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Navigating uncertain market conditions

The Great Moderation, a period of steady growth and low inflation risk, has given way to a new regime of greater macroeconomic uncertainty. How can investors navigate this new environment?

Summary

  • The end of the Great Moderation: It’s our belief that the Great Moderation, a prolonged period of steady growth and low inflation risk, has ended. The forces that helped support sustained periods of robust stock and bond returns may now be working in reverse.
  • Transition to a new era of Great Volatility: Increased macroeconomic uncertainty stemming from rising inflation, less central bank support, and a slower pace of globalization may lead to a prolonged period of volatility in financial markets.
  • Return sources in a new regime: In a new market regime, relying on market beta may not be enough to reach return objectives or preserve capital during prolonged drawdowns. We believe it will become imperative for investors to adopt portfolios designed to harvest macro volatility, capture security dispersion.

We believe the three megatrends of low inflation risk, inexhaustible central bank support, and globalization that helped drive market returns during the Great Moderation are coming to an end. Inflation is becoming a real risk to the global economy, the increased money supply of central banks is drying up, and globalization is stalling. Together, the reversal of these forces may lead to a new regime—an era of Great Volatility.

The start of the Great Volatility?

What will a new regime marked by higher inflation uncertainty, less central bank support, and a slower pace of globalization mean for financial markets? Greater macroeconomic uncertainty translates to greater policy uncertainty, resulting in more volatile security prices. Inflation now represents an immediate and real risk to economies that has proven difficult to slowdown as broad-based price pressures remain. We expect central banks to be more reactive to inflation running hot by raising rates and tightening financial conditions more often. For investors, even after the current inflation spike is tempered, tracking macroeconomic conditions and inflation sensitivities will continue to be critical.

Central bank reluctance to inject Quantitative Easing (QE) may result in periods of rudderless markets, where before “buying the dip”1 was the common response anticipating central banks would eventually ease financial conditions. From an investment perspective, we believe what is needed is more resilience and defensiveness built directly into strategies to avoid giving back several years’ worth of returns.  

The consequence of stalled globalization is, once again, more macroeconomic uncertainty than before. But at the micro level, we may see more variable company earnings surprises due to unpredictable supply chain issues. Consequently, more differentiated idiosyncratic return differences may become more commonplace between companies as some adjust and some struggle to adapt.

Return sources in a new market regime

If the forces that drove the last regime will no longer drive markets higher today, then a different approach to return generation is necessary. As we look ahead, harvesting macro volatility, capturing underlying security dispersion, and actively managing factor exposures will, in our opinion, become increasingly valuable.

Macroeconomic volatility
With inflation, growth, and policy uncertainty rising, we think there will be greater relative value opportunities within interest rate, currency, and domestic capital markets. For example, Figure 1 highlights short-term interest rate volatility, a major source of macro volatility, has accelerated to a level far greater than we saw in the past. If volatility does not return to its lower water level, then harvesting macro risk becomes an essential return source for portfolios. 

Figure 1: Macro volatility comes off double mute

1-month implied volatilities for 2-year swaptions (bps)

Macro volatility

Source: Calculated by the BlackRock Systematic team, using pricing data from Bloomberg, as of July 11, 2022. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

Security dispersion

Greater macro volatility has potential consequences for the absolute level of market returns, but it can also influence security dispersion, or the “cross-section” of market returns. High dispersion implies a wide difference between winners and losers in the market, while low dispersion implies a narrow difference. Figure 2 highlights how 2022’s environment of macro uncertainty has translated into a trend towards higher underlying security dispersion. This may lead to a greater emphasis on novel ways to measure a company’s sensitivities to these new vulnerabilities and uncover alpha opportunities.

Figure 2: Security dispersion breaking out to a higher-level trend

DM Country Cross Sectional Volatility %

Security dispersion

Source: Calculated by the BlackRock Systematic team, using pricing data from Bloomberg, as of July 11, 2022. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

Factor risk
While more macro uncertainty may make total returns of markets stall at times, we think we are more likely to see more rapid factor reversals and rotations happening underneath the surface. Figure 3 highlights factor returns, as measured by MSCI World indices, since their inception in 2005. A single factor, the Momentum factor, has dominated the excess return space over that period.  However, coinciding with several macroeconomic events—reopening dynamics, energy shocks, runaway inflation, rising rates—there has been a pattern of sharp factor reversals in 2022. Given an environment of greater macro uncertainty, mindfulness of factor risks grows in importance.

Figure 3: More frequent factor reversals possible?

Excess returns by single factor exposure

Factor reversals

Source: MSCI, based on MSCI World Factor Index returns, as of June 30, 2022. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index.

A modern toolkit for uncertain markets

At its core, generating excess returns comes from two primary sources: (1) Having robust forecasting skills through an information edge, or (2) Successfully managing risk premia such as market beta or factor exposures in portfolio construction. Our systematic investment process seeks to do both by leveraging a modern system for investing.

Building and maintaining an information edge

Our systematic investment process seeks to provide an information edge in security selection, relying on a data-centric and science-based method for empirically testing investment ideas. We can make use of the ocean of unstructured data that is available and analyze it using techniques like natural language processing or geospatial data tracking. In this technology-driven approach, data is no longer overwhelming or inconsistently applied to support an investment thesis. Direct connections between data points and investment forecasts are made, transforming data into potentially useful information.

Our market experts and investment researchers partner together to build investment models that aim to forecast security returns. From a security selection perspective, investment model insights can be scaled across an entire universe of securities—essentially enabling the ability to have a view on every security in the market, every day—something very difficult to achieve without an army of analysts who apply their own personal biases. 

Portfolio construction to manage return sources

Systematic investing takes a disciplined approach to portfolio construction, building portfolios that purposely integrate return sources and balance trade-offs between expected risk, return potential, correlation, and cost. Over the course of several decades, we have developed distinct capabilities across asset classes, market caps, regions, time horizons, and investment styles. Each capability can be applied in both long-only and long-short applications with additional options to gear leverage levels. By blending and combining capabilities to build single strategies, we seek to create outcome-focused solutions that can work in different market environments.

Conclusion

The Great Moderation has ended, and we are entering a new regime of greater volatility. Inflation is likely to become a more enduring risk to global economies than in decades past. The end of limitless central bank liquidity may take the “buy the dip” behavior out of markets, leading to slow drawdowns or more frequent corrections. And the super-cycle deflationary trend of globalization may be stalling. The net result is greater macro uncertainty which translates to more volatile security markets.

In this new market environment, we believe taking advantage and managing new return sources like macro volatility, security dispersion, and risk factor exposures will become increasingly important. Investment managers may need to adapt their toolkit to be able to break through in these uncharted markets.

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Authors

Raffaele Savi
Head of Systematic Investing & Co-CIO of Systematic Active Equities
Jeff Shen, PhD
Co-CIO of Systematic Active Equities
Tom Parker
CIO of Systematic Fixed Income