Arguably the top three market themes of 2022 have been rising rates, high inflation, and the war in Ukraine. With the year at an end, we think a good starting point for this post is the December performance of our Two Sigma Factor Lens, as well as a short review of these three major themes and where they stand.
In the second section, we will review risk factor performance for all of 2022, including commentary on the two top and bottom performing factors for the year.
Exhibit 1: December 2022 Factor Performance
Source: Venn by Two Sigma. The median and percentile columns measure the performance of each factor in the Two Sigma Factor Lens relative to the entire history of the factor in USD, using monthly data for the period March 1995 - December 2022.
A Review of 2022 Market Themes as of December
1. Rising Rates: After raising rates by 75 bps every month since June 2022, the Fed conducted its first reduced 50 bps hike in December. Believe it or not, the fed funds effective rate was near zero to start the year but ended at 4.33%.1
Despite the smaller hike in December, the latest meeting was accompanied by hawkish comments from Fed Chair Jerome Powell. The Summary of Economic Projections showed a rate of 5.1% by the end of 2023, higher than investors expected.2 This helped contribute to both our Equity and Interest Rates Factors being down -5.07% and -2.48% in December, respectively. Related to rising rates, our Foreign Currency Factor, which in the US version of our factor lens is short the USD, gained 5.75%. The USD has been trending downward since the start of November 2022.3
Rising rates are also more than a US phenomenon. A Reuters article reports that “Central banks overseeing the 10 most heavily traded currencies delivered 2,700 basis points (bps) of tightening in the 54 hikes over the past 12 months.”4
2. High but Moderating Inflation: November was the last CPI report to be released in 2022, coming in at 7.1% YoY. This marks the 5th month in a row that YoY CPI has fallen since it peaked at 9.1% in June.5 While falling inflation is no doubt a welcome sign going into 2023, absolute levels are still a ways away from the long run 2% target that Powell recently doubled down on,6 and core PCE is still up 4.7% YoY which is the Fed's preferred inflation measure.7 As a result, the risk of recession due to high inflation, and as a result higher rates, is still a top consideration for 2023.
Our Local Inflation Factor fell in December alongside downward trending 10Y breakevens.8 Falling inflation expectations are due to a variety of factors, including central bank policy and reduced supply chain disruptions.
3. The War in Ukraine: Russia invaded Ukraine on February 24, 2022. While the shockwaves of this event could be felt in virtually every corner of the market, perhaps most affected was global energy supply. Surging energy prices also affected many risk factors throughout the year, including Commodities, Trend following, and Momentum.
In particular, Europe had a meaningful reliance on Russian natural gas that needed to be reevaluated. This led to the European Council banning 90% of all Russian imports by the end of 2022 and promoting more ways to secure and share gas supply in the EU.9 The G7 and Australia also capped Russian oil at USD $60 per barrel as recently as December 5th.10 In response, Putin banned all oil exports to countries that implemented this price cap.11
In summary, the war in Ukraine has spurred a changing energy supply chain which is continuing to develop. Since the central theme of EU action is learning to live with less Russian energy, forces that helped drive energy commodity prices upward in 2022 will likely be different in 2023.
2022 Factor Performance
The two top and bottom factors of 2022: Value and Trend Following, as well as Equity and Interest Rates, reinforce key themes for the year. We provide more color on these factors further below.
To help provide performance context for all of our factors, the table below includes a “standard deviation event.” We believe that a value of +/-2 for this column is a reasonable indication that 2022 performance was “historically significant” based on the annual history for each factor. The only factor to meet this historically significant criteria was Interest Rates, with Crowding just missing the mark.
Exhibit 2: 2022 Factor Performance
Source: Venn by Two Sigma. All factors include annual returns back to 1996, except Crowding beginning in 2008 and Local Inflation in 1998. “2022 Standard Deviation Event Column” is a z score calculation using each year’s annual return, and the standard deviation of that list of annual returns. This standard deviation input to the z score is what we show in the column “Historical Annual Standard Deviation,” not the standard deviation of each factor’s full higher frequency time series.
The Best Performing Risk Factors of 2022
Our Value Factor is market neutral by construction and was the single best performing factor in 2022, returning 25.57%.
Often thought of as growth, the short side of the Value factor tends to be negatively affected by higher rates and inflation as its expected cash flows are further into the future. The opposite is true for the long side, where cash flows are expected sooner.
While our Value factor didn’t quite reach the standard deviation cut off to have a “historically significant” year, context is everything. Using Kenneth French’s value factor (HML) going back to the 1920’s, we can see that value experienced its longest and worst drawdown in almost a century. Benefitting from a COVID-related economic reopening,12 October 2020 marked the beginning of what could be a historic comeback for value that has continued through 2022. With higher rates and inflation taking the reins sometime between 2020 and today, believers in continued value outperformance may need to keep an eye on the potential for rates and inflation to reverse trend in 2023.
Exhibit 3: Historical Value Factor Performance
Source: Drawdown table generated by Venn by Two Sigma. HML returns pulled from Kenneth French’s data library to construct the chart. October 2022 end date due to data availability. (https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html). “HML” refers to high book-to-market stocks minus low book-to-market stocks. This example of HML is referring to US equities only and is from the Fama/French 3 Factors model. Chart is shown in log scale.
Our Trend Following Factor was up 13.95% in 2022 by going long or short across futures contracts for fixed income, commodities, equities, and currencies based on their 6 and 12 month trends.
The fixed income sleeve has been a major driver of positive performance in 2022, with strong positive trends in the US dollar and energy commodities likely providing additional support.13 Trend Following was net short fixed income, which experienced historically significant negative performance.14
It is sometimes debated whether Trend Following is a reliable market hedge. In 2022 specifically, many asset class trends were in some way linked to rising rates, high inflation, or the war in Ukraine, which provided Trend Following with consistent underlying macro themes to capitalize on trending markets.
Exhibit 4: 2022 Performance of Trend Following and Related Sleeves
Source: Venn by Two Sigma
As a bonus to our two top performing factors, it is worth noting that our Crowding Factor just missed the 2 standard deviation cut off for 2022 after very strong performance in December to close out the year. This means that stocks that were heavily shorted by the investment community underperformed stocks that were less heavily shorted.
The Worst Performing Risk Factors of 2022
Our Equity and Interest Rates Factors are what we consider “Tier 1” factors, meaning they are the most liquid and that their risk can often be found in other asset classes. For example, one can find significant equity risk in high yield fixed income.
This challenged many investors who relied on historical relationships between equities and bonds for diversification, such as seen in a typical 60/40. For example, a 60/40 in 2022 would have returned -16.0%.16
Typically these factors diversify each other, but they fell together in 2022. For example, the average historical rolling 1-year correlation between these factors back to March 1995 is -0.18. At the end of 2022, this correlation reached as high as 0.77, its highest point in our history.15
Exhibit 5: Rolling 1-Year Correlation Between Equity and Interest Rates Factors
Venn by Two Sigma. The chart shows rolling 1-year correlations between Venn’s Equity and Interest Rates Factors using monthly data from March 1995–December 2022.
While both the Equity and Interest Rates Factors fell dramatically in 2022, we believe it is important to appreciate how much more significant annual underperformance was for the Interest Rates Factor. For example, Interest Rates annual factor performance was -3.02 standard deviations from its historical mean, shown in exhibit 2.
Below we show the complete historical monthly return distribution of our Interest Rates Factor, overlaying how many months for 2022 fell into each bin, and helping to emphasize the significance of 2022’s negative monthly returns.
Exhibit 6: Interest Rates Full History Factor Monthly Return Distribution
Venn by Two Sigma. The chart shows the monthly return distribution of Venn’s Interest Rates Factor from March 1995–December 2022. Numbers above each bin refers to the number of times a 2022 monthly return fell into the specified range.
More Ways to Read About 2022
While there was plenty to investigate in terms of risk factor performance in 2022, we invite you to also read about our 2022 top five things for the Venn platform as well. Additionally, if you’re interested in reviewing a particular monthly performance report for 2022, they can be found at the links below.
Wishing you a happy and healthy, 2023.
12 In general, "Social Distancing Stocks" tended to be tech and growth type stocks. "Reopening Stocks" like airlines, hotels, etc., tended to fall into the (long) value category. A good example of this theme playing out was the day that Pfizer announced its vaccine candidate on November 9th, 2020. On that day, reopening themes drove the market and the Russell 1000 value was up 4.1% with Russell 1000 growth down -1.8%.
13 For example, the US dollar measured by the DXY Index was up 6.03% in 2022 while the iShares Global Energy ETF (IXC) was up 47.8%. Source for DXY: https://www.barrons.com/market-data/indexes/dxy.
14 More specifically, our Interest Rates Factor is represented by the Bloomberg Barclays Global Treasury 7-10 Year index, currency hedged, from 2022 onwards, and a GDP-weighted sum of constituent country interest rate gross returns before that.
15Data going back to March 1995. Using daily data the historical correlation is -0.14 and 2022 is 0.38.
1660% equities represented by MSCI ACWI index and 40% fixed income represented by the Bloomberg Barclays Aggregate index, rebalanced quarterly.
References to the Two Sigma Factor Lens and other Venn methodologies are qualified in their entirety by the applicable documentation on Venn.
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