The importance of getting the asset allocation decisions right has long been engrained 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 February 2018 as well as the previous forecasts over the last year. Forecasts are updated each month with the latest macro-economic and risk factor changes. 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:
USD currency declining on a trended basis against major trading partners. Short term interest rates and inflation on the rise which is negative for fixed term assets. Economic growth remains positive as indicated by year over year increases in commodity prices.
Equity risk aversion is above its long-term average which is negative for equities. Term spreads increased on a trended basis which can be indicative of turning points. 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:
Diversified commodities have the most favourable ranking over the coming three-months followed by emerging market equities.
Among fixed income asset classes, emerging market bonds have the most favourable ranking and high yield bonds the least favourable.
Developed market REITs continue to fall in the rankings from previous quarters.
This month we also take a deeper dive into equities.
What are the key market movers and what can we expect from equities over the coming three months?
Asia ex-Japan equities have the most favourable ranking up one place from last month.
US large and small caps occupy the most favourable rankings among developed markets.
European and UK small caps rankings indicate they are the least favourable areas to invest.
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 3 three-month ahead view as taking a deeper look within another asset class.