What Will Drive Market Volatility in 2025?

As we move into the holiday season, market commentators take it upon themselves to stuff our collective stockings with their forecasts for the coming year. Recent years have demonstrated how unpredictable the world can be and how this can rapidly impact markets and volatility levels. It is therefore with some trepidation that we discuss our thoughts for the year ahead.

As hedge fund allocators, our focus is less on the direction of markets (thankfully) and more on the opportunities that may present themselves within markets. Through this lens, we feel that one of the big differences between 2024 and 2025 may well be the nature of the factors driving market volatility. For the most part, 2024 has been a year of waiting — waiting for elections in many of the largest democracies and waiting for central banks to start cutting rates. Market volatility, when it has emerged, has largely been a function of a change in expectations of what’s likely to happen. One could even argue that the change in market positioning following the US election was still primarily influenced by speculative expectations, centred around investor interpretations of what a Donald Trump presidency would mean.

We believe that 2025, by contrast, will be a year when market volatility will be driven by actual events and not expectations. Trump will be in power, and markets can react to policy rather than speculation on social media. Central banks are now into their rate-cutting cycle, so we may see more changes to interest rates next year. There may even be more tangible geopolitical progress, particularly in relation to the situation in Ukraine, which has been at a near stalemate for the last 12 months.

Why does this matter? Fundamentally, the source of market volatility is important as it affects market efficiency. Most theories about market efficiency suggest that when circumstances change, market agents react to new information, helping markets reach a new efficient equilibrium.

Active managers, such as hedge funds, are among these agents. Therefore, real changes to the macroeconomic landscape, such as Covid, or the spike in inflation, led to the kind of market volatility on which macro hedge funds thrived.

In contrast, much of the past 12 months has been characterised by brief spasms of market volatility driven by fickle changes in expectations or shifts in market positioning—essentially noise—making it much harder to generate returns.

The flip side of this coin is that returns have been generated by trading opportunities arising from relative value mispricing within markets. Stable environments for equities and credit, such as those we've seen over the last two years, tend to be good for security selection disciplines. Hedge funds have seen strong uncorrelated returns across a range of strategies this year, whether they are human-driven discretionary Equity Long-Short or computer-driven Quantitative Equity Market Neutral.

This positive environment has been supported by two tailwinds:

• First, internal market dynamics were significantly misaligned by the Covid market shock, followed by the inflation shock. This is evidenced by the narrowing discrepancy between 'cheap' and 'expensive' stocks on an earnings-to-price metric globally over the past few years.
• Second, higher interest rates have acted as a positive restorative force on market pricing (discussed at length in previous Early Views).

All these factors may be challenged in 2025. If we are right about the real sources of macroeconomic change next year, the environment for equities is likely to be less stable. In addition, measures of intra-market dislocation in equities are much less pronounced than they were two or three years ago, and interest rates are coming down. For the first time in a while, it feels easier to be contrarian about the sources of alpha from hedge funds over the next 12 months: fade the strategies that have been performing well recently and seek opportunities in those that have struggled.

However, we started this piece with a caveat, and we’ll finish with one too. Timing hedge fund strategies accurately is almost as hard as timing markets. Good managers find ways to outperform regardless of the market environment.

Key drivers of hedge funds' performance: An early November snapshot

Equity long-short:

• Global equity indices continued to climb to new highs in November, led by the US
• Performance across the asset class was good last month, but this was mainly driven by beta. This reflects a tougher environment for shorting, as heavily shorted names have gone against consensus and outperformed global equities
• The outperformance of heavily shorted stocks has continued from October. Many of these stocks seem to have weaker fundamentals but may have been supported by broader market trends.
• Performance has been weaker for European-focused funds – both month-to-date and year-to-date – where equities have generally struggled to keep pace with their US counterparts
• While European equities were net bought last month, the increase was mainly driven by domestic funds, whereas US and global managers seemed less enthusiastic about the region

Credit:

• Credit slightly underperformed equities in November, with US loans, investment grade, and high yield all rising about 75-100 basis points each. High-yield credit spreads narrowed modestly, ending at levels close to the tightest since the Global Financial Crisis
• Corporate credit managers generally posted modest positive returns, with convertible arbitrage managers significantly outperforming for another month. These managers benefited from specific issuer-related events and stock volatility in the electric vehicle, crypto, and IT sectors. High-yield long-short and capital structure arbitrage strategies were also generally profitable, while portfolio-level hedges negatively impacted some managers
• GSE preferred securities, which are preferred stocks issued by government-sponsored enterprises like Fannie Mae and Freddie Mac, rallied strongly after the US election on expectations that these entities might exit conservatorship under the new administration
• Meanwhile, financial preferred securities declined, impacted by volatility in the rates market
• It was another positive month for Structured Credit managers, driven by carry as well as mark-to-market gains from several sectors.

Relative Value:

• Event-driven strategies generally struggled in November. Spreads in longer-dated situations widened, potentially due to some multi-strategy capital withdrawing, following deal break losses in October
• In Europe, some soft catalyst trades have been subject to degrossing as a result of the political and economic uncertainty following the US election. Encouragingly, several notable new deals were announced, including UniCredit's US$16 billion unsolicited takeover bid for Banco BPM, a take-private of Summit Materials (building materials) by Quikrete for US$11.5 billion, Charter Communications acquiring Liberty Broadband in a $12 billion all-stock deal and Amcor buying Berry Global (plastics packaging) for US$8.4 billion
• Deals that closed during the month include Centamin/Anglogold Ashanti, Axionics/Boston Scientifics, and Nuvei/Advent. Juniper Networks is under pressure as the Department of Justice is reportedly considering litigating to block the US$14 billion acquisition by HPE. Nippon Steel continues to try to conclude its US$15 billion US Steel acquisition before Trump, who opposes the deal, returns to office
• In Asia, a local consortium may step in as a "white knight" to support a management buyout for Japan’s 7&i to ward off Couche-Tard's hostile bid. In Korea, firms continue to announce corporate governance reforms, e.g. Samsung Electronics announced a US$7.2 billion buyback, and LG Uplus outlined mid-to-long-term financial goals, achievement strategies, and shareholder return plans

Discretionary Macro:

• November has seen strong performance across the Discretionary Macro peer group. Macro managers started the month with lighter risk as they awaited the outcome of the US election before deciding how to progress. Since Trump’s victory, there has been meaningful re-risking in ‘Trump trades’ and themes around divergent economic growth and policy outlooks
• Growing disparities between the US and euro area remain in focus. A broad long US dollar bias has been profitable as markets assessed the impact of US trade policy shifting toward a more protectionist stance, while economic data continued to support the narrative of US exceptionalism. Short-biased curve steepeners in the US performed well earlier in the month, though some giveback is expected due to price action in the final week of November. However, cross-market themes between US and euro area fixed income appear to have held up better
• Japanese themes also seem to have contributed positively. Much of the risk remains in short positions in Japanese government bonds (JGBs), although we have seen currency risk added against the euro rather than the US dollar
• Elsewhere, more idiosyncratic themes in emerging markets such as Turkey and Argentina benefited macro positioning. Brazilian rates trades looked set to reverse recent losses earlier in the month, though underwhelming proposals to cut fiscal spending saw the sell-off resume

Systematic Macro:

• Up until the last week of the month, trend-following strategies had been generating relatively attractive positive performance. The long US dollar positioning, which it appears almost all programmes have now adopted, has been beneficial as the incoming Trump administration outlined plans for implementing additional tariffs. Broad-based long equities positioning has also helped drive returns
• Despite weaker performance from commodity exposures, alternative trend strategies were also in the black in November, with long equity and credit risk contributing
• Other systematic macro programmes appear to have had a mixed performance. Commodities have been challenging, while some fixed income positions, particularly long positions in German Bunds, have proven to be profitable.

On the radar:

• The very short-term focus is on whether the equity rally will continue through the year- end, as is often the case in thinner seasonal markets while participants await the Trump inauguration
• In January, the focus will likely shift to Trump's first 100 days in office and whether he implements tariffs at the levels he threatened, potentially impacting global trade
• The concurrent risk for the first half of next year remains the trajectory of core data on inflation and employment, and the extent to which central banks have room to cut rates

All data Bloomberg unless otherwise stated.