Hedge Fund Strategy Outlook Q3 2019

Changing rate environment, heterogeneity within Europe, and a combination of broad macro factors and idiosyncratic situations should create opportunities.

Our Top Convictions

Long/Short Credit

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.

Long Short Equity— Europe

Under a backdrop of slow growth, low inflation and continued central bank support, European stocks appear inexpensive versus both historical and relative valuation norms.

Discretionary Macro

A renewed easing stance across major developed central banks and broadly divergent opportunities in emerging markets should present skilled managers with a wide range of potential directional and relative value trading opportunities.

 

Macro Observations

Looking at the big picture there are five primary macro factors we consider the most relevant to hedge strategy allocation going forward. They are geopolitics, growth, valuations, sentiment, and liquidity.

Geopolitics

  • BREXIT continues to be delayed with little progress
    Theresa May resigns, uncertainty continues to hurt European economic growth, EU elections see Populists gaining
  • US, China, Europe, Japan Iran trade sanctions and tariffs remain in the headlines
    US/China trade talks stalled, Trump delays auto tariffs against Europe, Japan, US/Iran tensions rising
  • Venezuela’s political unrest may disrupt oil supply & increase inflation risk
    Russia seems to be influencing Venezuelan politics

Growth 

  • Global economic growth fears continue
    Trade tensions, Brexit uncertainty, and strong US Dollar slows order books. That said, bad news is known and there are signs of leading indicators improving
  • Earnings slowdown fears diminish
    US and European EPS estimates improve dramatically in Q4 2019 and Q1 2020 
  • 2020 GDP estimates
    Y-O-Y Real GDP growth expected to remain below trend

Valuations

  • US valuations no longer cheap but not expensive
  • Europe and emerging market equities cheap relative to US but no upside catalyst seen (yet)
  • Forward Price/Earnings and Price/Sales Ratios now in neutral territory
  • US dollar & US government bonds becoming expensive
  • Credit spreads now in neutral valuation territory

Sentiment

  • VIX levels indicate that some fear evident
  • In our opinion, recent pullback in many equity markets has shifted investor psychology to a “risk-neutral’ mode
  • Excessively bullish positioning in global government and investment grade bonds indicates to us a possible ‘crowded trade’
  • Bond volatility near historic lows indicates possible complacency

Liquidity

  • Financial conditions improving from poor levels
    - Fed’s recent announcement on ‘pause’ to rate rises removes negative influence
    - China easing credit conditions
    - ECB announced further easing though additional targeted long-term refinancing operations
  • Investor cash levels near historical lows
  • Talk of Fed rate cuts
  • Tariffs seemingly not beneficial to global corporate profit margins


Long Short Credit

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. Long short credit managers are well positioned given their nimbler profiles and we believe should be able to generate alpha with an increased focus on issuer-specific catalysts such as refinancings and M&A. Managers are also finding attractive opportunities in capital structure arbitrage.

High Yield Index Total Return by QualitySeptember 30, 2018–June 30, 2019

High Yield Index Total Return by Quality

Source: ICE BofAML, Federal Reserve Bank of St. Louis. Data from September 30, 2018 to June 30, 2019. Past performance is not an indicator or a guarantee of future performance. 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. Quality Weightings: Ratings shown are assigned by one or more Nationally Recognized Statistical Rating Organizations (“NRSRO”), such as Standard & Poor’s, Moody’s and Fitch. The ratings are an indication of an issuer’s creditworthiness and typically range from AAA or Aaa (highest) to D (lowest). When ratings from all three agencies are available, the middle rating is used; when two are available, the lowest rating is used; and when only one is available, that rating is used.

Long Short Equity—Europe

After a sustained period of underperformance over the past 10 years, we believe that Europe is poised to outperform. Under a backdrop of slow growth, low inflation and continued central bank support, European stocks appear inexpensive versus both historical and relative valuation norms. After a pause earlier this year, we expect European earnings growth to pick up later in 2019 with an acceleration into the start of 2020. The MSCI Europe Index’s ~3.8% dividend yield is nearly double the yield of the MSCI US Index and looks particularly attractive versus European bonds with negative yields. Additionally, Europe offers a lot of diversity for developing both long and short themes. While our outlook is positive, some near-term uncertainty surrounding Brexit and global trade issues could temporarily derail our thesis.

Various Regional and Asset Class Yields

Various Regional and Asset Class Yields

Source: Bloomberg. Dividends of MSCI Europe Index and MSCI USA Index as of June 28, 2019. US, UK, Japan, German 10-Yr bond yields are based on their respective generic government 10-Yr Yields and are as of July 17, 2019. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. 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.

Discretionary Macro

We continue to like the opportunity set for discretionary macro managers across both developed and emerging markets. A renewed easing stance across major developed central banks is pointing toward their concerns around increased macroeconomic uncertainties. At the same time, emerging markets are offering broadly divergent opportunities due to a combination of broad macro factors (trade war, falling developed market rates, currency fluctuations) and idiosyncratic situations (differing growth rates, elections and recent leadership changes, etc.). The resulting complex global macro picture should present skilled managers with a broad range of potential directional and relative value trading opportunities.

Fixed Income, Equity and FX Volatility January 1, 2016–June 6, 2019 (Indexed to 100 at December 31, 2015)

Fixed Income, Equity and FX Volatility

Source: Bloomberg, Data from January 1, 2016 to June 6, 2019. Past performance is not an indicator or a guarantee of future performance. 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.

12-Month Outlook Summary for Q3 2019

Long / Short Equity

In our view, long/short equity managers are positioned favorably as a result of current market conditions. Many managers believe that investors’ concerns that have recently weighed in on equities were overplayed. Companies are navigating through macro headwinds and managing investors’ expectations as first quarter earnings results have broadly come in better-than-expected. Current Fed policy implies an accommodative stance on equities as investors are now pricing in multiple rate cuts for the remainder of the year.

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. Maintain a favorable outlook for volatility arbitrage with higher market volatility presenting attractive trading opportunities.

CONVICTION SENTIMENT

Event Driven

Corporate activity remains healthy but has slowed down from a strong 2018. Tailwinds for corporate activity continue – corporate tax cuts, cash repatriation, high CEO confidence, and low interest rates. However, delays in a trade war resolution between the US and China remain a headwind. Merger arbitrage spreads remain attractive relative to Treasury yields. We are cautious on special situations due to the many value traps caused by disruptive technology but believe the market has discounted a significant amount of the risk.

CONVICTION SENTIMENT

Credit

Long/short credit managers appear to be well positioned to benefit from shifts in investor sentiment through actively managing net exposures and to potentially generate alpha from a catalyst rich environment. Defaults remain low with limited new opportunities. In structured credit, fundamentals are strong, and yields look attractive on a relative basis. In private credit, we prefer niche strategies.

CONVICTION SENTIMENT

Global Macro

The opportunity set remains attractive, particularly for global managers that can benefit from dislocations around slowing growth, increased central bank activity, and higher volatility. Local politics and fund flows may present risks in emerging markets, but specialists may benefit from resulting relative value opportunities. Systematic strategies can benefit from more consistent trends and an improving correlation environment but remain susceptible to short-term volatility.

CONVICTION SENTIMENT