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Inflation marks the systematic strategies landscape

Macroeconomic measures implemented in response to the COVID-19 pandemic, supply chain disruptions, sociopolitical events, and changing Fed policy have heightened uncertainty around the path of future inflation. Depending upon the particular features of the systematic investment strategies approach, these strategies may experience changes in inflation expectations either as a threat or an opportunity.

July 21, 2022

Yung Shin Kung | Chin Te Liu

Head and Chief Investment Officer | Head of Research & Technology

After a multi-decade period of globalization-driven disinflation, COVID-19 has ushered in four main sources of inflationary pressure: (1) an increase in the money supply to support deficit spending and sustain unemployed workers, (2) a shift in the composition of the consumer expenditure basket towards goods rather than services, (3) rigidities in the labor market exerting upward pressure on wages, and (4) supply chain fragility. Russia’s war with Ukraine has further exacerbated the situation.

Investors react to meaningful changes in inflation through security selection and asset allocation shifts. We focus on understanding the risks embedded in factor strategies through the prism of specific economic and market conditions, also known as regimes, which coincide with variations in the performance characteristics of the strategies we invest in. Changing inflation expectations naturally coincide with shifting regimes, and unsurprisingly 2021 witnessed meaningful factor rotations.

Potential inflation scenarios

Transitory Accelerating Deflation
Recent inflation data proves temporary. Monetary and fiscal policy are effective in moving the economy back in line with long-term trend growth asinterest rates remain stable. Inflation psychology takes hold, reflected in higher longer-term inflation breakeven levels. Investors continue to reposition away from nominal, duration-sensitive assets and a cycle of hoarding takes grip. Central banks seek to reassert price stability through more aggressive monetary policy. Depending upon the policy mix and the extent to which finished goods price increases pass through to wages, this could resultin stagflation.  Lower labor force participation and supply shocks impact economic growth. Logistical
bottlenecks limit the effectiveness of fiscal policy and there is limited scope to stimulate through monetary policy. 

We are keenly interested in the question of how changes in inflation expectations impact various systematic investment strategies, and we see a good degree of variability in the magnitude and directionality of systematic strategies’ inflation sensitivity.

Over the past several decades, both consumers and investors have grown accustomed to limited volatility in the prices of goods and services in developed market economies. COVID-19 has brought forth multiple potential sources of inflationary pressure. This has coincided with an increasingly bipartisan dismantling of US economic ties to China and conflict in Ukraine, which together introduce upward price pressures on a variety of goods and heighten the complexity of reinvigorating the world’s strained supply chains. An investment landscape with significant inflation risk is an interesting one for systematic strategies.

Depending upon the particular features of their underlying economics, these trading strategies may see changes in inflation expectations as a potential headwind or a tailwind. We seek to understand and account for the ways in which shifts in economic and market regimes impact both our expectations for systematic strategy performance and the ways in which various systematic strategies relate to one another.

Sensitivity of systematic strategies to inflation

Strategy type Description Inflation sensitivity Example
Fundamental – Valuation
Fundamental strategies express a view that market pricing is inefficient on the basis of an alternative appraisal methodology and seek to profit from that inefficiency, implicitly taking appraisal risk. Many valuation strategies favor near-term cash flows over long-term cash flows, and are implicitly short duration/synthetic steepeners. The performance of these strategies often correlates positively with inflation changes and levels. Equity Buyback seeks to capture the tendency of stocks of companies in developed markets buying back their shares to outperform their counterparts. The strategy seeks to exploit inefficiencies in the valuation of equities by observing corporate buyback activity.
Fundamental – Carry Carry strategies assume market pricing is efficient and accept absolute or relative price risk for a return if pricing remains consistent.  Changes in inflation expectations are directly at odds with pricing efficiency, and carry strategies can be susceptible to loss as inflation expectations increase both outright and via substitution effects, particularly fixed income and commodity carry strategies. Merger Arbitrage seeks to capture the return associated with the risk that announced merger transactions fail to consummate by providing liquidity to a group of investors unwilling or uninterested in holding deal risk. The spread between the share price of the company being acquired in advance of merger consummation and the price being offered at consummation offers a well-defined carry to investors willing to assume that the deal will not break.
Tactical –Intermediation  Intermediation strategies take inventory risk and extract economic rent for supplying balance to the market and bridging temporary gaps in supply and demand. Intermediation strategies can benefit from an expansion in trading activity catalyzed by
changing inflation expectations. The flipside is that inflation can present a greater degree of inventory price risk, which these strategies tend to accept.
Duration Extension seeks to capture returns from the periodic rebalancing activity of duration-benchmarked investors in the US interest rate markets. The strategy takes short-term inventory risk in exploiting liquidity/congestion dynamics associated with the rolling of securities infixed income benchmarks. 
Tactical – Flow Flow strategies take price discovery process risk and seek to exploit lead-lag effects attributable to the heterogeneity of physical and informational resource constraints among market participants.  Flow strategies benefit meaningfully from lead-lags in investor rebalancing activity both as inflationary pressures grow and as they recede.

Managed Futures seeks to capture autocorrelation dynamics in benchmark instruments across asset classes through a range of price-trend signals. The strategy is predicated on the notion that the absorption of and reaction to market-sensitive information differs across investors, creating lead-lag effects and price trends. 
Tactical – Positioning Positioning strategies take price elasticity risk and express a view that market positioning imbalances engender skews in the probability distributions of assets
price returns.

Positioning strategies generally benefit from the unwinding of consensus/crowded positions as what were formerly considered lower probability outcomes are recast as higher probability outcomes. Intraday Breakout in Energy  seeks to exploit agency constraints and risk aversion inherent in the structure of energy markets which result in time-varying market liquidity depth. The strategy is designed to capture the tendency of markets to gap over the course of a trading day in the face of short-term supply-demand imbalances and takes a position consistent with the direction of large intraday market moves.

Inflation: “Some days you tame the tiger. And some days the tiger has you for lunch.”

To what extent and for how long will inflation rise? The uncertainty surrounding the effects of inflation has increased massively. The current situation is calling for existing investment strategies to be reviewed and new opportunities to be evaluated.

 

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