Summary
More fragmented economies and monetary policies would open more regional relative value opportunities that should support Hedge Funds.
Strong alpha generation since mid-2023
Hedge Funds (HF) are up 4.2% year-to-date as of March 2024, which compares well with diversified global allocations, including 40/60 Equity/Bond portfolios which are up around +2.2% and have higher volatility. HF performance year-to-date was led by CTAs, EM focused and L/S Equity both Directional and Neutral. Overall, the HF industry continued to produce very strong alpha, up an estimated 6%+ y/y.
Markets have been switching from one goldilocks to another in 2024, and prepare for more fragmentation going forward
Late last year, markets had been pricing in that growth would slow enough to bring inflation down, leading central banks to start a full easing cycle, thus boosting risky assets. Since January, amid evidence of more resilient world growth, markets have priced in stickier inflation as well as delayed and shallower monetary easing. In other words, investors have retraced last year’s overly optimistic inflation and easing expectations, and overly pessimistic growth projections.
Nine implications for HF
- More fragmented economies and monetary policy would open more regional relative value arbitrage opportunities, especially in bonds. Besides, as markets remain concentrated on tech, more differentiation should continue to be seen in other segments. This may support hedge funds (HF).
- The pulse in relative value arbitrage will nonetheless be capped by US exceptionalism, especially for assets tied to the US dollar, as the fate of inflation and rates will continue to dominate the narrative for longer.
- Momentum looks increasingly vulnerable, paving the way for less market directionality with more trials and errors especially in bonds and their proxies. In essence, momentum is stretched mainly in US and Japanese equities, and historically, when the macro backdrop has been supportive, a reversal in momentum has proved manageable for broader markets. Still, this means higher risk for L/S equity. On the positive side, it would imply less competition for HF from beta.
L/S Equity Neutral should continue to generate strong alpha, with more regional nuances
The alpha environment remains supportive, albeit with more regional nuances. Stock price and valuation correlations have collapsed in most regions year-to-date, while stock dispersion surged. It has been driven by a tiring equity rally, more economic differentiation as we moved along the economic cycle, and as investors anticipated a pending pivot from most central banks. It provided a very favourable environment for L/S Equity managers. These conditions remain largely in place in the EU but have reverted to average in the US and Japan, where rates will likely remain a dominant driver for longer.
EM Fixed Income Arbitrage, access to EM markets with affordable risk
The EM debt backdrop remains attractive for EM focused HF, but the dominance of DM rates and implications from stickier DM inflation are the main risks.
The hurdles for investors to allocate in the segment are lower. Structural EM risks have receded, EM growth continues to outperform DMs, while EM rates have just started to decline. Chinese deleveraging is an obvious constraint, but should remain manageable. While EM debt valuations are fair-to-slightly-rich, the net carry (adjusted for risk) is one of the most appealing relative to other assets.
Merger Arbitrage to leverage on the return of corporate activity
We expect corporate activity to resume, which will provide managers with a broader menu of opportunities. Deal funding stress is receding as we enter the final phase of monetary tightening. Corporate confidence is reviving amid signs that global growth is remaining resilient and banks are willing to lend again, reflected by easing lending standards. Lots of dry powder is still waiting to be deployed ($2tn in private equity, $5tn sitting in corporate cash1), while a pipeline of delayed acquisitions since rates surged in 2022 is also ready to proceed. US election uncertainty might delay some operations in sensitive sectors, but there is a strong M&A rationale for strategic deals in sectors exposed to AI and digitalisation, the energy transition, re-onshoring and energy. Tighter corporate margins and moderating profit and revenue growth are also supporting external growth.
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