Broken, Fixed, Better?

The Japanese artform of Kintsugi involves repairing broken pottery using lacquer mixed with precious metals, leaving the cracks prominently visible. This process often enhances the value of the piece beyond its original worth. At times during the second quarter of 2025, it seemed as though Donald Trump was engaging in his own version of Kintsugi with financial markets. However, his approach involved deliberately breaking systems and reconstructing them with visible cracks, yet, somehow leaving equity markets higher than before.

In June, we saw further examples of this disruptive pattern, adding to the tariff-related noise from earlier in the quarter. The US got involved in the conflict between Israel and Iran (including direct strikes from the US on Iranian nuclear enrichment facilities), only to then demand a full ceasefire. The US then threatened to pull out of NATO and openly questioned whether it would support Article 5, only to then secure a promise of significant increases in defence spending from all NATO members.

Equity market investors seem to believe that, despite the volatility in getting there, the ‘repairs’ to trade relations and global geopolitics are worth more than the initial disruptions. The S&P 500 finished the second quarter at record highs, up +10.6%, while the Nasdaq was even more exuberant at +17.7%. Credit spreads tightened, and the prices of oil and gas were materially lower over the quarter, despite heightened tensions in the Middle East.

Furthermore, for active investors, the last quarter was one of unusually large gains. The Morgan Stanley Index of crowded hedge fund long positions returned +32.2% during the quarter, while factor exposures to high beta and high volatility stocks also delivered one of their strongest quarters on record.

However, this technical behaviour is potentially troubling on two fronts. Firstly, markets displaying such froth are generally short-lived and historically prone to correction. Even quantitative equity market-neutral hedge funds, which typically thrive when crowded stocks perform well, are struggling to navigate the extremes of these dislocations. Confusingly, crowded short positions have been outperforming the broader market, while other factor measures of intra-market valuation, such as Value and Quality, have been largely disregarded by recent flows. Secondly, there is a risk in the pattern of market reactions to policy interventions. If markets signal to the US administration that disruptions can be made with relatively minor consequences, this could embolden further ‘unconventional’ measures.

Another notable characteristic of financial markets in the second quarter was the weakness of the US dollar (USD). This is particularly striking given its historical behaviour as a safe haven during periods of market volatility. Since Liberation Day on 2 April, the correlation between the dollar and global equity markets has turned positive. For multi-asset managers with significant USD exposure, this presents a dilemma: should risk models account for Trump-driven dynamics (likely USD depreciation alongside rising equities) or shocks external to the US (likely USD appreciation when equities decline)? Systematic macro strategies have been grappling with this challenge, compounded by the whipsawing nature of markets in recent months.

For now, all eyes remain on the US administration. One of President Trump’s primary concerns appears to be with Federal Reserve (Fed) Chairman Jerome Powell, as Trump has raised the possibility of replacing him early, potentially within the next few months. With the potential impact from any 1 August decisions, a president unafraid to take action to advance his objectives, and a corporate earnings season that may reveal the real impact of tariffs on businesses, it would take a bold investor to expect the third quarter of 2025 to be any less eventful than the second.

Key drivers of hedge funds’ performance: An early June snapshot

Equity Long/Short (ELS):

• Global equities generally had a strong month. European equities were the exception, as they both lagged their US and Asian peers and traded with a higher level of volatility around geopolitical question marks like conflict in the Middle East and tariff rhetoric
• At a sector level, it’s worth highlighting that the AI theme was again in focus. Many tech hardware stocks reaped the benefits in June while more consumer-oriented AI names (think Apple) posted more modest returns. Energy stocks saw a quick bout of outperformance as the escalation in the Middle East conflict led to supply-side concerns, though this sharply reversed around the ceasefire and hedge funds seemed to press short in the sector
• Performance across the Equity Long/Short space has been broadly positive in June, though we note that European ELS funds lagged their peers (in sympathy with equity markets). Beta has been a positive or negative component of returns – dependent on region – while alpha was modestly positive and driven by longs. Tech sector specialists look to have had another strong month
• Gross exposures remain elevated and pushed even higher during the month as prime brokers reported multiple weeks of net buying activities, with long additions outpacing short covering

Credit:

• June was another good month for risk assets, and credit spreads were tighter with US high yield (HY) outperforming US investment grade (IG) and leveraged loans. Treasuries also rallied on increased near-term expectations of a rate cut from the Fed
• Corporate credit managers experienced mixed results in June. Convertible bonds were modest detractors, as elevated levels of primary issuance weighed on secondary market valuations, offsetting gains from new issues. Government-Sponsored Enterprises (GSEs) also contributed to minor losses for some managers, following strong year-to-date (YTD) returns. In contrast, stressed and distressed credits, including a UK water utility, and reorganisation equities performed well, supported by the favourable market backdrop
• Portfolio-level credit hedges, alongside rates hedges, proved to be detractors for certain managers. Positive returns for structured credit managers were driven by modest mark-to-market gains as well as carry offset by hedges

Event Driven:

• June was a quiet return month for most event driven strategies. Hard equity catalyst funds posted modest gains, while event credit funds recorded slight declines. Merger spreads tightened marginally over the course of the month
• Notable new deals in US and Europe in June include Chart Industries/Flowserve in the US, which agreed to merge in an all-stock deal, at a combined valuation of about US$19 billion, a UK private equity deal (Spectris/Advent - US$6 billion, whereby KKR may launch a rival bid), and a large cross-border pharma deal (Blueprint Medicine/Sanofi (US$9.5 billiion)
• The UK continues to generate healthy deal volumes, particularly in real estate and tech/industrials. Mediobanca, which is seeking to acquire Banca Generali, announced a plan to return EUR 4.9 billion to shareholders in an effort to fend off a hostile bid from smaller rival Banca MPS
• The US Steel/Nippon Steel deal finally closed after President Trump approved the transaction, contingent on a national security agreement between the parties. In Japan, the Carlyle Group acquired TRYT for US$220 million, representing a 34% premium. Meanwhile, the South Korean presidential election paved the way for a clearer path towards corporate governance reforms

Discretionary Macro:

• June was a strong month for Discretionary Macro strategies. Long positions in government bonds from Group of Ten (G10) nations, added later in the month, benefitted from rising expectations of central bank rate cuts
• A short bias in European rates also performed well, particularly in relative value structures against USD and GBP rates. Short USD trades continued to add value as investors rotated away from the greenback, with EUR long positions proving especially rewarding
• Long positions in global equities further supported returns
• However, commodities presented challenges amid volatility in crude oil and gold markets, though some tactical shorts delivered gains as geopolitical tensions in the Middle East eased towards the end of the month

Quantitative strategies:

• June was another strong month for widely held equity market-neutral factors, including Momentum, High Beta, and High Volatility. However, many specialist managers in this space actively manage their overall exposure to these factors. This, combined with weak performance on the short side of many portfolios, led to modest struggles for quantitative equity market-neutral strategies during the month
• Conversely, some systematic macro managers saw some respite from the recent poor performance, with gains in the last week of the month. The strongest performing exposures were the short USD and long stock indices positions
• One area of pain for trend following strategies was exposure in oil and gas, which has been whipsawed by the quickly changing sentiment around the situation in the Middle East

On-the-radar:

• Short term, the focus remains on any market implications of hastily agreed trade agreements (or lack thereof), considering the sustained threat of tariffs
• Not long after that we will have the first earnings season in which tariffs could start to show up as a factor in corporate earnings. Watch for companies that have front-loaded activity to get ahead of tariffs, or those that are delaying big decisions given the uncertainty
• Longer term, the focus remains on the balance between growth, inflation and rates, the last of these being of particular interest to the US president given his increasingly public frustration with the Fed