Hedge Fund Strategy Outlook

Q1 2018

To begin each quarter, the Research and Portfolio Construction teams at Franklin Templeton’s K2 Advisors share their outlook for hedge strategies. We believe offering these insights to investors and financial advisors will help them better understand the rationale for owning retail mutual funds that invest in hedge strategies.

As the Liquidity Tide Recedes… Will Investors Need a Different Boat

The post-2008 expansion of the Fed’s balance sheet from around US$900 billion to nearly US$4.5 trillion today has been one of the most dominant market shaping forces over the last decade; a massive tide of liquidity that lifted assets across the globe — in some instances indiscriminately — while influencing investor behavior. In addition to yields being driven toward record lows and stock markets to record highs, many investors migrated toward riskier assets while the cost of capital was kept artificially suppressed. We believe this dynamic is about to change. The tide appears to be receding.

While the Federal Reserve has already embarked on its journey towards rate normalization, other major central banks around the world also appear poised to begin unwinding in 2018, with many striking increasingly hawkish tones. In addition, global growth has reset inflation expectations to the upside, led by China’s resilient economy.

All Federal Reserve Bank Total Assets (in Millions of Dollars)
December 1995 – December 2017

Cyclically Adjusted Price-to-Earnings Ratio

Source: Bloomberg, U.S. Federal Reserve. Data from December 31, 1995 to December 29, 2017. Important data provider notices and terms available at www.franklintempletondatasources.com.

Investors who are not prepared for this shift from the recovery era of monetary accommodation to the expansionary post-QE era may be exposed to significant risks, in our view. Markets could see increased volatility and sharp corrections, recalling, for example, the magnitude and speed of adjustments in U.S. Treasury (“UST”) yields that occurred during the fourth quarter of 2016.

One of the challenges for investors in 2018 will be that the traditional diversifying relationship between bonds and risk assets investors expect may not hold true in this new era, particularly if we experience the cycle of UST declines we anticipate. It’s quite possible to see risk assets also decline as the “risk-free” rate (yield on USTs) ratchets higher. Markets have become accustomed to exceptionally low discount rates — a shift higher would materially impact how those valuations are calculated.

Additionally, we feel a sense of complacency has developed across the asset classes as UST returns and risk-asset returns have often had positive correlations, along with positive performance, in recent times. However, the positive outcomes achieved under the benefit of extraordinary monetary accommodation can mask the actual underlying risks in those asset categories. As monetary accommodation unwinds, those positive correlations could continue but with the opposite effect — simultaneous declines across bonds, equities and global risk assets as we exit an unprecedented era of financial market distortions. These are the types of correlations and risks we are aiming to reduce in 2018.

The bottom line is that we believe the massive tide of low-cost money that lifted all boats and allowed for carefree sailing is receding. Investors who are not prepared for this change may be exposed to significant risks. Perhaps it is time to look to add other boats to one’s portfolio, crafts better suited to navigating the sandbars, rocks, and muddy waters that we believe will likely surface in the coming quarters. While these developments may affect hedge fund strategies differently, alpha for the hedge fund universe has historically strengthened in these environments of increased dispersion and volatility, particularly when interest rates rise.

Long/Short Equity Europe

Europe appears poised for higher economic growth with strong consumer confidence, improving inflation, and decreasing unemployment levels. While these factors should trickle into earnings, markets are currently pricing in low growth.

Europe-to-U.S. Price to Book Ratio
December 1998 – November 2017

Hedge Fund Long Alpha by Net Exposure

Past performance is not an indicator or a guarantee of future performance.
Source: Bloomberg. MSCI Europe Local Index to MSCI USA Local Index. Data from December 31, 1998 to November 30, 2017. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com. Indexes are unmanaged and one cannot invest directly in them. They do not reflect any fees, expenses, or sale charges.

European equity valuations appear more favorable on a historical relative basis. Europe-to-U.S. Price to Book ratio remains at record lows. Recent developments such as Brexit may lead to further bifurcation (i.e. domestic-oriented companies vs. companies with international sales) within Europe, creating clear groups of winners and losers. Long/short investors within the region may be able to take advantage of this dispersion. It’s our belief that uneven growth across the region will result in increased dispersion of stocks, sectors, or countries which should help generate higher alpha. Similar to the U.S., rising interest rates driven by the European Central Bank’s unwinding of fiscal stimulus may allow companies to experience similar tailwinds as U.S. companies have.

Discretionary Macro

Shifting central bank policies, changing central bank leadership, potential for geopolitical instability and other risk factors may all serve to increase market volatility, and provide discretionary macro managers with an improved opportunity set for trading across fixed income and currency markets.

Additionally, we believe that the calendar of economic and geopolitical events in 2018 should offer attractive trading opportunities for discretionary macro managers focused on fixed income and currency markets.

Relative Value – Fixed Income

While rates have remained lower for longer than the market originally anticipated, duration risk is still prevalent in many fixed income investors’ portfolios. In our view, the high yield market has never been more interest rate sensitive.

High Yield Market Weight by Yield-to-Worst
As of November 30, 2017

Hedge Fund Long Alpha by Net Exposure

Past performance is not an indicator or a guarantee of future performance.
Source: JPMorgan. High Yield market represented by the JPMorgan High Yield Index. Important data provider notices and terms available at www.franklintempletondatasources.com for additional data provider information. Indexes are unmanaged and one cannot invest directly in them. They do not reflect any fees, expenses, or sales charges.

We believe relative value fixed income managers such as long/short credit managers are well positioned, given their shorter duration portfolios, and should be able to generate alpha from rising sector dispersion.

12-MONTH OUTLOOK SUMMARY FOR Q1 2018

  • Neutral
  • Up Trend
  • Down Trend
StrategyConviction SentimentSummary Statement
Long/Short Equity

We remain constructive on long/short equity investing despite our cautious views on current equity market conditions. Although index valuations have moved higher, recent corporate earnings and macro indicators have implied further upside in the market. The present environment should create opportunities for managers to generate returns on both sides of their books. Steady rising interest rates, as well as discussions about tax reform that preceded its actual enactment in Q4 2017, both created sector and company-specific dispersions, which we expect to continue over the next 12 months.
Relative Value

The less directional nature of relative value strategies remains attractive amidst the greater uncertainty in the markets. We maintain a slightly positive view for convertible arbitrage and volatility arbitrage and a neutral outlook for fixed income arbitrage. With actual volatility at very low levels, the long volatility profile has attractive asymmetry as a complement to our other investments.
Event Driven

We believe corporate activity will remain robust and potentially increase as the Trump administration employs more business-friendly policies. CEO optimism is high, and potential tax code changes could boost corporate activity. There has been significant progress on tax reform, which was finalized in late December. Merger arbitrage spreads remain attractive relative to yields while special situations and activism will likely be more equity market dependent.
Credit

While rates have remained lower longer than the market originally anticipated, duration risk is still prevalent in the credit markets. Long/short credit managers have naturally shorter duration portfolios and should benefit from sector dispersion when rates do rise. Defaults remain low with limited new opportunities. In structured credit, fundamentals remain strong and yields look attractive on a relative basis. Demand for private credit remains high.
Global Macro

Maintain positive outlook for all global macro sub-strategies. A more favorable outlook for discretionary macro given the possibility of increased market volatility across rates and currencies. Focus on opportunistic and relative value investment themes in emerging markets due to rising valuations. A cautiously favorable outlook for systematic macro strategies.

Our Top Convictions

For a more complete discussion of our outlook for each hedge strategy, download the print version.

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