Hedge Fund Strategy Outlook Q1 2020

In our view, pricing dislocations in Europe, performance dispersion across the credit spectrum, and shifts in the political landscape provide abundant opportunities for select strategies.

Strategy Highlights

Long/Short Equity- Europe

We believe Europe will benefit from an inflow of foreign capital as investors start to feel more comfortable with the risks inherent to the region. In our opinion, the upside of European managers’ long books remains elevated as persistently overlooked companies gain more traction.

Long/Short Credit

Recent dispersion in high yield bonds could provide managers with a better environment in which to pick specific credits on both the long and short sides.

Macro Discretionary

Market focus has started to shift to the prospect of fiscal expansion, particularly in Europe, which may create directional and relative value trading opportunities for discretionary managers.

 

MACRO THEMES WE ARE DISCUSSING

Sector and Geographical Rotations Likely to Continue in 2020

We expect a rotation from those sectors that formally had strong earnings growth into sectors that have lagged in the past few years. We believe this sector rotation should benefit equity hedge fund alpha as managers look to buy past laggards while using past leaders as market hedge positions. Likewise, cyclical sectors and value factor-sensitive securities may outperform defensive and growth-oriented sectors. Much of the negative economic and earnings growth news may be priced into European and emerging market equities while much of the positive news is potentially priced into US equities and the US dollar. A rotation into non-US equity markets may become evident in 2020, and many macro commodity trading advisors (CTAs) and equity long/short managers may benefit from this shift.

Are Investors’ Global Inflation Expectations Too Low?

We wonder if consensus inflation expectations are too low given global growth seems to be stabilizing. If wage or price inflation surprises to the upside, the yield curve may steepen in 2020, and some bond markets may come under pressure as interest rates rise. Credit long/short hedge fund managers should benefit from this scenario in our opinion, as the performance variance between bonds in different countries or sectors should offer alpha opportunities.

Has the Rally in Global Government Bonds Gone Too Far?

According to Bloomberg as of December 30, 2019, the December 2020 Fed Funds futures market is forecasting US Fed Funds to be near 1.39%. This is not much lower than the current level of 1.55%. It seems to us that the Fed rate cuts might mostly be priced into bond valuations. We wonder if a selloff in global bond markets may present a good hedging scenario for managers in the relative value, event-driven, and macro/CTA strategy categories.

What Impact Will Upcoming Political and Trade Events Have on Market Volatility and Hedged Strategies?

With the November 2020 US election cycle fast approaching, we expect market volatility to increase from the current low levels. Campaign policy headlines involving the health care and energy sectors could influence investor perceptions leading up to the election. Hedged strategies may benefit by going long the sectors thought to benefit from a policy tailwind while hedging out equity market volatility through short positions in sectors potentially hurt by policy statements. Additionally, the ongoing Brexit and trade discussions should contribute to investor uncertainty and cross-sector and cross-asset class volatility.

LONG/SHORT EQUITY-EUROPE

We expect renewed interest in European equities as investors rotate to undervalued European markets, potentially improving the relative valuation dislocations between Europe and the US. Broad macro uncertainties about the US-China trade war and Brexit have temporarily diminished, and central banks continue to accommodate investors’ appetite for risk-on assets. Many European companies even offer relatively high dividend yields, which we believe are sustainable based on payout ratios and corporate debt levels.

Various Regional and Asset Class YieldsAs of December 18, 2019

Difference between 3-month Implied and Realized Volatility in S&P 500, Euro Stoxx 50, and Nikkei 225 Indexes

Source: Bloomberg, MSCI. 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 sales charges. Past performance is not an indicator or a guarantee of future performance.

LONG/SHORT CREDIT

High yield bonds have experienced higher levels of dispersion in 2019, particularly across the quality spectrum. Higher-quality bonds have rallied given higher sensitivity to rates, and lower-quality bonds have lagged due to both macro and idiosyncratic credit concerns. This dispersion could provide managers with a better environment in which to pick specific credits. That is particularly salient on the short side, as weaker credits, particularly those in challenged sectors such as health care and retail, have experienced sharp declines in response to negative fundamental developments. We expect this dispersion to continue into 2020 as investors become more discerning into the later stages of the credit cycle.

High Yield Performance by QualityJanuary 1, 2019–December 16, 2019

High Yield Performance by Quality

Source: ICE BofAML, Bloomberg. Data from third party sources may have been used in the preparation of this material and Franklin Templeton has not independently verified, validated or audited such data. Franklin Templeton and its third party sources accept no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. 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 sales charges. Past performance is not an indicator or a guarantee of future performance.

MACRO DISCRETIONARY

Markets are starting to recognize the effective limits of monetary policy, which has been a key supporter of asset prices in the years following the Global Financial Crisis. With developed-market policy rates at or near the perceived lower bound, attention has started to shift to the prospect of expansionary fiscal policy, particularly in Europe. Directional and relative value macro opportunities may arise from key policy changes as well as associated shifts in the political landscape with considerable focus on the US presidential election.

Monetary Policy Rates in Major Developed MarketsJune 29, 2007–December 18, 2019

Average Forward 52-Week S&P 500 Return

Source: Bloomberg. Important data provider notices and terms available at www.franklintempletondatasources.com. Past performance is not an indicator or a guarantee of future performance.

12-Month Outlook Summary for Q1 2020




Long / Short Equity

While valuations are at all-time highs, the US economy remains robust with little threat of inflation and the postponement of rising interest rates by the Federal Reserve. Various macro uncertainties seemed to have diminished, but the upcoming presidential election could help create opportunities on both sides of managers’ books whether through candidates’ rhetoric specific to certain sectors or incremental developments in the trade war. Most long/short equity managers feel comfortable redeploying market risk back into their books and continue to focus on the fundamentals of their companies.




Relative Value

Volatility in equities has remained stubbornly low, offering an attractive entry point to be long optionality in shares in case of a future market shock. Convertible bond markets are showing meaningful growth in new issuance and improved dispersion, and continued flows in sovereign debt have been helpful to fixed income managers, resulting in an overall favorable environment for non-equity relative value strategies as well.




Event Driven

Merger deal volumes have rebounded from a slowdown earlier in the year but remain far from record levels as the market is still struggling with broad geopolitical uncertainties in the US and abroad. At the same time, merger arbitrage spreads are somewhat lower, consistent with low levels of global interest rates and realized volatility. This is similarly true for other types of corporate activity, limiting the opportunity set for special situations investing. We believe both types of corporate activity will resume in force once trade war and global growth uncertainty is resolved, but remain neutral in our outlook.




Credit

A slow-growth environment can provide opportunities for long/short credit managers to generate alpha. On the long side, managers are increasingly taking an active role to drive desired financial restructuring. On the short side, weaker credits, especially those in challenged sectors, are trading off meaningfully in response to negative fundamental developments. Structured credit managers can potentially benefit from attractive carry and supportive fundamentals. In direct lending, we prefer niche strategies. Distressed is challenged from both an opportunity set perspective as well as the path to exiting positions.




Global Macro

We think discretionary managers remain well placed to benefit from active monetary and fiscal policy agendas, mixed growth outlooks, and the potential for higher volatility ahead of the US presidential election. Macro conditions, including subdued inflation and accommodative policy, may remain supportive of emerging markets strategies, but idiosyncratic and market liquidity risks remain. Our outlook for systematic strategies is cautious around extended positioning in certain asset classes even though we like the diversification benefit.





INSURANCE-LINKED SECURITIES

The catastrophe bond market is seeing attractive pricing as the new issuance pipeline picked up significantly with record Q4 2019 issuance. The broader catastrophe bond selloff in November and December was primarily driven by new issuance coming to market at more attractive valuations. For the higher-risk segments of the market like retrocessional, a lack of deployable capital has led to a double-digit increase in pricing for January 1, 2020. Based on historical standards, a material increase in retrocessional pricing should eventually impact the broader reinsurance market, but this is likely to take a longer lead time.