The importance of getting the asset allocation decisions right has long been in grained in the thinking of investors and financial professionals. The difficulty has been how to get outside the realm of the subjective and have an approach that delivers consistently. A large body of academic research - much of it by my partners and co-founders of Parala - has long identified that understanding the state of the macro-economy and how it is evolving can be very useful in determining investment asset returns. At Parala, our combined skills and pioneering insights on financial market behaviour has resulted in a state-of-the-art investment methodology able to forecast the movement of security prices by modelling the correlation of macro-economic variables to individual assets and to factors that have been shown to drive market performance. The methodology is distinguished by its ability to learn and adapt across time and to quickly respond to fast-changing landscapes. It underpins the multi-asset solutions we provide for our institutional clients and the funds we advise.
Parala's approach is straightforward and intuitive but one which requires highly complex and proprietary calculations to execute effectively. We've found that a simple way of expressing changes in expected investment outcomes is to use heatmaps. The heatmap below covers nine major asset classes. It shows a three-month ahead view of expected performance from December 2017 as well as the previous forecasts over the last year. Forecasts are updated each month with the latest macro-economic and risk factor changes. In the future, we will extend the analysis to look at the expected performance within specific asset classes. For example, we can look at expectations for the UK, Eurozone, the US and Asian equities.
What are our models telling us about key developments across asset classes for the coming months? A good place to start is considering some of the key macro trends that we have recently observed:
A fall in the USD currency against its major trading partners on a trended basis.
Short term rates and inflation trended upward which is negative for fixed assets.
A slight increase in equity risk aversion which tends to be negative for equities.
Economic growth is positive but year over year increases in commodity prices were the lowest seen in 2017
These macro variables and many others are part of the information set we use to generate forecasts which can then be distilled into rankings and the heatmap below. A nice thing about the table is that it can be used to assess the relative attractiveness of different asset classes at a point in time as well as trends in individual asset class expectations across time with the more attractive potential returns moving from red to green.
So, what are the observable trends and what might we expect in terms of asset class relative returns over the next three months?
Here are some takeaways:
Emerging market equities have the most favourable ranking over the coming three months followed by diversified commodities.
Among fixed income asset classes, emerging market bonds have the most favourable ranking and corporate bonds the least favourable.
Diversified commodities improved four places in the rankings along with developed market equities.
In my prior publication, I promised we would take a deeper dive into a specific asset class and this month I've chosen commodities and other hard assets.
What are the key market movers and what can we expect from commodities and other hard assets over the coming three months?
Energy commodities have the most favourable ranking and were the biggest sector mover.
Industrial metals have the next most favourable ranking improving from the prior month.
DM REITs have the lowest ranking within the sector which is partially due to their negative sensitivity to rising rates and inflation.
Our state-of-the-art investment model is constantly learning and adapting to changing macro-economic and market conditions. Next month, we will provide an update to our three-month ahead view as taking a deeper look within another asset class such as fixed income or real assets. Until then.