By Stephan M Kessler, global head of quantitative investment strategies (QIS) research at Morgan Stanley, and Vishwanath Tirupattur, global head of Quantitative Research at Morgan Stanley,

As year end approaches, one thing is clear: we will remember 2022 as a dismal year for traditional investment strategies across asset classes.

With around 10 trading days remaining, major equity markets across the globe have posted double-digit negative returns for the year, with the S&P 500 down ~19%. Government bonds, which typically come to the rescue when equities see a significant drawdown, didn't deliver as global central banks raised policy rates dramatically, taking the World Government Bond Index down ~17% year to date. Credit markets declined as well, with the Bloomberg Global Aggregate Credit Total Return Index posting a negative total return of ~15%. For traditional investment strategies, there really was nowhere to hide. Nevertheless, 2022 has turned out to be a decent year for systematic factor or quant investing. As measured by the SG Alternative Risk Premia Index, quant strategies posted a healthy positive total return of 3.9%, providing both diversification and capital appreciation in a difficult market environment. We will explore why systematic factor strategies performed relatively well and what 2023 may hold for them.

We are often asked how quant strategies, which are predicated on historical data, can handle a volatile market environment with few historical precedents. Don't current dynamics “break” quant strategies? In our view, quant's strong outperformance in 2022 resulted from a diverse set of catalysts. We think that the monetary policy tightening unleashed by global central banks led to substantial and durable macro trends that could be captured by “trend-following” strategies. A re-emergence of dispersion in interest rates across the globe sparked the revival of “carry” strategies. Equity value investing re-emerged as higher rates forced investors to focus more closely on fundamental valuations, increasing the efficiency of the “value” factor. Disruption in valuations related to technological advances has receded – e.g., the normalization of Tesla's valuation versus the broader auto sector. Similarly, communications sector disrupters have surrendered some of their outperformance. More broadly, we saw the gap between value and growth valuations shrink.

We think these performance patterns are likely to continue in the coming year. Our economists anticipate a transition from an environment with generally rising policy rates to one where inflationary pressure recedes and our macro strategists look for rates curves to steepen. During this transition, we expect global growth to slow, with G10 GDP growth bottoming at 0.2%Y in 3Q23. Not surprisingly, our chief investment officer Mike Wilson expects US equity markets to sell off in 1Q23, reaching levels as low as 3,000-3,300 for the S&P 500 before ending the year about flat at 3,900. From a quant perspective, these significant market swings tend to favor short-to-medium-term trend-following strategies. As the differences in central bank policies across the globe persist, “carry” returns should be attractive. Indeed, being long bonds in regions with high rates may benefit investors as their holdings appreciate when rates eventually normalize. Finally, defensive value investing tends to be well placed to deliver returns offsetting the higher cost of capital.

In our 2023 Global Strategy Outlook, we highlighted a range of quantitative strategies that we feel particularly strongly about for 2023. One way to capitalize on the outlook for the continuation of trending markets and peaking rates is through a rates trend-following strategy with a long bias toward rates. While the environment continues to be favorable for value investing, with market volatility remaining high investors should concentrate on undervalued stocks of high quality – crossing value filters with quality filters, in quant speak. Equity value improvements we have suggested in the past – reducing accounting noise, considering sector effects, and incorporating cyclical effects on performance – should be additive. Value-investing benefits extend to rates value strategies as well. In fact, translating our rates strategists' views into expected returns, the outlook for a rates value strategy is strong.

Finally, 2022 was challenging for sellers of rates volatility. With policy rates peaking and inflation decelerating, strategies that incorporate systematically selling rates volatility should be profitable in 2023. While we would overweight the strategies outlined above, we continue to emphasize that success in quant investing requires careful portfolio construction that diversifies across different quant strategies.

Enjoy your Sunday, and we wish you all a festive holiday season and prosperous new year.