Key takeaways:
- The shift in central bank policies indicates a transition to a new market phase, focusing on economic slowdown rather than inflation. This requires careful navigation and strategic positioning
- Downgrades in Credit Long/Short and Merger Arbitrage to neutral reflect caution due to tightening spreads and regulatory challenges. These changes highlight a careful approach to evolving market conditions
- Despite specific downgrades, the overall outlook remains broadly positive, with continued opportunities across the hedge fund landscape. We maintain a cautiously optimistic stance, adapting to ongoing market dynamics
1. Introduction
The third quarter of 2024 was a turbulent period of elections, global conflicts, central bank action and significant pockets of short-term volatility across all asset classes. Yet despite this backdrop, the S&P 500 ground out new highs. Two things appear to be happening: one, the spectre of inflation has been tamed; and two, investors believe that policymakers have their backs now that a cutting cycle has begun in earnest in the US and Europe.
From a hedge fund perspective, there was a clear split in recent performance. Most strategies continued to deliver positive returns through the third quarter, with Credit and Market Neutral Equity Long/Short strategies extending their recent strong runs. However, Systematic Macro suffered a very difficult quarter on a range of short-term reversals and false starts on new narratives across many different asset classes.
2. Our Outlook
We are entering a new phase for markets. Policymakers’ fears are now focused on economic slowdown and less on inflation.
Timing inflection points in markets is a fool’s game, but evidence from central banks’ direction change suggests that we are entering a new phase for markets. Policymakers’ fears are now focused on economic slowdown and less on inflation. They need to strike the balance between cutting rates quickly enough to avoid recession, and not so quick as to renew inflation concerns.
Against such a challenging backdrop, and given the historic tightness of credit spreads, we have reduced our outlook in Credit Long/Short from positive to neutral. We also note the growth of regulatory challenges to the M&A landscape which coincides with slightly less-favourable risk/reward pay-offs in the average merger. Therefore we have also reduced our outlook for Merger Arbitrage from positive to neutral.
Despite these two downgrades, we remain broadly positive across the hedge fund universe. We are closely monitoring intra-market behaviour in equity markets, focusing on dispersion and valuation spreads, to determine the right time to adjust our outlook on Micro Quantitative and Market Neutral Equity Long/Short. We are not quite there yet. Similarly, spreads continue to tighten in Structured Credit, but fundamentals remain supportive, and so we remain positive for the time being.
Figure 1 summarises our stance on different hedge fund strategies for Q4 2024
Figure 1. Q4 2024 Outlook Versus Q3 2024 Outlook
3. The Details
3.1 Credit
The economy has held up well, capital markets are accommodative, and the Federal Reserve’s rate-cutting cycle should ease financial conditions.
We have downgraded our outlook on Credit Long/Short to neutral from positive. High yield spreads remain near post-GFC tights, reducing attractive long opportunities. A high proportion of “problem” credits in the loan market makes shorting difficult. The economy has held up well, capital markets are accommodative, and the Federal Reserve’s rate-cutting cycle should ease financial conditions. Lower-rated credits have lagged, showing stress and elevated dispersion. However, subdued market volatility limits opportunities. Capital Structure Arbitrage remains a focus for many Credit Long/Short managers.
We remain neutral on Distressed strategies. Elevated defaults are expected to persist as higher rates impact more levered companies. However, expectations have moderated as the distressed universe is smaller, and capital market access has eased.
In Convertible Arbitrage, we remain favourable on the idiosyncratic opportunities in credit-sensitive and volatility-oriented convertible bonds for the medium term. However, near-term caution is warranted given the strong returns year-to-date, increased hedge fund interest, and broad markets trading around fair value estimates.
Overall consumer performance remains solid despite some recent mixed economic data.
Credit-sensitive convertible bonds have performed well year-to-date but still offer opportunities for alpha through credit selection and engaging with issuers in liability management transactions, such as buybacks and exchanges. Higher-quality, balanced, or higher-delta convertible bonds, like investment-grade utilities, could benefit from a sustained increase in volatility. Primary markets are expected to remain active as issuers address 2025/2026 maturities, creating opportunities from new issues and flows. Expanding issuer diversity should benefit the strategy’s long-term health.
The key risks to our positive stance in Convertible Arbitrage include a deep recession, a significant increase in defaults, or a substantial rise in net supply.
We remain favourable on Structured Credit opportunities in the medium term. Credit spreads across many sectors (despite a narrowing this year) remain wide relative to corporate credit markets and historical levels. Loss-adjusted yields remain elevated driven by higher base rates, wider spreads, and portfolio asset mix. Managers generally also have more senior and investment grade risk.
Overall consumer performance remains solid despite some recent mixed economic data. Aggregate debt and debt service costs remain low. Increases (from very low levels) in defaults and delinquencies for auto loans and credit cards have been most pronounced among younger, lower-income borrowers with low FICO scores. The residential mortgage-backed securities sector remains supported by ongoing house price appreciation, record homeowner equity, and favourable supply-demand dynamics. Commercial real estate debt has significantly repriced and remains one of the few distressed sectors, with considerable dispersion. The key risk for Structured Credit is a significant, broad-based rise in residential and consumer asset-backed securities delinquencies and defaults, driven by persistently high interest rates and/or significantly higher unemployment.
3.2 Quantitative Strategies
We remain positive in our outlook for Micro Quantitative strategies. Equity dispersion has remained high over recent months and returns from Statistical Arbitrage and other Micro Quantitative strategies has remained strong. Given the range of uncertainties facing the global economy, we expect to see a continued positive environment for Micro Quantitative strategies if volatility picks up and equity dispersion continues. Two areas of caution, however, are bringing us to the lower end of our positive stance. Firstly, global earnings-to-price convergence measures are now closer to long-term averages than at any point since the significant widening during 2018-2020. Secondly, we believe higher rates help correct market inefficiencies, and a rate-cutting cycle from the Federal Reserve may weaken this effect, especially if interest rates align more closely with long-term inflation expectations.
We believe higher rates help correct market inefficiencies, and a rate-cutting cycle from the Federal Reserve may weaken this effect.
In Macro Quantitative strategies, we maintain our neutral stance. Performance has been very weak for these strategies in the third quarter, but we do not believe that recent performance is out of line with what is historically a lower Sharpe ratio part of the hedge fund landscape. This could be driven by the strong performance of trend-following strategies in recent years, prompting other non-trend strategies to incorporate some trend exposure. This integration can create more pathways for the transmission of losses, given the highly leveraged and liquid nature of these strategies. As a result, we are not changing our expectation of returns from Macro Quantitative over the medium term, but we are mindful to reduce exposure where we have multiple sub-strategies in the same portfolio given this risk of higher correlation.
3.3 Macro
We maintain a positive view on Global Macro strategies, as changes to the global fiscal and monetary policy landscape can challenge investor sentiment and shift market narratives. While the direction of travel in interest rates is clearer, uncertainty remains around how far, and how fast, different central banks ease policy as officials’ focus moves from inflation to economic activity.
Political risks remain elevated heading into the US election. Changing political tides can accelerate a handful of structural macro themes, including supply chain realignment, defence spending and the transition to a greener economy. In the emerging markets, Turkey and Argentina are once again important regions of focus, while improving sentiment around China could ignite new macro themes.
3.4 Event Driven
Political risks remain elevated heading into the US election. Changing political tides can accelerate a handful of structural macro themes.
We have reduced our outlook on Merger Arbitrage to neutral given the balance of worsening indicators across the strategy. Deal volume has increased in 2024, with a good range of deals in the mid and smaller capitalisation spectrum, which is important for portfolio breadth. However, spreads have begun tightening, and the average downside/ upside ratio of the merger universe has increased to around 3x, nearing the long-term average of 3.8x.
The other key reason for caution is the significance of antitrust investigations, which have been painful this year, and could see a significant deterioration with a possible new US stance on cross-border deals post-election and the appointment of a new EU antitrust commissioner. In addition, measures of CEO confidence in the deal landscape have decreased in recent months.
In broader event strategies such as Special Situations, we remain neutral overall, but we see pockets of opportunity. Multi-event managers have shifted towards Event Credit as the higher interest rate environment pressures firms to restructure their balance sheets. More broadly, there is a strong flow of new catalyst ideas in both equity and credit, driven by restructurings and shareholder pressure to improve margins. Specific opportunities exist in the UK water and power sectors given the regulatory reviews, and we see interesting prospects in corporate governance reform in Asia, particularly in Korea and China, with continued opportunities in Japan.
3.5 Equity Long/Short
We are maintaining our positive outlook for low-net and Market Neutral Equity Long/Short strategies. However, while not quite ready to downgrade, we are slightly more cautious in the near term due to their strong year-to-date performance. Gross exposures remain elevated compared to recent history, possibly indicating higher manager risk-taking. Many prime brokers report that a larger portion of gross exposure is now in index and ETF positioning rather than single names.
The market neutral style of Equity Long/Short investing is more popular now than a few years ago, with more managers running more assets, particularly on larger multi-strategy platforms where leverage is driven by optimisation dynamics rather than a more aggressive stance from the managers themselves. We are closely monitoring whether this continued shift presents any additional contagion risks for the industry. Our current view is that risks such as momentum reversals may be more painful going forward, but that broader systemic risks is not materially heightened.
The link between fundamentals and price during earnings seasons remains strong, giving a tailwind to alpha generation through better research processes.
Dispersion in equity markets remains strong, and even with rates decreasing we expect there to be a positive cost of capital over the medium term. This should continue to force markets to be discerning on valuations. The link between fundamentals and price during earnings seasons remains strong, giving a tailwind to alpha generation through better research processes.
We remain neutral on Long-Biased Equity Long-Short, driven by our lack of clarity on the future path for equity markets. We continue to note the challenges posed by macroeconomic uncertainties and the overvalued nature of global equity markets, particularly in the US.
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