Asset allocation trends – February 2022 update

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 and technology called AlphaPredictor® which is able to forecast the movement of security prices by modelling the correlation of macroeconomic variables to individual assets and to factors that have been shown to drive market performance.  It is distinguished by its ability to learn and adapt across time and to quickly respond to fast-changing landscapes.

The heatmap below covers 9 major asset classes.  It shows a 3-month ahead view of expected performance through April 2023 as well as the previous forecasts.  The investor currency for the expected returns is USD.  Each forecast reflects the latest macroeconomic and risk factor changes prior to the forecast date. 

What is our model 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:

• Recession risk remains but the expected likelihood declined in polls among economists even as the Fed continued to tighten monetary policy in the face of strong consumption and employment data
• Industrial metals are lower 4% year-over-year but rose 8.5% in January as the market became more positive on China’s reopening and its government’s steps to support the economy
• Default spreads are wider than a year ago reflecting investors’ greater risk expectations if the Fed keeps rates higher for longer, but spreads have been tightening in recent months
• The US term spread remains inverted, and inflation remains elevated but year-over-year measures of headline and core CPI are declining
• An uncertain economic outlook with economic data sending mixed signals suggests that market volatility will likely remain high

These macro variables and many others are part of the information set used in AlphaPredictor® 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 3 months?

Here are some takeaways:

• Expected return rankings for equities were lower than for bonds for most of 2022
• Treasuries and inflation linked bonds had higher expected return rankings than credit in 2022
• Within alternatives, gold was ranked more highly than REITs in 2022
• For the three months ahead ending April 2023, equities and other risk assets including EM debt are ranked more favourably than treasuries and investment grade corporates
• The highest ranked asset class over the next three months is EM equities and the lowest ranked is global inflation-linked bonds

Our state-of-the-art investment model is constantly learning and adapting to changing macroeconomic and market conditions.  Next month, we will provide an update to our 3-month ahead view and take a deeper look into another asset class.  Until then…..