January 31, 2019

Hedge Fund Strategy Outlook Q1 2019

Volatility returned, and asset classes were significantly challenged – often indiscriminately.

Discretionary Macro

We maintain a positive outlook for the opportunity set in discretionary macro trading. A busy geopolitical calendar and continued quantitative tightening across developed markets should result in continued elevated volatility levels across many asset classes, potentially resulting in an attractive trading environment for discretionary macro managers.

Relative Value Fixed Income - Sovereign

Diverging macroeconomic data, and varied policy responses to it coming from central bankers in both Developed and Emerging Markets are likely to persist in the intermediate term. Resulting price action in global fixed income markets is expected to remain a source of market volatility and potentially attractive trading opportunities for managers specializing in those markets, favoring relative value opportunities rather than outright directional bets.

Long Short Credit

With interest rates rising, duration risk is in focus for credit market participants. The changing rate environment and market technicals are leading to greater variation in performance among different credit asset classes such as investment grade, high yield, and leveraged loans. We believe long/short credit managers are well positioned given their shorter duration portfolios and should be able to generate alpha from rising sector dispersion. Managers are also finding attractive opportunities in capital structure arbitrage.

It’s the End of the Fed’s World As We Know It…

Painful memories of the ‘Great Recession’ howled back to the surface in the fourth quarter. Volatility returned, and asset classes across industries, geographies, and capital structures were significantly challenged – often indiscriminately.

In our view, this most recent tempest is a function of markets beginning to connect the dots between the 10+ year bull market in risk assets and its association with cheap government money. That is, the spectacular rebound we’ve enjoyed since 2008 was in some parts synthetically driven. While the US Federal Reserve’s (Fed’s) massive quantitative easing (QE) program was originally deployed to stabilize financial markets, it created asset price distortions along the way. We believe these are beginning to correct.

The QE response to the 2008 crisis was swift and surprisingly effective, but in many ways it treated only symptoms and not the cause. Essentially more leverage was added to the system, not removed. Debt was moved from one pocket to the other — from the private sector to the public. In addition, instead of it being a short-term intervention, QE persisted for more than a decade.

The result? Bond yields were pushed down and equities buoyed — while the costs of capital were kept artificially suppressed. This steered many investors toward riskier assets, encouraged leverage and, in some instances, rewarded complacency.

Looking ahead, we expect the reversal of QE to have significant impacts on bond and equity markets. Persistently low yields and the Fed’s “buyer of last resort” role will not be a permanent arrangement. The dynamic cannot be sustained. Ultimately many of the financial sins of the “Great Recession” (unwarranted debt, excessive leverage and spending, etc.) have yet to be fully atoned. At some point the world’s margins will have to be called.

Just this past fall, we saw bond and equity markets in the US decline concurrently as rates rose. That may seem anomalous, but in our view, because bonds and equities were equally propped up by Fed intervention, they have been equally vulnerable to the opposite effect as Fed policy unwinds. These are the types of valuation corrections we expect to see as the artificial effects of prolonged monetary accommodation are dismantled. Investors who are not prepared in 2019 may be exposed to unintended risks.

So what does this all mean for hedge funds? From a very high level we would say the environment looking forward is promising. While no one wins with panicked, indiscriminate, and forced selling, modest volatility is good in that it provides intelligently-hedged strategies an opportunity to earn fundamental alpha on both sides (long and short) of their trades.

Discretionary Macro

There are many potentially attractive trade opportunities for discretionary managers. These stem from broad macro risks, including the aforementioned central bank policy divergence and geopolitical risks associated with leadership changes in major economies. The importance of those factors was highlighted by the recent market sell-off, and we believe they will continue to drive market volatility. Recent increases in volatility favor managers with return profiles positioned to take advantage of increased volatility and expertise in diversifying asset classes, including commodities, currencies, and fixed income.

Economic Policy Uncertainty, News Based, Index
12-Month Rolling Average
January 2000 to December 2018

Economic Policy Uncertainty, News Based, Index

Source: Capital Market Insights Group, FactSet, Economic Policy Uncertainty. The “Economic Policy Uncertainty Index” uses newspaper articles and several other factors to measure economic uncertainty. 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.

 

Relative Value Fixed Income - Sovereign

Diverging macroeconomic data, and varied policy responses coming from central bankers in both developed and emerging markets are likely to persist in the intermediate term. Resulting price action in global fixed income markets is expected to remain volatile and potentially create attractive trading opportunities, favoring relative value opportunities rather than outright directional bets.

Target Rates of Central Banks Around the World
As of December 31, 2018

Target Rates of Central Banks Around the World

Source: Bloomberg as of 12/31/18. Most central bank rates are expressed in overnight terms (the rates depository institutions pay to borrow money from the central bank), however some exceptions apply. Past performance is not an indicator or guarantee of future results.

 

Long Short Credit

With interest rates generally higher over the course of 2018, we expect that portfolio duration has likely driven losses for some fixed income investors. Long short credit managers are well positioned for this environment, given their shorter duration portfolios, and should be able to generate alpha from rising sector and rating bucket dispersion. Managers are seeing many buying opportunities in select higher quality credits given recent spread widening around year-end.

High Yield Market Weight by Yield-to-Worst
As of December 31, 2018

High Yield Market Weight by Yield-to-Worst

Source: ICE BofAML, Bloomberg. Data as of December 31, 2018. High Yield market represented by the ICE BofAML US High Yield Index. 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.

 

12-MONTH OUTLOOK SUMMARY FOR Q1 2019

Long / Short Equity

We are cautious on the market environment for long/short equity managers. As global growth continues to slow, both domestic and international investors have looked to the US as a leading indicator of future economic growth. With the federal corporate tax cuts anniversary on January 1, 2019, investors have begun to question what the sources of earnings growth will be. The strength in companies’ Q3 2018 quarterly results have not offset investor concerns over peak margins, rising wages, and other input costs.

CONVICTION SENTIMENT

Trending Key

Neutral
Up Trend
Down Trend

Relative Value

The less directional nature of relative value strategies remains attractive amidst the greater uncertainty in the markets. We have a neutral outlook for fixed income arbitrage and convertible arbitrage. We maintain a favorable outlook for volatility arbitrage with higher market volatility presenting attractive trading opportunities.

CONVICTION SENTIMENT

Event Driven

Corporate activity was strong in 2018 and is expected to remain healthy next year. Tailwinds for corporate activity continue –corporate tax cuts, cash repatriation, high CEO confidence, and low interest rates. The most significant headwind is the trade war between the US and China. Merger arbitrage spreads remain attractive relative to Treasury yields. We are cautious on special situations due to many value traps (stocks that appear cheap but actually may not see share prices recover due to impacts to their businesses) caused by disruptive technology. However, we are more positive on special situations when properly hedged.

CONVICTION SENTIMENT

Credit

Rates are rising, and duration risk is still prevalent in the credit markets. Long/short credit managers have naturally shorter duration portfolios and should benefit from increased dispersion. Defaults remain low with limited new opportunities. In structured credit, fundamentals remain strong and yields look attractive on a relative basis. In private credit, we prefer niche strategies.

CONVICTION SENTIMENT

Global Macro

Favorable outlook for the strategy overall, with preference given to discretionary managers. An active geopolitical calendar, diverging central bank policies, and higher volatility across asset classes should present attractive trading opportunities for nimble relative value macro managers. More cautious outlook in systematic strategies, which can benefit from an improving correlation environment but remain susceptible to choppy market action.

CONVICTION SENTIMENT