Q2 2023

Certainly Uncertain

Macroeconomic conditions have We certainly find ourselves in

been exceptionally volatile over uncertain times—but how uncertain
the past three years. 2020 featured are they?
the onset of a global pandemic.
Inflation emerged in 2021 after lying In short, quite uncertain. As I show
dormant for decades. Central banks below, macreconomic uncertainty is
responded to elevated inflation in currently high versus history when
2022 by aggressively hiking interest measured quantitatively. That
rates. As of May 2023, inflation said, the key question, which I aim
continues to be well above target, to address in this note, is whether
the federal funds rate is at its elevated uncertainty is likely to
highest level since before the global persist, or should we instead expect
financial crisis, and further rate a return to the low uncertainty
hikes may be necessary. Meanwhile, environment of the 2010s? As a
economic activity remains resilient, logical follow-on to this question,
and unemployment is at its lowest I also address the implications for
level in over 50 years, though the investors, both in terms of possible
banking sector is beginning to reel returns to traditional assets, and as
from compressed margins (which to what alternatives might prosper
show up today as losses if marked or decline in such an environment.
to market, and tomorrow as lower
earnings) and a shrinking deposit We can quantify macroeconomic
base. uncertainty by measuring the
degree to which the economy has
become more or less predictable over
time. When data releases are close

Thank you to Cliff Asness, Jeffrey Bolduc, Jim Cavanaugh, Jonathan Fader,
Antti Ilmanen, Kevin Infante, Bradley Jones, Bryan Kelly, Ken LeStrange,
Thomas Maloney, and Daniel Villalon for helpful comments and suggestions. Thank
Jordan Brooks you to Noah Feilbogen and Nick Kirchner for assisting me with the data and exhibits,
Principal as well as for constructive conversations and suggestions.
2 Certainly Uncertain | 2Q 2023

to their predicted value, uncertainty is low; a decade during which macro uncertainty was
when prediction errors are large, uncertainty consistently, and often meaningfully, below
is high. Following this logic, Kyle Jurado, average.3
Sydney Ludvigson, and Serena Ng (JLN, 2015)
use a large set of economic releases to build a Elevated macro uncertainty is associated with
comprehensive monthly “macro uncertainty both high equity market volatility and negative
index.” Figure 1 plots the JLN index from
1
equity market performance. During months
1960-2022. Macro uncertainty has indeed in which the JLN index exceeds one, average
been exceptionally elevated throughout the annualized excess returns for U.S. equities is
2020s. It peaked in the first half of 2020 and -16 percent and average annualized realized
is currently at levels not seen since the 1980s, volatility is 21 percent, versus +6 percent
save for during the global financial crisis. The 2
average excess returns and 12 percent average
recent period stands in contrast to the 2010s, realized volatility in all other months.

Figure 1: JLN Macro Uncertainty Index

July 1960 - December 2022

6.0

5.0

4.0

3.0
Z-Score

2.0

1.0

0.0

-1.0

-2.0

Source: Kyle Jurado, Sydney Ludvigson, and Serena Ng (2015)

The evidence strongly suggests macro months—with high and low uncertainty
uncertainty is likely to remain elevated for periods clustering together. Beyond sheer
some time. Historically, macro uncertainty statistics, however, the current monetary
tends to be very persistent—on the scale policy and market backdrop strongly supports
of quarters and years, not weeks and the premise uncertainty is here to stay.

1 The JLN uncertainty index is publicly available on Sydney Ludvigson’s website. The authors use a high-dimensional statistical factor
model to produce one-month-ahead forecasts of 132 macroeconomic series. The uncertainty index is the common component of the
conditional volatility of the forecast errors at each point in time. It is standardized to have a mean of zero and standard deviation of
one.
2 To confirm the reasonableness of JLN, I compare their uncertainty index to a simple measure that is constructed by taking the absolute
value of the difference between actual and forecasted values for year-on-year real GDP growth, CPI inflation, and industrial production
growth, and averaging across these three releases each quarter. By virtue of equating uncertainty to the conditional volatility of
forecast errors, as opposed to the magnitude of realized forecast errors, JLN is more theoretically appealing. It is also more empirically
appealing, utilizing a much larger set of economic releases. Nevertheless, the two indices track each other well, with a correlation 0.7.
3 This note discusses the drivers of subdued macroeconomic volatility during the 2010s, and links it to the below average performance
of trend following strategies during that decade.
 Certainly Uncertain | 2Q 2023 3

Macro Uncertainty Tends to be Highly

Persistent
Let’s start with the data. While asset returns historical persistence, it is likely to remain
are notoriously difficult to forecast, asset elevated for some time. The one-year forecast
volatility tends to be persistent and, therefore, is 1.06 (85th percentile), and the two-year
much more predictable. If stock market forecast is 0.89 (84th percentile).
volatility is high this month, it is a good bet
it will be high next month. Perhaps the same Statistical forecasts are far from sure things.
is true for macro uncertainty. Let’s use the Perhaps “this time is different” and macro
current month’s JLN to predict next month’s uncertainty will rapidly recede? Unfortunately,
JLN: 4
the economic backdrop suggests this time is
unlikely to be an exception. There are two key
JLN (t+1) = 0.98 x JLN (t), R2 = 97%4 catalysts supporting elevated macroeconomic
volatility moving forward:
Macro uncertainty is indeed extremely
persistent. If the JLN index is 1.0 this month, 1. The impact of aggressive rate hikes is only
our best prediction is it will be 0.98 next starting to be felt, and central banks are
month, and 0.9812 ≈ 0.8 next year. The half- facing tradeoffs between employment and
life of shocks to macro uncertainty is around inflation for the first time in decades.
4 years.
2. Market-implied expectations of key
As of the end of 2022, the JLN macro economic variables disagree materially
uncertainty index stands at 1.27, which is the with policymaker and economist forecasts,
88 percentile relative to history (though a
th
and even disagree across markets.
far cry from the highest spikes). Based on its

Monetary Policy Backdrop: Rate Hikes

and Trade-Offs
The impact of aggressive monetary policy etc. It also influences bank lending, with
tightening on the economy is only beginning higher interest rates and a flattening yield
to be felt. Monetary policy influences curve typically compressing net interest
economic activity primarily through its margins, leading banks to reduce the
impact on interest rate-sensitive components availability of credit. These effects take time
of demand—e.g., business and housing to work their way through the economy. This
investment, demand for consumer durables, shouldn’t be news. Milton Friedman observed

4 Don’t be shocked by the extremely high R 2. In this simple time series model the R 2 is simply the slope coefficient squared. So, the high
R 2 simply means the JLN measure is very persistent.
4 Certainly Uncertain | 2Q 2023

long ago “monetary actions affect economic rates in 1980 when unemployment rose, only
conditions only after a lag that is both long to begin a hiking cycle shortly thereafter
and variable.” 5
inducing a prolonged recession. And tradeoffs
foster heightened uncertainty about the future
Beyond the delayed impact of ongoing rate course of policy—note the enormous volatility
hikes, for the first time since the early 1990s at the front end of the yield curve in March
central banks are beginning to face trade- 2023 as a case-in-point, with banking sector
offs between their employment and inflation concerns leading to sharp downward revisions
objectives. For the past few decades there was
6
monetary in policy expectations.
little ambiguity in whether monetary policy
should be accommodative or contractionary: Beyond these anecdotes, we observe a
when inflation was running hot, economic meaningful effect in the data. During
activity was typically quite strong; when months in which the Federal Reserve faced
inflation was languishing below target, tradeoffs—defined as months in which core
economic activity was typically weak. PCE inflation exceeded four percent (twice the
Ambiguity in degree, yes. But not in direction. Fed’s target) and unemployment was above
With the Federal Reserve and other central the Congressional Budget Office estimate of
banks hiking interest rates into high inflation, NAIRU—JLN averaged 0.6 vs. -0.1 in all other
it is overwhelmingly likely they will face the months. All else equal, when the Fed faces
prospect of weakening economic conditions tradeoffs, macro uncertainty is meaningfully
while inflation remains well above target. above average; when they do not face
tradeoffs, macro uncertainty is below average.
Historically, central banks facing tradeoffs has For the statistically curious, the difference-
been a catalyst for elevated macro uncertainty. in-means is highly significant, with a t-stat in
Tradeoffs can cause central banks to abruptly excess of seven.
change policy—the Volcker Fed cut interest

Market Backdrop: Disagreement

An additional catalyst for sustained elevated The front end of the yield curve is the most
macro uncertainty is the degree to which dramatic example. Figure 2 (LHS) plots the
markets and policymaker and economist May 3 fed funds futures curve, along with the
forecasts disagree on the evolution of key latest FOMC Survey of Economic Projections
macroeconomic variables: interest rates, (SEP) fed funds rate forecasts. The futures
inflation, and growth. market is currently pricing the May 3 rate
hike was the final of this cycle. The Fed will
begin cutting interest rates in September

5 The fallacy the monetary transmission mechanism works quicker nowadays likely stems from the observation that monetary policy
actions are rapidly incorporated into liquid asset prices like stocks and bonds. But since asset prices tend to be quite volatile, and since
their ownership is concentrated among wealthier households, the impact of changes in liquid asset wealth on consumption is pennies
on the dollar, and this “wealth effect” is not a key channel through which monetary policy actions influence economic outcomes.
6 All central banks, de facto if not de jure, strive for full employment and low inflation. The European Central Bank, for example, is not
indifferent between two percent inflation / five percent unemployment and two percent inflation / ten percent unemployment, despite
officially having only a price stability mandate.
 Certainly Uncertain | 2Q 2023 5

and will cumulatively slash interest rates by zero rate cuts in 2023. The disparity between
roughly 2.25 percent over the next 18 months, FOMC projections and futures market pricing
culminating with a funds rate of around is the largest observed since the SEP began
3 percent at end of 2024. Futures market in 2012.9 How is this disagreement resolved?
pricing has been enormously volatile. At the Either the FOMC and forecasters are right and
beginning of March, it was pricing a peak interest rate expectations get re-priced, or the
funds rate of nearly 6 percent, and a funds rate futures market is right and Federal Reserve
of 4.25 percent at the end of 2024.7 credibility erodes. Either scenario is likely to
contribute to financial market volatility and
Volatility at the front end of the curve is continued elevated macro uncertainty.
indicative of elevated economic uncertainty.
Even more alarming, however, is the degree The front end of the yield curve is not alone in
of disagreement between the market-implied its dissonance. Inflation-linked bond markets
path of the federal funds rate and what FOMC forecast inflation returning to two percent
members and economists forecast. While over the next year and staying there for the
the market believes the tightening cycle is next decade. FOMC and economist forecasts
over and rate cuts are imminent, all FOMC foresee disinflation, but at a more gradual pace
members and over 70 percent of economists (see Figure 2 RHS).10
surveyed by the Financial Times forecast 8

Figure 2: Expectations of Interest Rates and Inflation

Fed Funds Futures Curve and FOMC SEP Forecasts Inflation Expectations (Market & Survey Based)
6.0% 6.0%

5.5%
5.0% Current YoY Inflation: 5.0%
5.0% Consensus Forecasts
SEP
Average YoY Inflation

March 8
4.0% Inflation Breakevens
4.5% 2023
Jan 18
4.0% 2023 3.0%
May 3
3.5% 2023
2.0%
3.0%
1.0%
2.5%

2.0% 0.0%
0 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y
Years Out from April 11, 2023

Source: AQR, Federal Reserve, Bloomberg, Consensus Economics. SEP forecasts are as of March 22, 2023. Consensus forecasts and
inflation breakevens are as of May 3, 2023. Forecasts are subject to change without notice.

7 This is not the first time this hiking cycle futures markets have dramatically piled on bets of lower rates. Last June’s surprisingly high
inflation print and the first sign of disinflation last Fall led to similar, albeit less dramatic, front-end rallies.
8 See Financial Times: “Economists Think Fed Will Keep Raising Interest Rates Despite Bank Turmoil,” March 19, 2023.
9 The difference between the futures market-implied path of the funds rate and surveys may be partially explained by a negative risk
premium in futures pricing. If investors wish to insure themselves against a state of the world in which interest rates are lower (as might
occur in a recession), they may be willing to pay a premium to hold a long futures position.
10 Both market-based and survey-based long-run inflation expectations have remained quite well anchored during the recent inflation
experience. Should core inflation continue to run meaningfully above central bank targets, or if inflation re-emerges after a monetary
policy pivot, we cannot count on this confidence persisting. Inflation expectations are a key driver of actual inflation, so a de-anchoring
of long-term inflation expectations would make disinflation much more challenging, likely requiring a steeper cost in terms of economic
weakness and unemployment. In additional, a de-anchoring could prompt nominal bondholders to demand a significant inflation risk
premium as in the 1980s. See Brooks (2021) and Ilmanen (2011, ch. 9).
6 Certainly Uncertain | 2Q 2023

We can square this circle. Perhaps interest rate also material disagreement across different
futures and inflation markets are forecasting asset classes.
an imminent and dramatic slowdown in
economic activity. This would likely put To be sure, I am not arguing policymakers and
downward pressure on inflation and could economists have it right and markets wrong,
cause the Fed to shift from focusing on or vice versa. Things still must play out. But
inflation to employment. But a deep recession the large amount of disagreement indicates
would be very painful for equities, which show that the economy is on a knife’s edge, and
no evidence of pricing in a slowdown. Not only dissonant market pricing is a powder keg for
is there stark disagreement between market- higher volatility.11
based and survey expectations, but there is

Implications for Investors

Why should investors care about elevated standardized). There is a strong association
macroeconomic uncertainty? between the measures—JLN is 0.6 correlated
with VIX and 0.5 correlated with realized
First, macro uncertainty tends to be associated volatility. If macro uncertainty remains
with financial market volatility. Figure 3 elevated, financial market volatility is likely to
plots JLN against 22-day realized equity be high as well.
market volatility and the VIX index (all series

Figure 3: Macro Uncertainty and Stock Market Volatility

10.0

8.0

6.0
Z-Score

4.0

2.0

0.0

-2.0

JLN Realized Vol VIX

Source: AQR, U.S. Bureau of Labor Statistics, Federal Reserve, Bloomberg, Kyle Jurado, Sydney Ludvigson, and Serena Ng (2015)

11 Although it is too soon for a full retrospective, the events of March conform to this narrative. Tighter monetary policy in the form of higher
short-term interest rates and long-maturity yields caused a pair of banks, which mismanaged their balance sheets into one giant interest
rate bet, to fail. While markets are rightly questioning banking sector profitability and the viability of some regional banks, the fallout from the
failures of Silicon Valley Bank and Signature Bank are unlikely to spark a widespread financial crisis. (This is my opinion, of course. But there
is scant evidence of widespread expectations for an impending economic calamity—since the end of February, real GDP growth forecasts
were revised up by an average of 40 basis points, according to data from Consensus Economics.) The policy response of the Fed and
Treasury ensures banks will have the liquidity to meet deposit demand, knowledge of which should stave off further runs. And systemic bank
failures and financial crises have typically been the result of deteriorating asset quality on bank balance sheets, not the composition of their
deposits or duration mismatches. Yet, the level of uncertainty at the front end of the yield curve led the Silicon Valley Bank shock to cause to
a massive re-pricing of monetary policy expectations and a spike in macro and market volatility more broadly.
 Certainly Uncertain | 2Q 2023 7

Second, as periods of high macro uncertainty know. We never know. But elevated macro
often correspond to periods of surprisingly uncertainty means our collective ignorance
high inflation or surprisingly weak growth, about the future performance of markets is
equity markets have tended to do poorly today greater than average.
when macro uncertainty is elevated. More
generally, the performance of traditional Faced with the prospect of persistent macro
assets over intermediate horizons is closely uncertainty, investors should diversify, at least
linked to economic developments. Figure 4 partially, away from simple equity risk. Bonds
displays the Sharpe ratios of stocks, and commodities in a strategic allocation can
bonds, and commodities since 1970. Their help mitigate poor equity market performance
performance varies significantly across due to negative growth shocks (bonds) or
decades, and it is not uncommon to realize positive inflation shocks (commodities).
negative ten-year excess returns when Figure 4 shows an “equal risk” portfolio of
faced with macroeconomic headwinds. For stocks, bonds, and commodities—a simple
example, stocks were negative in both the “risk parity” portfolio in which the weight on
1970s (stagflation) and the 2000s (tech bust each asset class is inversely proportional to
and global financial crisis). High macro its realized volatility—delivers much more
uncertainty means we are especially unsure as consistent performance across macroeconomic
to which economic environment we will end environments than equities (or any single
up in. It is possible we experience a stagflation asset class). In addition, many long-short
redux, and stocks deliver meager performance. liquid alternative strategies have little
Or perhaps a productivity boom is on the sensitivity to the macroeconomic backdrop
horizon, and we will see a repeat of the “new and can provide strong performance across a
economy” of the 1990s. We simply don’t range of market environments.

Figure 4: Sharpe Ratios of Traditional Assets

1970 - 1979 1980 - 1989 1990 - 1999
1.2
Stagflation 1.2
Volcker Era 1.2
The New Economy

0.8 0.8 0.8

0.4 0.4 0.4

0.0 0.0 0.0

-0.4 -0.4 -0.4

Stocks Bonds Commodit ies Equal Risk Stocks Bonds Commodit ies Equal Risk Stocks Bonds Commodit ies Equal Risk

2000 - 2009 Past 10 Years 1970 - 2023

1.2
Tech & GFC 1.2
Stagnation, Pandemic, Inflation 1.2
Full Sample

0.8 0.8 0.8

0.4 0.4 0.4

0.0 0.0 0.0

-0.4 -0.4 -0.4

Stocks Bonds Commodit ies Equal Risk Stocks Bonds Commodit ies Equal Risk Stocks Bonds Commodit ies Equal Risk

Source: AQR, Barclays Live, Bloomberg, Ibbotson Associates (Morningstar). As of March 31, 2023. Excess returns are in excess of cash
proxied by the ICE BofAML U.S. 3-Month T-Bill Index. Stocks are defined as the MSCI World Index. Bonds are defined as the Bloomberg
Barclays U.S. Government Bond Index and, prior to 1973, the Ibbotson U.S. Intermediate Government Bond Index. Commodities are
defined as the Bloomberg Commodity Index.
8 Certainly Uncertain | 2Q 2023

Some investment strategies may actually of economic catalysts and cross-market

capitalize on elevated macro uncertainty. dispersion associated high macro uncertainty
Trend-following strategies, which at their core can make the opportunity set more attractive
profit from the systematic tendency of markets for some strategies.14
to gradually incorporate new information,
tend to outperform when economic shocks are Admittedly, we’d recommend this
large and markets experience stress. The SG kind of diversification unconditionally.
Trend index, an equal weighted average of the Diversification and risk mitigation should be
performance of the ten largest trend-following key considerations in any strategic allocation.
managers, has posted positive returns in the Timing when you need diversification is a
three largest equity market drawdowns since fool’s errand, and investors that do so typically
the inception of the index in 2000 (Figure 5). find themselves the proverbial, “day late,
A more comprehensive approach to trend dollar short.” But with macro uncertainty
following that includes economic trends 12
elevated and likely to remain so for some time,
and alternative markets13 may provide even it is an opportune moment for investors to take
more robust tail protection, as well as superior stock and ensure their portfolios are resilient
average returns. While Global Macro is a to a wide range of outcomes.
highly heterogenous category, the abundance

Figure 5: Performance of SG Trend Index in Equity Market Drawdowns

60%

40%
21.1%
20%

0%

-20%

-40% -32.1%

-60%
Average Nov 2007 to Apr 2000 to Jan 2022 to Jan 2020 to Oct 2018 to
Feb 2009 Sep 2002 Sep 2022 Mar 2020 Dec 2018

MSCI World SG Trend

Source: AQR, Bloomberg. Figures shown are based on monthly returns. Past performance is not a guarantee of future performance.
Please read important disclosures in the disclosures.

12 See Brooks et al (2023).

13 See Babu et al (2020).
14 Brooks (2017) presents a systematic approach to global macro investing that has historically delivered attractive and positively
convex returns.
 Certainly Uncertain | 2Q 2023 9

References
Babu, Abhilash, Ari Levine, Yao Hua Ooi, Lasse Heje Pedersen, and Erik Stamelos. 2020.
“Trends Everywhere.” Journal of Investment Management, 18(1): 52-68.

Brooks, Jordan. 2017. “A Half Century of Macro Momentum.” AQR Capital

Management White Paper. (https://www.aqr.com/Insights/Research/
White-Papers/A-Half-Century-of-Macro-Momentum)

Brooks, Jordan. 2021. “What Drives Bond Yields.” AQR Capital Management White Paper.
(https://www.aqr.com/research-archive/research/white-papers/what-drives-bond-yields)

Brooks, Jordan, Noah Feilbogen, Yao Hua Ooi, and Adam Akant. 2023. “Economic Trend
Following.” AQR Capital Management White Paper. (https://www.aqr.com/Insights/Research/
White-Papers/Economic-Trend)

Ilmanen, Antti. 2011. “Expected Returns: An Investor’s Guide the Harvesting Market Rewards.”
John T. Wiley & Sons, West Sussex.

Jurado, Kyle, Sydney C. Ludvigson, and Serena Ng. 2015. "Measuring Uncertainty." American
Economic Review, 105(3): 1177-1216.
10 Certainly Uncertain | 2Q 2023

Disclosures
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an
offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed
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accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or
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This material is not research and should not be treated as research. This paper does not represent valuation judgments
with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not
represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither
the author nor AQR undertakes to advise you of any changes in the views expressed herein.

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market
events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this
presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor
the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes
investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no
assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future
market behavior or future performance of any particular investment which may differ materially, and should not be relied
upon as such.

The information in this paper may contain projections or other forward-looking statements regarding future events, targets,
forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There
is no assurance that such events or targets will be achieved, and may be significantly different from that shown here.
The information in this document, including statements concerning financial market trends, is based on current market
conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.

Performance of all cited indices is calculated on a total return basis with dividends reinvested. Broad-based securities
indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment
funds. Investments cannot be made directly in an index.

The ICE BofAML US 3M T-Bill Index measures the U.S. Treasury securities maturing in 90 days that assumes reinvestment
of all income.

The SG Trend Index is designed to track the largest 10 (by AUM) CTAs and be representative of the managed futures trend-
following space. The AQR Funds - AQR Managed Futures Strategy Fund is a constituent of the SG Trend Index.

The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity
market performance of developed markets.

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 Certainly Uncertain | 2Q 2023 11

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UK Financial Conduct Authority (“FCA”).

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