Why Quants Could Win Big By Exploiting 2022’s Macro Effects And What To Expect In 2023

The Federal Reserve raised interest rates by another quarter of a point in February, marking the eighth consecutive raise as it tries to rein in inflation. Amid this backdrop, many quantitative funds enjoyed massive returns in 2022.

A banner year for quant funds in 2022

For example, sources familiar with the matter told Reuters that AQR recorded its best year ever in several of its strategies on the back of strong macro trends in 2022. AQR’s multi-strategy Absolute Return Strategy returned 43.5% net due to “careful portfolio selection,” Reuters reported.

The fund’s Equity Market Neutral Global Value and Global Macro strategies generated record annual returns at 44.7% and 42% net, respectively, while its Alternative Trend Strategy recorded its best-ever return of 48.9% net.

More broadly, in November, a benchmark for trend-following funds, a popular quant strategy, was on track for its best year dating back to 2000. A traditional factor portfolio was headed for its largest annual gain since at least 2008.

One potential problem for human investors in 2022 was that many of them weren’t in the market during the last extreme inflationary cycle in the 1970s and 1980s. However, quant funds rely heavily on models that track data all the way back to those years — giving them a leg up on their human counterparts.

The major milestones exploited by quants in 2022

In an interview, Mike Harris of Quest Partners shared insight into some of the trends his quant fund was able to exploit in 2022. A source familiar with the matter told ValueWalk that Quest Partners returned 25.29% for 2022.

Thinking back to the many critical milestones we experienced in 2022, Harris believes that a large part of the year was the return of inflation, which was a powerful economic force.

However, he also noted that until 2022, we really hadn’t seen inflation for nearly 40 years. Like many other investors, Harris also had not invested through such an extreme inflationary cycle, although he has read many books that gave him a good understanding of what played out in the 1970s and 1980s.

“It wasn’t a market that most of us lived through,” he said. “How did we get to this runaway inflation? It is pretty simple. The pandemic, like the global financial crisis, forced the world’s central banks into action, easing monetary policy by lowering interest rates, printing money, and creating significant liquidity.”

He adds that on one hand, those moves had the anticipated impact of stabilizing the markets and keeping the economy on its feet despite the disruptions. However, he noted that the challenge is when central banks lower rates to the extent they had lowered them and then print as much money as they did.

Massive moves by central banks

Those moves create tremendous demand, and then when the pandemic hit and caused massive supply chain disruptions due to the widespread lockdowns, there was too much demand and too little supply. As a result, prices soared, and central banks initially thought the price increases would be transitory and dissipate quickly. However, they discovered that the inflation was stickier than they had anticipated.

Of course, 2022 was a year of significant monetary tightening. The Federal Reserve kept moving assets from its balance sheet every month and repeatedly hiked interest rates by 75 basis points, although historically, the typical move has been only 25 basis points at a time.

“Any time there’s a 75-basis-point move, let alone multiple ones, you can tell there’s a sense of urgency,” the manager pointed out. “… When we look into 2023, will this aggressive hiking cycle get inflation back in check? We certainly hope so but can’t forget that it accomplished this by reducing demand, which tends to slow economic growth. If 2022 was a year of inflation, 2023 looks to be a year of recession. And we don’t know how bad the recession is going to be.”

Other market participants, like BlackRock
BLK
, think a recession is guaranteed. In its weekly commentary at the end of January, the firm stated that a recession was “foretold.” The BlackRock team expects major central banks to overtighten policy due to worries about the persistence of core inflation, which excludes food and energy prices.

Possibility of a recession in 2023

Harris is a little less sure on how bad a recession might be, but he noted that if one occurs, it could be slight, mild or deep. Of course, he noted that it’s very difficult to predict as things stand right now. However, he finds two things particularly interesting. The first is that all of the world’s central banks are not on the same schedule, which he said created some interesting macro trades last year.

“The Federal Reserve had come out of the gate raising rates quickly and aggressively,” Mike points out. “The flip side was the Bank of Japan didn’t start raising rates until the end of the year. We’re starting to see some real divergence in interest rates across the globe. This has created opportunities in currencies, fixed income and equities. For the first time in a long while, there are real economic differences across geographies.”

He added that the other thing people are thinking about right now is a possible Fed pivot. Harris explained that market participants may be wondering whether the Fed will buckle under pressure from politicians and others as the economy starts to slow following layer after layer of aggressive rate hikes.

If the Fed blinks

It’s no secret that raising interest rates so fast has created turmoil in the economy. Harris believes if the Fed does “blink,” we may see a temporary market recovery. On the other hand, he said if central banks have blinders on and are 100% focused on fighting inflation, it will probably lead to a deeper recession.

“The more they tighten aggressively, the more economic growth will falter and slow,” Harris adds. “It will be interesting to see if central banks have that resolve. Remember in the last period, everyone was focused on the ’70s and ’80s. Central banks took their foot off the gas, and inflation came back. If the central banks pause, we’ll have to wait and see how that is digested.”

He questioned whether a pause would let the economy come back and whether that might then bring another strong wave of inflationary pressures.

On the other hand, Blackrock is more resolute in its view of what the Fed will do. In their end-of-January commentary, the BlackRock team said they don’t expect the Fed to “blink” at all. Noting that PCE data in the U.S. is tracking well above the Fed’s 2% policy target even going into 2024, the firm expects central banks to require more evidence that core inflation and wage pressures are “sustainably subsiding” before they even think about easing policy.

BlackRock thinks this process will take “a long time” and “is unlikely to happen this year.” The BlackRock team added that the markets are pricing rate cuts for 2023 even though the Fed and the European Central Bank “insist they will stay the course.” BlackRock expects more hikes to follow after the eighth hike in early February — and predicts that central banks will keep rates high for a time after they finish hiking.

While Mike seems a little less sure on the future, he agrees with BlackRock on some points. He thinks central banks around the globe understand what a powerful force inflation is and that they have to hit it with both barrels of the gun to get things in check. Everything that’s been said to market participants indicates that they’re committed to this fight.

“I’m of the opinion that if they are more aggressive, it will lead to a deeper recession,” Mike adds. “That said, I think there are real differences now between the drivers and goals of global fiscal and monetary policy. Politicians and central banks should be like the separation of church and state, but it’s gotten murky in recent years. It’s entirely possible central banks will bow to pressure.”

A separation of politics and monetary policy

Central banks have been aligned with politicians for many years. Easing leads to a market recovery, and politicians take credit for it. However, central banks are now fighting against the politicians who are trying to tell them not to put the brakes on the economy too much.

They’re calling out politicians, pointing out that their constituents are facing higher living costs as food and energy prices rise. Central banks are warning that the only way to get living costs back in check is by dramatically slowing the economy.

Amid all the headlines and commentary from multiple sources about the strong jobs market, we did start to see some layoffs into the end of the year. However, the last two employment data prints showed the market remained relatively strong. That could bring us full circle back to the likelihood that central banks will need to be aggressive.