Inflation is a friend of your trend

Nick Baltas is a managing director and head of R&D and cross-asset delta-one Systematic Trading Strategies at Goldman Sachs

The inflation path in Covid’s latter era has been notably eventful.

Base effect distortions contributed to artificially high levels of inflation in the second quarter of 2021. Debate between “team transitory” and “team permanent” monopolised the rest of the year, until the case was closed for good — as indicated by the (simplified, perhaps, yet powerful) wisdom of the crowds in the intensity of Google searches:

What followed were consecutive multi-decade inflation highs globally during the first half of 2022, partly fuelled by geopolitical tensions, with central banks playing catch-up. In this environment, hedging inflation risk has been more relevant for investors than any other time in the recent history.

The repercussions in asset prices this year have been pronounced. The bond sell-off marked historic levels while equities kept on grinding down towards bear market territory, causing the equity-bond correlation to turn positive and challenge balanced equity-bond portfolios. On the other side of the spectrum, many commodities soared for the better part of the year before more recently retracting amid recessionary concerns.

These pronounced price trends were successfully captured by systematic cross-asset trend-following strategies — trendy quants, in other words — which delivered their best first half of any calendar year in more than two decades. These strategies, typically deployed by systematic managed futures funds and managing $327bn as of Q1 2022, build directional exposures across assets from all asset classes as a function of recently developing trends. Mechanically, they perform strongly when developed trends persist, such as the aforementioned inflation-induced ones, but disappoint in periods of abrupt reversals.

The 2022 performance of trend-following strategies has been in stark contrast to the 2010s. What was then so special about the recent strong price moves across commodity, interest rate and equity markets? There was a common theme: none happened overnight.

Instead, price trends started forming gradually during the second half of 2021 as a consequence of the progressively increasing macroeconomic uncertainty (though anchoring biases and disposition effects may also have come into play). Investors, while assessing and digesting market information, particularly as it regards inflation, started reflecting their views onto asset prices gradually, perhaps cautiously under-reacting to it. This early trend formation was further fuelled by the anticipated activity of the largest non-profit seeking market participant, namely central banks.

And with the turn of the year, fuelled by broader herding and geopolitical tensions, gradual moves became suddenly stronger. Risk management tactics only strengthened the trends, such as when stop-loss orders were triggered in falling markets or when commodity consumers entered long futures positions to hedge soaring prices.

All these dynamics constitute a textbook manifestation of the formation of price trends. The point is neither to repeat academic findings (the literature is vast anyway), nor to make any claim that trend-following strategies constitute a direct inflation hedge.

Rather, it is to argue that inflationary regimes mechanically give rise to macroeconomic uncertainty, debates around transient and steady states, and central bank action (or lack thereof). All these dynamics are ingredients for a price-trendy environment; inflation is a friend of your trend. And while convexity and “crisis alpha” properties of trend-following strategies have long been recognised, such convexity properties seem to carry over across inflationary regimes too, as shown by a long-term analysis:

Should the environment shift, with recession fears growing, several recently established inflationary trends would likely reverse. Subject to its responsiveness, a trend-following strategy would pivot away from current exposures in an attempt to benefit from the forming of any opposing recessionary trends. That’s why such strategies have been historically deployed by institutional investors as strategic allocations rather than tactical ones.

But there is an elephant in the room: the lacklustre performance of trend-following strategies in the 2010s. Do we dare argue that this time is different?

The performance of trend-following strategies between the end of the Global Financial Crisis and the start of the Covid pandemic was mostly unexciting, which raised doubts around their usefulness.

Many of the explanations put forward to explain the mediocre performance have since been rejected. It seems neither to be a consequence of crowding, nor the reduced efficacy of trading signals to capture trends, nor the seemingly reduced diversification between assets.

Instead, research sketches out a period empirically characterised by three stylized facts as it relates to price trends:

1. The markets across asset classes were less frequently in a “trendy” mode.

2. Even when markets exhibited a “trendy” mode, the average size of market moves has been more muted than usual.

3. The frequency of “trend breaks” had increased compared to historical standards

All three factors were the consequence of one key fundamental macroeconomic mechanism: the “Fed put”, an unprecedented accommodative monetary policy that subdued yields. The Fed put was a crash mat under any market turmoil. In such an environment of relative fundamental certainty, any negative news inflicting a downturn has been promptly mitigated, with the market subsequently rebounding, hence mechanically leading to whipsaw markets with frequent “trend breaks”.

Yet in spite of the unfriendly environment, assets under management across the systematic managed futures industry remained relatively stable. A need to hedge for crisis meant trend-following strategies remained a part of institutional portfolios:

That period is seemingly over. Central bank hawkishness of tone and action has replaced the Fed put as inflation has taken over for good. This time seems different.