5d MA)

US Equity Performance

Source: QS Investors

Consider defensive equity income.  While we largely lean neutral on stocks at a high level, our equity strategists note that investors who seek exposure may want to consider defensive equity income strategies.  Defensive equity income gives investors equity market participation, but also seeks to provide downside protection with the expectation of a more stable equity return and high dividend yield.  It invests in dividend-paying stocks that exhibit low volatility price and earnings volatility to provide low-risk exposure to equity while providing a pickup on yield over bonds.

Fixed Income Outlook

All else equal, it is likely that higher US Treasury yields would negatively impact total returns across government/agencies, credit and structured products.  Just how much depends on the pace of rising yields throughout the remainder of the year.  Currently, two views stand out the most in our models:

Underweight high yield corporates.  Our expected total return for US high yield (HY) corporates during the next month falls well below that of our broad fixed income market proxy, the Bloomberg Barclays Aggregate Bond Index, which is comprised primarily of lower-yielding US government and agency securities.  Since 2011, our current projected underperformance of HY relative to the broader fixed income market sits at the bottom 7th percentile.  Elevated implied volatility in the equity market is partially driving our forecast: high yield bond prices have shown to exhibit correlation to their issuers’ equity prices.

Consider Treasury Inflation-Protected Securities (TIPS).  TIPS provide inflation protection and can serve as an effective diversifier within a portfolio.  On the back of recent economic data and prospects for growth, market-derived expectations suggest that inflation could rise in the future.  Our models incorporate these measures to form a view, and all things considered, we believe that TIPS could be worth consideration.

Markets are expecting inflation to rise in the future: 10y breakeven rate (%)

Treasury Inflation-Protected Securities

*Breakeven rate represents the market-implied rate of inflation over the next 10 years

Calculated as 10y nominal UST yield - 10y real yield UST yield

Source: Bloomberg and QS Investors

Looking Ahead

It’s tricky out there.  February showed us that risk markets care more about interest rates than they have for some time.  Inflation, growth and monetary policy are being looked at closer.  Accordingly, the path of rates during the rest of the year will likely impact expected and realized returns, volatility and correlations across asset classes.  For now, our view on rates is that increases will occur more so in the front-end of the curve versus the intermediate/longer end, which may imply a more muted impact on risky assets.  Regardless, now may be a good time for investors to re-align their respective multi-asset allocation strategies to meet their investment objectives and risk tolerance.

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IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.