What the New Tax Bill Means for Cross-Border Portfolios

While there seemed to be a consensus that U.S. Equities will struggle through the first half of the year before finishing strong, views are now varying on the degree and timing of a potential recession.----- Transcript -----Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Monday, January 23rd at 11am in New York. So let's get after it. Coming into this year, the number one investor concern was that everyone seemed to have the same outlook for U.S. equities - a tough first half followed by a strong finish. Views varied on the degree of the drawdown expected and magnitude of the rebound, but a majority expected a U.S. recession to begin sooner rather than later. Fast forward just a few weeks and the consensus view has shifted materially, particularly as it relates to the recession view. More specifically, while more investors are starting to entertain a soft landing for the economy, many others have pushed out the timing of a recession to the second half of the year. This change is due in part to China's reopening gaining steam and the sharp decline in European natural gas prices. While these are valid considerations for investors to modify their views, we think that price action has been the main influence. The rally this year has been led by low quality and heavily shorted stocks. It's also witnessed a strong move in cyclical stocks relative to defensive ones. This cyclical rotation in particular is convincing investors they are missing the bottom and they must reposition. Truth be told, it has been a powerful shift, but we also recognize that bear markets have a way of fooling everyone before they're done. The final stages of the bear are always the trickiest. In bear markets like last year, when just about everyone loses money, Investors lose confidence. They question their process as the price action and cross-currents in the data create a hall of mirrors. This hall of mirrors only increases the confusion. This is exactly the time one must trust their own work and ignore the noise. Suffice it to say we're not biting on this recent rally because our work in process is so convincingly bearish on earnings. Importantly, our call on earnings is not predicated on the timing of a recession or even if one occurs this year. Our work continues to show further erosion with the gap between our model and the forward estimates as wide as it's ever been. Could our model be wrong? Of course, but given its track record, we don't think it will be wrong directionally, particularly given the collection of leading series and models we published that point to a similar outcome. This is simply a matter of timing and magnitude, and we think the timing is imminent. We find the shift in investor tone helpful for our call for new lows in the S&P 500, which will finish this bear market later this quarter or early in the second quarter. Getting more specific, our forecasts are predicated on margin disappointment and the evidence in that regard is increasing. When costs are growing faster than sales, margins erode. This is very typical during any unexpected revenue slowdown. Recessions in particular lead to significant negative operating leverage for that very reason. In other words, sales fall off quickly and unexpectedly, while costs remain sticky in the short term. Inventory bloating, less productive headcount and other issues are the primary culprits. This is exactly what is happening in many industries already, and this is without a recession. It's also right in line with our forecast and the thesis that companies would regret adding costs so aggressively a year ago when sales and demand were running so far above trend. Bottom line, after a very challenging 2022, many investors are still bearish fundamentally, but are questioning whether negative fundamentals have already been priced into stocks. Our view has not changed as we expect the path and earnings in the U.S. to disappoint the consensus, expectations and current valuations. In fact, we welcome the change in sentiment positioning over the past few weeks as a necessary development for the last stage of this bear market to play out. Bear markets are like a hall of mirrors designed to confuse investors and take their money. We advise staying focused on the fundamentals and ignoring the false signals and misleading reflections. Thanks for listening. If you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcast app. It helps more people to find the show.

23 Jan 20233min

The financial landscape is filled with predictions about what comes next for markets, but how do investors use these forecasts to put a portfolio together?----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, January 20th at 2 p.m. in London. The financial landscape is filled with predictions about what markets will do. But how are these predictions used? Today, I want to take you through a quick journey through how Morgan Stanley research thinks about forecasting, and how those numbers can help put a portfolio together. Forecasting is difficult and as such it's always easier to be more vague when talking about the future. But when we think about market expectations, being specific is essential. That not only gives an expectation of which direction we think markets will go, but by how much and over a specific 12 month horizon. Details here can also really matter. For example, making sure you add dividends back to equity returns, adjusting bond forecasts for where the forwards are, and thinking about all asset classes in the same currency. In this case, U.S. dollars. Consistency in assumptions is another factor that is difficult but important. We try to set all of our forecasts to scenarios from our global economics team. That is more likely to produce asset class returns that are consistent with each other and to the economy we expect. With these returns in hand, we can then ask, "what's an optimal asset allocation based on our forecasts?" Now, everyone's investment objectives are different. So in this case we'll define optimal as a portfolio that will generate higher returns than a benchmark with a similar or better ratio of return to volatility. This type of analysis will consider expected return and historical risk, but also how well different asset classes diversify each other. As Morgan Stanley's forecasts currently stand this approach suggests U.S. equities are relatively unattractive. Sitting almost exactly at the year end price target of my colleague Mike Wilson, our U.S. Equity Strategist, expected returns are low, while volatility is high and U.S. stocks offer minimal benefits for diversification. Stocks in Japan and emerging markets look better by comparison. But the real winner of this approach continues to be fixed income. Morgan Stanley's rate strategists in the U.S. and Europe continue to think that moderating inflation in 2023 will help bond yields either hold around current levels, or push lower, resulting in returns that are better than equities with less volatility. Our expected returns for emerging market bonds are also higher, with less volatility than U.S. and European stocks. Forecasting the future is difficult, and it's very possible that either our market forecasts or the economic assumptions to back them will be off to some degree. Still, considering what is optimal based on these best estimates, is a useful anchor when thinking about strategy. And for the moment, this still favors bonds over stocks. Thanks for listening. Subscribe to Thoughts on the Market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.

20 Jan 20233min

With housing data from the last few months of 2022 coming in weaker than expected, what might be in store for mortgage investors? Co-Heads of U.S. Securitized Products Research Jim Egan and Jay Bacow discuss.----- Transcript -----Jim Egan: Welcome to Thoughts on the Market. I'm Jim Egan, Co-Head of U.S. Securitized Products Research here at Morgan Stanley. Jay Bacow: And I'm Jay Bacow, the other Co-Head of U.S. Securitized Products Research. Jim Egan: And on this episode of the podcast, we'll be discussing the U.S. housing and mortgage markets. It's Thursday, January 19th at 11 a.m. in New York. Jay Bacow: So, Jim, the housing data hasn't been looking all that great recently. We've talked about this bifurcated outlook for the U.S. housing market, still holding that view? Jim Egan: So to catch people up, the bifurcated housing narrative was between housing activity. And by that we mean sales and housing starts and home prices. We thought there was going to be a lot more weakness in sales and starts at the end of 2022 and throughout 2023, then home prices, which we thought would be more protected. Since we came out with that outlook, it's safe to say that sales have been materially weaker than we thought they'd be. To put that into a little bit of context, existing home sales for the most recent month of data, which was November, showed the largest year over year decrease for that time series since the early 1980s. Pending home sales, we only have that data going back to 2001, but pending home sales just showed their weakest November in the entire history of that time series, so weaker than it was during the great financial crisis. Now, Jay, when we talk about those kind of weaker than anticipated sales volumes, what does that mean for your markets? Jay Bacow: Right. So while homeowners clearly are going to care about home prices, mortgage investors care more about the housing activity. And they care about that because that housing activity, those home sales, that results in supply to the market and it actually results in supply to the market from two different sides. There's the organic net supply from home sales. And then furthermore, because the Fed is doing QT, the faster the pace of home sales, the more the Fed balance sheet runoff is. And so as those home sales numbers come down, you get less supply to the market, which is inarguably good for mortgage investors. Now, the problem is mortgage spreads have repriced to reflect that at this point. Jim Egan: Now Jay, a lot of things have repriced. Jay Bacow: Right. And I think the question now is, is that going to keep up? But turning it over to you, what's causing this slowdown in home sales? And do we think that's going to continue? Jim Egan: I think in a word, it's affordability. A lot of the underlying premises behind our bifurcated narrative, we still see those there they're just impacting the market a little bit more than we thought they would. From an affordability perspective, and we've said this on this podcast before, the monthly mortgage payment as a percentage of household income has deteriorated more over the past year than really any year we have on record. From a numbers perspective, that payment's gone up over $700. That's a 58% increase. That's making it more difficult for first time buyers to buy homes and therefore pulling sales activity down. But where the bifurcation part of this narrative comes from, a lot of current homeowners have very low, call it maybe 3-3.5%, 30 year fixed rate mortgages. They're not incentivized to list their homes in this current environment and we're seeing that. Listing volumes are close to 40 year lows. In a month in which sales fall as sharply as they just did, we would expect months of supply at least to move higher and that roughly stayed flat. And so you have this lack of inventory, people aren't selling their homes, that means they're also not buying a home on the follow which pulls sales volumes down, leading to some of those numbers we talked about on top of just how long it's been since we've seen sales fall as sharply as they have. But on the other side of the equation, that's also keeping home prices a little bit more protected. Jay Bacow: Okay. So you mentioned affordability is impacting home sales, but then what's happening to actual home prices? Are they holding up then? Jim Egan: We think they will now. Don't hear what I'm not saying, that doesn't mean that home prices keep climbing. It just means that the pace with which they're going to slow down or the pace with which they're going to fall isn't as substantial as what we're going to see on the activity front. Now year over year HPA most recently up 9.2%. We think in the next month's print, that's going to slow to a little bit below 8% down to 7.9%. On a month over month basis from peak in June of 2022, home prices are off 3%. We think they'll fall a further 4% in 2023. But to kind of put some guardrails around that bifurcation narrative, that drop only brings us to the fourth quarter of 2021. That's 30% above where home prices were onset of the pandemic in March of 2020. On the sale side, our base case was that we were going to fall back to 2013 levels of transactions. And given how data has come in since then, it looks like we're heading lower than that. Jay Bacow: All right. So we think housing activity is going to continue to fall, but that slowdown in housing activity means that home prices, while seeing the first year on year decline since 2012, are going to be well supported. Jay Bacow [00:04:51] Jim, always a pleasure talking to you. Jim Egan: Great talking to you, too, Jay. Jay Bacow: And thank you for listening. If you enjoy Thoughts on the Market, please leave us a review on the Apple Podcasts app, and share the podcast with a friend or colleague today.

19 Jan 20235min

At a recent meeting of analysts from around the globe, we identified three central transitions for 2023 that may help investors shift towards a focus on long-term trends as opportunities.----- Transcript -----Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between public policy and financial markets. It's Wednesday, January 18th at 10 a.m. in New York. What do you get when 45 global research analysts gather in a room for two days to debate secular market trends? A plan. In particular, a plan to deal with a world where key underpinnings of the global political economy are changing rapidly. For investors, we think that means concentrating on multi-year secular trends as an opportunity. In markets where short-term focus has become the norm, it stands to reason that there's less competition and more potential outperformance to be earned by analyzing the market impacts of longer-term trends. That's why we recently gathered analysts from around the globe to identify the key secular themes that Morgan Stanley research should focus on this year. The agenda for our meeting included over 30 topics, but the discussion gravitated around a smaller subset of themes whose potential market impact was substantial, but perhaps beyond what analysts could plausibly perceive or analyze individually. Understanding these three global transitions appeared central to the questions of inflation, interest rates and the structure of markets themselves. The first is rewiring global commerce for a multipolar world, one with more than one meaningful power base and commercial standard, where companies and countries can no longer seek efficiencies through global supply chains and market access without factoring in geopolitical risks. We've spoken much about that in this space, but our analysts believe the practical implications of this trend are not yet well understood. The second is decarbonization. While this isn't a new theme, we think investors need to shift from debating whether it will be meaningfully attempted to sizing up the impact of that attempt. After all, 2022 saw both U.S. and European policymakers putting the power of government behind decarbonization. Now we'll focus on helping investors grapple with both the positive and negative market impacts of this transition, which the International Energy Agency estimates could cost about $70 trillion over the next 30 years. Identifying the companies, sectors and macro markets that will benefit, or face fresh challenges, is thus essential work. Finally, we'll remain focused on tech diffusion. Once again, not a new theme, but what is new is the speed and breadth with which tech diffusion can impact sectors that were previously untouched. Fragmented industries or those with high regulatory barriers look poised for a multi-year transition via tech diffusion. Opportunities may appear in finance, health care and biopharma. We expect the next five years of tech diffusion to move meaningfully faster than the last five, and so we'll focus on delivering important market related insights. So, you'll be hearing more from us over the course of 2023 on these three transitions and their impacts on markets. Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

18 Jan 20233min

At the start of each new year, we identify 10 overarching themes for the year and beyond. So what should investors be keeping an eye on in the coming months?----- Transcript -----Welcome to Thoughts on the Market. I'm Ed Stanley, Morgan Stanley's Head of Thematic Research in Europe. Along with my colleagues, bringing you a variety of perspectives, today I'll be discussing 10 key themes for 2023. It's Tuesday, January the 17th at 2 p.m. in London. At the start of the New Year, we identify 10 overarching, long-term themes that we believe will command investor attention throughout the year and beyond. If you're a regular listener to the show, you may have heard my colleagues and I discussing some of these topics over the past year. We will certainly revisit them in 2023 as we develop new insights, but let me offer you a roadmap to navigate these themes in the coming months. First, company earnings and margins are likely to come under pressure this year as pricing power declines and costs remain sticky. Both the U.S. and Europe look at risk from this theme. The S&P 500 earnings will likely face significant pressure and enter an earnings recession, and Europe earnings similarly will likely fall 10%. Second is inflation. Last year we flagged that inventory had grown sharply, while demand, especially demand for goods, is falling. In 2023, companies will need to decide how they want to handle that excess inventory, and we believe many will turn to aggressive discounting. Up next is China. We've talked a lot over the last few months about China's expected reopening, and we believe a V-shaped recovery in China's growth is now likely, given the sudden change in prior COVID zero policy. We expect a 5.4% GDP growth for China in 2023. Our fourth theme is ESG. We think that what we call ESG rate of change, i.e. companies that are leaders in improving environmental, social and governance metrics, will be a critical focus for investors looking to identify opportunities that can both generate alpha on the one hand and ESG impact on the other. Next, in Q4 last year, you may have heard us talk about Earthshots, which is our fifth theme. These are radical technological decarbonization accelerants or warming mitigants. Clean tech funding is one of the most resilient segments in venture, and breakthroughs are becoming more frequent. We're keeping a close eye on the key technologies that we think will hold the greatest decarbonization potential in 2023 and beyond. Sixth, we're in the upswing of unicorns, i.e. privately held startup companies with a valuation over $1 billion, needing to re raise capital to maintain operations and growth. In the absence of unicorn consolidation, we expect money to flow out of public equities to support or compensate for the weakness in private investments. This will be the year of the down round, in our view, where companies need to raise additional funds at lower valuations than prior rounds. But also we expect it to be a year of opportunity for crossover investors and a potential reopening of the IPO market. Next, I've already mentioned our China forecasts, but we are also in the early innings of the "India Decade", which is our seventh theme. India has the conditions in place for an economic boom fueled by offshoring, investment in manufacturing, the energy transition and the country's advanced digital infrastructure. This is an underappreciated multi-year theme, but importantly one that is gathering momentum right now. Our other regional theme to watch this year is Saudi Arabia, which is also undergoing an unprecedented transformation with sweeping social and economic reforms. With about $1 trillion in "gigaproject" commitments, and rapid demographic shifts, it's our eighth big theme. And one that we think could easily leave people behind given the blistering speed of change. Penultimately, with the emergence of ChatGPT, the future of work is set to be further disrupted. We believe that we are on a secular trajectory towards the workforce, particularly the younger Gen Z, entering what we call the "multi-earner era" - one where workers pursue multiple earning streams rather than a single job. There are a vast array of enabler stocks for this multi-year era, in our view. And finally, last but not least, we believe obesity is the "new hypertension" and that investing in obesity medication is moving from a linear secular theme to an exponential one, with social media creating a virtuous feedback loop of education, word of mouth, and heightened demand for weight loss drugs. So that's it. Hopefully we've given you some thought provoking macro, micro, regional and ESG ideas for the year ahead. Thanks for listening. If you enjoy the show, please leave a review on Apple Podcasts and share Thoughts on the Market with a friend or a colleague today.

17 Jan 20234min

One of the frequent questions regarding Emerging Markets is whether outperformance will hold for the short term or the long term. So what factors should investors consider when evaluating the cross asset performance of EM?----- Transcript -----Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, January 13th at 2 p.m. in London. A common question when talking about almost any market is whether the view holds for the short term or the long term. Call it a question of whether to "rent" versus "own". Is this a strategy that could work over the next six months or is it geared to the next six years? This question comes up most frequently when we discuss emerging market or EM assets. We like EM on a cross-asset basis. We think equities in EM outperform those in the U.S. We think EM currencies outperform the U.S. dollar and the British pound. And we think EM sovereign bonds perform well on an outright basis and also relative to U.S. high yield. Several factors underlie this positive view. First, as we've discussed in this program before, a number of key themes for 2023 look like the mirror image of 2022. Last year saw U.S. growth outperform China, inflation rise sharply and central banks hike aggressively, a combination that was pretty tough in emerging market assets. But this year we see growth in China accelerating while the U.S. slows, inflation falling and central banks pausing, a reversal that would seem much better for EM. And this is all happening at a time when EM assets still enjoy a valuation advantage. Emerging market equities, currencies and sovereign bonds all still trade at larger than average discounts to their U.S. peers. All of that supports the near-term case for outperformance in emerging markets, in our view. But what about the longer term story? Here we admit there are still some uncertainties. On one hand, there are some countries where there's a quite positive long run outlook in the eyes of my research colleagues. I'd highlight Mexico here, a country that we think could be a major long term beneficiary of U.S. companies looking to shorten supply chains and bring more production back from Asia. But there are also major long term uncertainties, especially related to earnings power. The case for EM equities is often based around the idea that you get the higher growth of the developing world at lower valuations, an attractive combination that offsets the higher political and economic volatility. But as my colleague Jonathan Garner, Head of Asia and Emerging Market Equity Strategy, has noted, earnings for the EM market have been surprisingly weak over the long run and are still at levels similar to 2010. Growth so far has been elusive. Uncertainty around that long term earnings power is one of several reasons that it may be too early to say that EM will be a multiyear outperformer. But for the time being, we think those longer term concerns will be secondary to near-term support and continue to expect cross-asset outperformance from EM assets this year. Thanks for listening. Subscribe to Thoughts on the market on Apple Podcasts, or wherever you listen, and leave us a review. We'd love to hear from you.

13 Jan 20233min

At this week’s North American Leaders Summit, the U.S., Canada and Mexico committed to boosting the semiconductor industry in another key step on the path towards a multipolar world.----- Transcript -----Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Global Thematic and Public Policy Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the intersection between public policy and financial markets. It's Thursday, January 12th at 10 a.m. in New York. This week, the presidents of the United States, Canada and Mexico gathered for the North American Leaders Summit. For investors, the key result was a commitment by the countries to work together to boost the semiconductor industry in North America. While the practical details of this commitment will matter greatly, the agreement in principle underscores a few key themes for investors. The first is that the trend toward a multipolar world is ongoing, one where geopolitics increase commercial barriers and create the need for multiple supply chains, product standards and economic ecosystems. So countries and companies must rewire their own approach to production in order to cope. This semiconductor commitment is the result of a determination by the U.S. that it's in its own interest to develop a substantial and secure semiconductor industry in its own backyard, in order to mitigate supply chain risks to key industries like automobile production. In this way, the country's economy is less susceptible to overseas disruptions. And the U.S. was likely able to achieve this commitment with its neighbors by enacting the CHIPS+ legislation with bipartisan support. You may recall that legislation appropriated money to attract the construction of semiconductor facilities in the U.S. This brings us to our second point, which is that this commitment underscores the opportunity for Mexico to benefit from U.S. led nearshoring. As we've discussed on this podcast with our Mexico strategist, Nik Lippman, Mexico has a sizable manufacturing labor force and proximity to the U.S. For semiconductors, that means Mexico could potentially be a supplier or at least a supplier of the goods materials that go into fabrication. It's one of the key reasons that Nik has upgraded Mexico stocks to overweight. So in short, this meeting was another step on the path toward a multipolar world, a key trend we're tracking in 2023. Thanks for listening. If you enjoy the show, please share Thoughts on the Market with a friend or colleague, or leave us a review on Apple Podcasts. It helps more people find the show.

12 Jan 20232min

In 2022 it seemed like there was nowhere to hide from the negative returns in traditional investing. But if we look to quantitative strategies, we may find more flexibility for the year ahead.----- Transcript -----Vishy Tirupattur Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's head of fixed income research and director of Quantitative Research.Stephan Kessler And I'm Stephan Kessler, Morgan Stanley's global head of Quantitative Investment Strategies Research.Vishy Tirupattur And on this special episode of the podcast, we will discuss the return of quantitative investing. It's Wednesday, January 11th, at 10 a.m. in New York.Stephan Kessler And 3 p.m. in London.Vishy Tirupattur Stephan, 2022 was a pretty dismal year for traditional investment strategies across various asset classes. You know, equities, credit, government bonds—all of them had negative total returns for the year. And in fact, for traditional investment strategies, there really was nowhere to hide. That said, 2022 turned out to be a pretty decent year for systematic investing or factor investing or quantitative investing strategies. So can you start us off by giving us an overview of what systematic factor strategies are and how they performed in 2022 versus traditional investment strategies?Stephan Kessler Absolutely. So, if you look at quant strategies, or systematic strategies, key is 'systematic.' So we look at repetitive, persistent patterns in the markets which can be beneficial for investors. Usually they're data driven. So we look at data which can be price data, fundamental data like economic growth data and the like, which then gives us signals for our investment. Those strategies tend to have low long-term exposures to traditional markets such as equities and fixed income. So they work as diversifiers and the rationale for why they work comes from academic theory, by and large, where we look at risk premia, we look at structural or behavioral patterns that are well known in the academic world. So common strategies that investors apply can be carry investing, for example. So we benefit here from interest rate differentials where we borrow, for example, money in low yielding regions or currencies, and then we invest in high yielding currencies, clipping the difference in the interest rate between these regions. Value investing is another important style that investors implement, where they simply identify undervalued investments, undervalued assets by looking at price to book ratios, by looking at dividend yields, for example, to identify what appears to be cheap. Momentum investing is probably the third most important strategy here, which is where we benefit from the price trends in markets which we know to be persistent. So those are the, I think, the important styles—carry, value and momentum—but there are also more complex strategies where we model and identify very minute details in markets. We go really deep into the functionality of markets. Then the final point I would make is that these strategies tend to be long-short so they are not long biased as traditional investing is, but they can go really both directions in terms of their positioning.Vishy Tirupattur Investors often ask how quant strategies, that are typically predicated on historical data patterns, can handle volatile market environments with very few historical precedents. 2022 was anything but normal. Don't such market aberrations break quant strategies?Stephan Kessler That's a really good question. If you look at it from the higher level, it does seem like this was a unique market that actually should be challenging for systematic strategies which look at historical patterns. When you dig a little bit deeper, it becomes actually more nuanced. So the strong outperformance of quant in '22, we think is driven by the different catalysts that we saw in the markets. So for example, the tightening by central banks led to substantial and durable macro trends that can be captured by trend following. We saw a reemergence of interest rates across the globe through this monetary policy, which sparked the revival of carry investing. And then equity value investing reemerged as higher rates forced investors to focus more on fundamental valuations, and that led to an increase in efficiency of the value factor.Vishy Tirupattur Will any of the performance patterns that you saw in 2022 carry over into 2023? Or do you think the investment landscape for quant investors would be very different in this year?Stephan Kessler 2023 we think we'll look, of course, different from the past year. So, we'll move into an environment of low inflation where terminal rates are going to be reached by many central banks. And then equities will start the year in Q1 likely down to then end the year rather flat according to our equity strategists. Now, from a quant perspective, while this is different in terms of the actual dynamics, what remains is that we are likely to see market swings, which tend to favor short- to mid-term trend following strategies. The differences in central bank policies are also likely to remain so there's going to be a dispersion in rates and this dispersion in rates will help, in our expectation, carry strategies. It makes carry strategies attractive. Indeed, if you think about being exposed to, say, for example, carry in fixed income, where we go long bonds with high yields, we go short bonds with low yields and clip the difference, those bonds with particularly high interest rates are likely to also benefit from a normalization of rates. So, you could actually see an additional benefit where being invested in high yielding bonds will be then doubly positive because you earn the carry, but you also benefit from a normalization of rates and the increase in prices of those bonds. And finally, when we look at, you know, value investing, we think that is also likely to remain important because higher rates simply force investors to be focused on the valuations, to be focused on the financing of business activities, to be focused on healthy companies. And so we think that the market dynamics, while different, will continue to favor quant investing.Vishy Tirupattur So Stephan, you talked about a wide range of investment strategies within the quant world. Which of those strategies, what kinds of strategies do you think will drive outperformance in 2023?Stephan Kessler Yeah, I think it's specific forms of what I've mentioned is generally strategies which will do well. So, you know, if we start again with trend following, the market should be positive for it. There are though iterations of trend falling where we bias. And we think these types of biases—we have a long-bias or as we call it defensively-biased trend following strategies—those will be particularly positively performing because they will benefit from the higher rates that we see. We also think that some of the pricing out of inflation and then eventually in terms of the lower rates that we see, that should be beneficial for rates value strategies, where rates converge to longer term levels. And then something we haven't talked much about yet; volatility carry we feel is particularly interesting. Volatility carry means we are selling options in the markets. We sell a call option, a put option in the market, we earn the premium and then we hedge the beta that is embedded. So, we essentially try to earn the option premium without taking directional market risk, which works quite well in terms of harvesting a carry in calm market environments. But it tends to be causing negative returns, when you see spikes in volatility, when you see jumps in markets. We think that this is going to be an interesting investment opportunity, first on the Treasury side and then, once equity markets through this more difficult slowdown that we see at the moment, we also think volatility should get lower and that should benefit generally volatility carry in equities. So, selling equity options into the market. So those would be the particularly strong strategies. And then, as I already mentioned, there's this crossing of equity value and quality is a theme that we believe is particularly well-suited for the environment.Vishy Tirupattur If you're thinking about the outlook for 2023 for quant investors, what are the real risks? What can go wrong?Stephan Kessler So I think there's, of course, a range of things that can go wrong in such a dynamic and fluid market environment as we are at the moment. So one is that rates could continue to increase more than we expect at the moment, possibly driven by inflation being more resilient. That would not be good for rates carry strategies which tend to underperform in such environments because they are long. And so as those assets build up further, as the rates go up, the price of those assets would be hit. And on the back of that, the carry strategies would suffer. We also think that against all odds, growth is very resilient. There's a growth rally. That would, of course, hurt value type strategies, maybe through higher efficiency or resilience of tech stocks, for example. And then finally, if markets become to gap-y, i.e., if they don't trend but they really jump around through this market environment, that that might actually be negative for trend following strategies.Vishy Tirupattur Looks like 2023 will be a fascinating year ahead for quant investing strategies. So, Stephan, thanks for taking the time to talk to us.Stephan Kessler Great speaking with you, Vishy.Vishy Tirupattur And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

11 Jan 20239min