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Breaking with the past: the new face of financial markets in 2023 and beyond
Quantitative Investments
Financial markets today, in late 2022, are in the midst of a structural break. This may precipitate a regime change that will alter essential market risk-return features taken for granted over the past few decades: low inflation, low volatility, and low correlations. As this new market regime unfolds, investors' needs will shift, and investment solutions must adapt to new conditions to continue delivering attractive investment outcomes.
Above-average investment outcomes hinge on the quality of forecasts that inform investment processes of both discretionary and systematic investment strategies. However, predictive quality rapidly deteriorates when large paradigm shifts are underway. While they are rare, structural breaks in financial markets are notoriously difficult to identify and time as they tend to come with high market stress. As a result, they not only cloud human judgment due to behavioral distortions but also wreak havoc on quantitative models because of erratic data behavior.
The current structural break is being brought about by a well-known culprit: inflation. As inflation worms its way back into the economy and markets, it effects a structural break in real interest rates because central bank policy is forced to focus on its prime mandate of price stability at the expense of economic growth – much to the chagrin of today’s liquidity-accustomed investors.
The future face of markets largely depends on whether inflation will be able to settle in. Currently, there are many reasons why it will, in which case investors will have to grapple with the following three fundamental changes rippling through the grid of financial markets:
- Higher interest rates
- Higher volatility
- Higher correlations
In response, financial assets are re-pricing, giving rise to an increased need for systematic exploitation of real return sources, enhanced flexibility, and intelligent risk control as investors continue to seek steady returns and capital protection.
This paper will explain the reasons why the current structural break is occurring, outline the characteristics of the new regime, and demonstrate how systematic strategies can integrate the features needed to succeed in a profoundly changed market environment.
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