A more cautious stance
TSAI
1. Introduction
Financial markets are in a turbulent period right now, with global conflicts, central bank actions, and short-term volatility across all asset classes. Yet, despite this, the S&P 500 is still reaching new highs. It seems that two things are happening: one, the specter of inflation has been contained, and two, investors believe that policymakers will support them now that the rate-cutting cycle has begun in earnest in the U.S. and Europe.
From a hedge fund perspective, recent performance has been clearly divergent. Most strategies continued to deliver positive returns in the third quarter, with credit and market neutral equity long-short strategies continuing their recent strong run. However, systematic macro strategies had a very difficult quarter as many different asset classes saw a series of short-term reversals and false starts for new narratives.
2. Our Outlook
Against such a challenging backdrop, we downgrade our outlook on credit long/short to neutral from positive given the historic tightening of credit spreads. We also note that the growing regulatory challenges in the M&A space coincide with a slight decline in the risk/reward benefits of average M&A. As a result, we also downgrade our outlook on M&A arbitrage from positive to neutral.
Despite these two downgrades, we remain generally positive on the hedge fund space. We are closely monitoring the intra-market behavior of the equity markets, focusing on dispersion and valuation spreads, to determine the right time to adjust our outlook on micro-quant and market neutral equities long/short. We are not quite there yet. Similarly, spreads in structured credit continue to tighten, but fundamentals remain supportive, so we remain positive for now.
3. Details
3.1 Credit
We remain neutral on distressed strategies. High default rates are expected to persist as higher rates impact more leveraged companies. However, expectations have eased as the size of non-performing assets becomes smaller and access to capital markets is eased.
On the convertible arbitrage side, we remain positive on specific opportunities in medium-term credit-sensitive and volatility-oriented convertibles. However, given the strong returns so far this year, increased hedge fund interest, and the broader market trading around fair value valuations, caution is warranted in the short term.
Credit-sensitive convertibles have performed well year to date, but can still offer alpha opportunities through credit selection and liability management transactions with issuers such as repo and swaps. Higher quality, balanced or higher delta convertibles such as investment grade utility bonds are likely to benefit from continued volatility increases. The primary market is expected to remain active as issuers address 2025/2026 maturities, creating opportunities from new issuance and flows. Expanding issuer diversity should benefit the long-term health of the strategy. Key risks to our positive view on convertible arbitrage include a deep recession, a significant increase in defaults, or a significant increase in net supply. We remain bullish on medium-term structural credit opportunities. Credit spreads across many sectors (although narrowed this year) remain wide relative to corporate credit markets and historical levels. Loss-adjusted yields remain high, driven by rising benchmark rates, widening spreads, and asset mix. Managers also generally take more senior and investment grade risk. Despite some recent mixed economic data, overall consumer performance remains solid. Total debt and debt servicing costs remain low. Delinquencies and defaults on auto loans and credit cards are rising (from very low levels), most pronounced among younger, lower-income, lower FICO score borrowers. The residential mortgage-backed securities industry remains supported by continued home price gains, record homeowner equity, and favorable supply and demand dynamics. Commercial real estate debt has repriced substantially and remains one of the few distressed sectors, with considerable dispersion. The main risk to structured credit is that delinquencies and defaults on residential and consumer asset-backed securities will rise substantially and across the board, due to persistently high interest rates and/or a significant increase in unemployment.
Among macro quantitative strategies, we maintain a neutral stance. These strategies have had very weak performance in the third quarter, but we believe recent performance is partially inconsistent with the historically low Sharpe ratios in the hedge fund space. This may be due to the strong performance of trend-following strategies in recent years, prompting other non-trend strategies to incorporate some trend exposure. Given the high leverage and liquidity of these strategies, this consolidation could create more avenues for loss transfer. As a result, we do not change our return expectations for macro quantitative strategies in the medium term, but we are mindful to reduce exposure to multiple sub-strategies in the same portfolio given the risk of this higher correlation.
3.3 Macro
We remain positive on global macro strategies as changes in the global fiscal and monetary policy landscape could challenge investor sentiment and change the market narrative. While there is more clarity on the path of interest rates, uncertainty remains about the extent and pace of policy easing by different central banks as officials shift their focus from inflation to economic activity. Political risks remain high ahead of the US election. The changing political tides could accelerate some structural macro themes, including supply chain restructuring, defense spending, and the transition to a green economy. In emerging markets, Turkey and Argentina are again important areas of focus, while improved sentiment in China could spark new macro themes.
3.4 Event Driven
We have downgraded our outlook for Merger Arbitrage to Neutral given the deterioration in indicators across the strategy. Volumes have increased in 2024, with a broad range of deals across the small and mid-capitalization range, which is important for portfolio breadth. However, spreads have begun to tighten, with the average downside/upside ratio in the consolidation universe increasing to around 3x, close to the long-term average of 3.8x. Another major reason for caution is the importance of antitrust investigations, which have been painful this year and could deteriorate significantly with the new stance on cross-border transactions in the US after the election and the appointment of a new EU antitrust commissioner. In addition, CEO confidence indicators on deal prospects have declined in recent months. Across broader event strategies such as special situations, we remain neutral overall, but we see some opportunities. Multi-event managers have turned to event credit as the high interest rate environment forces companies to restructure their balance sheets. More broadly, there is a raft of new catalyst ideas in both equity and credit amid restructuring and shareholder pressure to improve margins. There are specific opportunities in the UK water and power sectors given regulatory scrutiny, and we see compelling prospects for corporate governance reform in Asia, particularly in South Korea and China, with continued opportunities in Japan.
3.5 Equity Long/Short
We remain positive on low net and market neutral equity long/short strategies. However, while not ready to downgrade, we would be slightly more cautious in the near term due to the strong performance of these companies so far this year. Total exposure remains elevated compared to recent history, which may indicate higher risk taking by managers. Many major brokers report that a large portion of total exposure is now in index and ETF positions 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 managing more assets, especially on larger multi-strategy platforms, and leverage driven by optimization dynamics rather than managers taking more aggressive positions themselves. We are closely watching whether this ongoing shift introduces any additional contagion risks to the industry. Our current view is that risks such as momentum reversals may be more painful going forward, but there has been no material intensification of broader systemic risks.
Equity market dispersion remains strong, and even with lower interest rates, we expect the cost of capital to remain positive in the medium term. This should continue to force caution on valuations. The link between fundamentals and prices remains strong during earnings season, providing a tailwind for alpha generation through better research processes. We are neutral on long-bias equity long-short strategies as we lack a clear view on the future direction of the stock market. We continue to focus on the challenges posed by macroeconomic uncertainty and overvalued global stock markets, especially the US stock market.