Our Q3 outlook remains very positive, driven by strong Sharpe ratios, strategic diversification, and favourable market conditions despite geopolitical and macroeconomic uncertainties
Our Q3 outlook remains very positive, driven by strong Sharpe ratios, strategic diversification, and favourable market conditions despite geopolitical and macroeconomic uncertainties
July 2024
We are positive on the higher rate regime, its impact on the efficiency of intra-market pricing, and the need for refinancing activity in both convertible bonds and high yield credit.
1. Introduction
The second quarter of 2024 continued the broad economic trends seen since the start of the year. Equities rallied (despite an attempted pull-back in April), expectations for rate cuts this year were further reduced, corporate earnings remained strong, and market volatility was subdued. Against this backdrop, most hedge fund strategies performed positively, but the lack of catalysts led to more muted returns than those seen in the first quarter. Some trend-following strategies saw losses as bond prices rallied following four years of declines and commodity prices whipsawed during the quarter.
2. Our Outlook
Last quarter, we noted our unusually positive stance across most hedge fund strategies, with seven ‘positive’ ratings and only four ‘neutral’. Our outlook for the third quarter remains equally unusual, as we have maintained the same rating across all 11 sub-strategies. Therefore, we uphold our extremely bullish outlook on the expected Sharpe ratios and return generation capabilities of the hedge fund industry. This is partly due to the relative lack of significant market developments in Q2 – much of our optimism remains intact. We are positive on the higher rate regime, its impact on the efficiency of intra-market pricing, and the need for refinancing activity in both convertible bonds and high yield credit.Broadly, we feel that risk assets are priced for close to perfection, with high P/E ratios for equity and tight spreads for credit, there are sufficient geopolitical and fundamental risks to make many hedge fund strategies attractive diversifiers to traditional assets over the next 6-12 months. Figure 1 summarises our stance on different hedge-fund strategies for Q3 2024.
Figure 1. Q3 2024 Outlook Versus Q2 2024 Outlook
Global credit markets, particularly in the US, remain benign despite the higher interest rate environment. Corporate profitability is strong, and credit spreads are tight.
3. The Details
3.1 Credit
With Credit spreads remaining tight and default rates subdued, we have maintained a positive view on Credit. Furthermore, Long/Short and our Neutral view on Distressed.
Global credit markets, particularly in the US, remain benign despite the higher interest rate environment. Corporate profitability is strong, and credit spreads are tight. Opportunities are increasing in high yield long/short and capital structure arbitrage, especially where companies are restructuring their liability profiles. We see more managers discussing outsized opportunities in special situation trades and holding cheap hedges through single-name shorts in higher-quality names trading at tight spreads. While we remain neutral on distressed situations, the general health of the US economy has reduced the number of stressed and distressed lenders.
We retain a favorable view of Convertible Arbitrage. Short-term returns have been strong and there are increasing flows into convertible bonds, both in long-only and long/short strategies. The broader convertible bond market continues to trade at close to fair value, but we maintain our positive view entirely on the fact that primary markets are seeing increased volumes, and that we expect them to remain active as around 40% of global convertible bonds are maturing in the next two years. There remains significant opportunity for managers to benefit from new issue flow.
We have maintained a positive stance on Structured Credit. Despite recent good performance, spreads for many sectors remain wide relative to broader corporate credit markets and relative to historic levels. Loss adjusted yields remain attractive, particularly through hedge fund structures that can use leverage. Aggregate consumer credit fundamentals remain solid, supported by low unemployment, strong balance sheets, and a good economy. Residential credit has performed well given the increase in home equity valuations and low, locked-in mortgage rates. Auto and credit card delinquencies for subprime borrowers have increased slightly but remain well below previous peaks.
3.2 Quantitative Strategies
We retained our positive outlook for Micro Quantitative strategies. Higher interest rates appear to be a positive catalyst for efficient internal market pricing dynamics, and we continue to see above-expected returns and Sharpe ratios for a range of managers across the micro-quant space. We expect this to continue for the foreseeable future, although we note risks of possible saturation in certain strategies from capital on large hedge fund platforms. Conversely, one area of growth in recent years has been the arrival of new buyside alpha capture businesses, which seek to commoditise and optimise the hedge fund decision marking process.
Major central banks have guided markets towards rate cuts despite largely disappointing inflation prints, and little in the labour market or economic activity data to support easing.
In Macro Quantitative strategies, we maintain our neutral stance. We continue to recognise that large volumes of assets have been allocated to macro quant strategies in recent years, and that for many of these very capacious strategies it can be difficult to assess how much capital is too much until after the event. However, these strategies tend to be very capital efficient and positively convex to risk-assets, therefore they can be an effective part of many hedge fund portfolios. One specific concern over the current macro environment is whether macro-quant funds can sufficiently predict and react to unique geopolitical events. In an increasingly uncertain world and with events such as the US election on the horizon, one might favour Discretionary Macro over systematic approaches, if only to minimise one’s regret function.
3.3 Macro
We maintain a positive view on Global Macro, particularly discretionary strategies which can benefit from an increased opportunity set with several catalysts for higher market volatility. Major central banks have guided markets towards rate cuts despite largely disappointing inflation prints, and little in the labour market or economic activity data to support easing.
With increasing changes in political leadership in the UK, France, and Mexico and the upcoming US election, markets’ attention has started to turn towards fiscal trajectories, international trade policy and shifting immigration trends. Risk assets and volatility markets have looked through macro uncertainty and geopolitical concerns thus far, but there is the potential for spikes in volatility as tailwinds subside (AI, expectation of deep cutting cycles) and risks rise (central bank policy error, election surprises, higher unemployment, higher term premium).
More broadly, equity markets are currently supported by high levels of corporate earnings. In the event of a normalisation of earnings, we expect to see equity volatility increase, which tends to be a positive environment for Macro strategies.
Annualised spreads are slightly higher than we have seen in recent months as capital has left the space following volatility in some announced deals recently.
3.4 Event Driven
We maintain our positive outlook for Merger Arbitrage, despite (and in some ways, because of) the relatively lacklustre performance for the strategy in the first half of 2024. M&A activity remains buoyant, with more large deals and more companies looking for strategic mergers. Premia paid on the announcement of deals has increased, providing a benefit to managers trading pre-event names, and we are seeing a wave of public-to-private deals as private equity companies look to work down their record cash piles.
Annualised spreads are slightly higher than we have seen in recent months as capital has left the space following volatility in some announced deals recently, particularly in crowded deals. There is anecdotal evidence of merger arbitrage books being shut down at large multi-strategy firms following disappointing performance year-to-date. Given the otherwise strong performance of the hedge fund industry, we feel that this is an opportune time to be contrarian on Merger Arbitrage. Volumes are high, spreads are wide and capital in the space is reduced.
The main risk to the strategy remains increased regulatory scrutiny. With increased numbers of political changes in developed markets, it is possible the new administrations take a harder line on M&A approvals, although we have not seen any evidence of this risk emerging so far.
We remain neutral on Special Situations, but as noted in the Credit section, we are turning more positive on Event Credit situations. Low growth and refinancing stress continue to provide ample liability management exercises as firms address maturity walls and/or interest costs. In addition, there are increasing numbers of short opportunities in Event Credit trades, making the overall strategy more market neutral. We remain neutral on equity event trades but note that there are interesting corporate governance trades in a number of Asian countries following the Japanese playbook of releasing shareholder value through reform. The most interesting of these trades is arguably in Korea, where the Value-Up program aims to increase the value of companies trading at significant discounts to book value.
We may see divergence in central bank policies which could in turn create dispersion across regions. Moreover, there are regional phenomena that managers are activity aiming to exploit.
3.5 Equity Long/Short
We maintain a positive outlook for Market Neutral and neutral for Long-Biased Equity Long/Short. Overall, we expect higher dispersion at the single stock level to continue as first and second quarter earnings continued to show that share prices remain tightly correlated to fundamental corporate health. We believe this phenomenon is strongly driven by non-zero rates, which leads to a higher cost of capital and a higher discount rate, meaning that earnings today are worth much more than earnings tomorrow.
We may see divergence in central bank policies which could in turn create dispersion across regions. Moreover, there are regional phenomena that managers are activity aiming to exploit. In the US, we continue to prefer sector specialists who can exploit individual trends in both healthcare/consumer behavior and in legislation around the industrials sector. In Europe, we see generalist strategies continuing to benefit from heightened dispersion in across countries, which should be further supported by political uncertainty and the growing debt maturity wall across the continent. In Asia, shifting market sentiment and leadership may warrant a diversified approach to the region, though geopolitics remains the largest risk.
We note with caution the apparent return of meme stock volatility in Q2, and note that hedge fund managers (and the markets more generally) appear to be better positioned and prepared for raids from retail investors. In addition, we observe that the US market continues to trade on a high P/E ratio supported by above normal earnings, and that any weakness in earnings growth could see a material repricing of equity market levels. Given the strong return to market neutral strategies during the market pull-back in 2022, we believe that hedge funds would navigate a market downturn well, but are realistic that periods of heightened volatility can lead to quicker changes in narrative.
You are now exiting our website
Please be aware that you are now exiting the Man Institute | Man Group website. Links to our social media pages are provided only as a reference and courtesy to our users. Man Institute | Man Group has no control over such pages, does not recommend or endorse any opinions or non-Man Institute | Man Group related information or content of such sites and makes no warranties as to their content. Man Institute | Man Group assumes no liability for non Man Institute | Man Group related information contained in social media pages. Please note that the social media sites may have different terms of use, privacy and/or security policy from Man Institute | Man Group.