Thoughts from the Desk: Multi-Asset Strategy


Thoughts from the Desk: Multi-Asset Strategy


MARCH 09, 2018

February 2018 Recap

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 (Exhibit 1).  Treasury yields also increased across the curve, and spreads in both investment grade and high yield credit widened.  While exacerbated by several other factors, concern surrounding inflation and rising interest rates were the main triggers behind the turmoil.

Exhibit 1: February was a rough month for equities

VIX Index (%; lhs) vs S&P 500 Index (%; rhs)


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 recent market developments discussed above have had a moderate impact on the forecasts outputted 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

1. 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 (Exhibit 2).  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.

Exhibit 2: We are near-neutral on stocks vs bonds

Probability of equity outperformance over the next month (%; 5d MA)


Source: QS Investors.

2. Consider defensive equity income.  While we largely lean neutral on stocks at a high level, our equity strategists note that investors may want to consider exposure to 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 price and earnings volatility to provide low-risk exposure to equity while providing a pickup on yield over bonds. (See Diversifying Traditional Value: Thinking Outside the Box with Defensive Equity Income)

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:

1. 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.

2. 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 (Exhibit 3).  Our models incorporate these measures to form a view, and all things considered, we believe that TIPS could be worth consideration.

Exhibit 3: Markets are expecting inflation to rise in the future

10y breakeven rate* (%)


Source: Bloomberg and QS Investors

*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

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 is a good time for investors to re-align their respective multi-asset allocation strategies to meet their investment objectives and risk tolerance.

Important Information

This material is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or QS Investors, LLC to enter into or arrange any type of transaction as a consequence of any information contained herein. QS Investors, LLC does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of QS Investors, LLC, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person.

The views expressed in this document constitute QS Investors’ judgment at the time of issue and are subject to change. The value of shares/units and their derived income may fall as well as rise. Past performance or any prediction or forecast is not indicative of future results. This document is only for professional investors. Investments are subject to risks, including possible loss of principal amount invested.

QSCR-18067 (March 2018)